When a landlord grants a lease of commercial premises to a tenant, the initial rent is negotiated and agreed between the parties. However, where the term of the lease is longer than a few years, the initial rent may not represent the true value of the premises for the whole term. Most commercial leases therefore contain a rent review clause allowing for the rent to change over time, to reflect the changing value of the premises and the lease.
Types of Rent Review:
The most common type of rent review clause provides for the rent to be reviewed to the best rent available on the open market – see Open Market Rent Review below. However, alternative forms of rent review include:
- Indexation – where the rent is increased in line with the increase in a published index, such as the Retail Prices Index. This offers the advantage of simplicity and ease of calculation, but may not accurately reflect changes in the value of property, which is influenced by different factors.
- Turnover rent – where the tenant pays a (lower) basic rent, plus a percentage of the turnover of the business (usually retail) conducted on/carried out on at the premises. This can be a way of sharing the risk of an uncertain new venture between the landlord and tenant, and also provides an incentive for the landlord to help ensure that the tenant’s business is successful. The burden of producing accounts and demonstrating the level of turnover falls on the tenant, and can be onerous. The rent payable can vary from year to year, dependent upon the success of the business.
- Stepped increases – where the rent increases are agreed at the outset. This offers the advantage of simplicity and certainty, but may not reflect actual changes in the value of property. For this reason, stepped increases are not often contained within commercial leases.
- Side-by-side / “geared” rent – where a head landlord (often a local authority) lets land to a developer who develops and underlets the land; the head landlord receives a (lower) basic rent, plus a percentage of the rental income from the underleases. Such an arrangement allows the parties to share both the risks and the rewards of the redevelopment.
Open Market Rent Review:
Most commercial leases provide for an open market rent review, i.e. rent is reviewed to the level of the best rent obtainable for the property on the open market, usually at 5-yearly intervals. (Most reviews are upwards only – see General Points for Consideration below.)
To establish the open market rent, it is assumed that there is a willing landlord and a willing tenant (not necessarily the current landlord and tenant), and that the hypothetical lease is to be granted (usually) for a term equivalent to the unexpired residue of the term of the existing lease.
The hypothetical new lease to be valued is usually broadly on the same terms as the existing lease other than rent, although some specific provisions of the existing lease may be expressly excluded, particularly if some personal concessions have been given to the original tenant.
A standard rent review clause will also contain various assumptions (e.g. that the tenant has complied with its obligations under the lease so far, and that the property is ready for immediate occupation and use), and disregards (e.g. any improvements made at the tenant’s cost, and any goodwill attributable to the tenant’s current occupation).
Rent reviews often give rise to disputes – after all there is much at stake for both parties – so every effort should be made to ensure that the rent review clause, albeit artificial, is at least internally consistent and coherent.
The rent review clause will also contain mechanisms for:
- instigating the review (can it be triggered by either party, or just the landlord?)
- dispute resolution, if the parties cannot agree the reviewed rent (usually determination by an arbitrator or expert), and
- the tenant to make a balancing payment following a late review, in respect of any rent shortfall, plus interest.
Once agreed, the reviewed rent should be recorded in a rent review memorandum, which should be signed by the parties in duplicate, and attached to the original and counterpart lease.
General Points for Consideration:
- Upwards only?
Historically, reviews have conventionally been upwards-only, such that if the value of the premises goes up, the rent goes up, but if the value of the premises falls, the rent stays the same. Many tenants find this unfair, and argue for upwards-or-downwards review, as a more accurate reflection of the value of the premises.
- Break option linked to review?
The lease may contain a break option linked to the rent review, such that if the tenant is unhappy with (or unable to pay) the reviewed rent, it can terminate the lease. Such clauses must be drafted carefully to ensure that the tenant does not inadvertently lose the right to break the lease.
- Stamp Duty Land Tax
Whatever type of rent review is chosen, the Stamp Duty Land Tax implications must be considered.
If the lease provides for a rent review during the first five years of the term (other than the last three months of such five year period), an estimate of the revised rent will have to be made at the outset, and SDLT calculated on this basis. After the end of this period, or once the revised rent becomes known if earlier, a further SDLT return will have to be made, and additional SDLT plus interest may be payable.
Rent review clauses are complex and contain many potential pitfalls. They must always be drafted with the utmost care. The specific wording of a rent review clause will depend on the circumstances of the individual letting and the individual parties involved.
If you have any questions regarding rent reviews in commercial leases or require any assistance, please do not hesitate to contact us at: firstname.lastname@example.org.