Rent Review Clauses in Commercial Leases
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One of the primary considerations when valuing a commercial property is the quality and quantity of rental that the property produces. The strength of the rental stream (determined by the length of term of the lease, quality of tenant, and the strength of the rent review clause) is central to capitalisation rate selection and value.
The wording of rent review clauses is therefore important for landlords, in achieving maximum rent and maximum value, and also for tenants so they are not tied into paying above market rents.
A brief analysis of some of the standard rent review clauses and their effect are set out below:
Mandatory or Optional Rent Review: Clause 2.1 of the Auckland District Law Society (ADLS) standard form Lease 3rd Edition 1993(2) states that "the annual rent may be reviewed by the landlord as follows." The word "may" is a discretionary term that allows the landlord to review the rental at his/her option. Often the word "may" is replaced by "shall".
The word "shall" is commonly misinterpreted as meaning that a review must take place as at the review date. This misconception can cause undue stress for landlords, particularly in the situation where a lease does not contain a ratchet clause and market rentals have fallen since the previous review. The 1997 Privy Council decision Melanesion Mission Trust Board v Australian Mutual Provident Society held that the word "shall" does not oblige either party to seek a review, but rather identifies the course of action to be taken for a valid rent review to be achieved, that is, the review remains at the landlord's option.
Ratchet Clause: A ratchet clause is a clause which prevents a proposed new annual rental (upon review) from being set lower than that payable immediately prior to the rent review. A ratchet clause can have the effect of creating a two-tier rental market. This results from the locking in of tenants by ratchet clauses to rental payments higher than they would agree to pay if they were starting a new lease.
When drafting a lease a landlord should include a ratchet clause, or at the very least, a partial ratchet clause i.e. a clause allowing the rent to go up or down upon review, but preventing the rental from falling below the commencement rental. The insertion of a ratchet clause allows the retention of a minimum rent or alternatively allows the landlord the discretion to reduce the rent in situations where there is an oversupply or where the tenant is struggling.
A tenant on the other hand should try and avoid the insertion of a ratchet clause, as this will allow the rent to fall during periods of oversupply.
Rental Incentives: Rental incentives, such as rental holidays and cash backs, are designed to tie tenants into property at high face rentals. The tenants after receiving the incentive can in effect be paying the market rental when the incentive is spread over the first term of the lease. The danger to the tenant arises at the first rent review. If the rent review clause is supported by a ratchet clause, it may have the effect of tying the tenant into paying the full-face rental, which in effect may be higher than market rents.
Tenants Improvements: A rental assessment performed by a registered valuer should ignore the tenants improvements on the basis that the tenant should not be held liable to pay rental for improvements that the tenant has made to the landlord's property.
To ensure that a fair market rent is assessed, a tenant prior to the signing of the lease should quantify the level of the tenant's improvements. A particular area to be noted is the fit-out i.e. who supplied the partitions, carpets, air conditioning etc. Evidence of costs, together with photographs (preferably dated) showing the exact nature of the premises being leased, will minimise future disputes and enhance the long term relationship of the parties.
Rent Review Date: The dates of any impending market rent reviews should be diarised by the landlord and actioned on time to receive the full benefit of the review. Clause 2.1(d) of the ADLS standard form Lease 3rd Edition 1993(2) states that the annual rent so determined or accepted shall be the annual rent on the review date or the date of the landlord's notice, if such notice is given later than three months after the review date. Therefore, if a tenant is notified twelve months after the actual review date, the landlord will only be able to claim any increase from that date.
Conclusion: The above is a basic overview of some of the standard rent review clauses. To the uninitiated, lease negotiations can be a harrowing exercise, but it need not be. We have extensive experience in negotiating and drafting leases and would be happy to assist you in all your leasing needs.
If you would like any assistance on Commercial Leasing please contact Philip Dreadon c/- Greig Bourke, Solicitors.
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