Negotiating your lease? Make rent review clauses work for you

An essential term in any commercial lease negotiation will be the method and frequency of rent reviews. Generally the parties will have opposing objectives, with the landlord wanting the ability to increase the rent during the term, and the tenant wanting to ensure that the rent does not increase so much as to be prohibitive to its ongoing operations. In this context, prior to entering into a new lease, careful consideration of the various rent review options and their implications is crucial.

Rent Review Clauses

The current standard form Auckland District Law Society Deed of Lease (ADLS Lease)[1] contains two rent review options. Other (non-ADLS) forms of lease will also contain rent review provisions. There are advantages and disadvantages to all options, and they are usually favoured differently between a landlord and tenant. We address the three most common methods of commercial rent review, being: Market Rent Reviews, Consumer Price Index (CPI) Reviews and Fixed Increases.

Market Rent Reviews

This requires the rent to be reviewed in accordance with the current market rates of comparable premises as at the rent review date.  Whilst the ADLS Lease does not provide any detail as to specific regards and disregards to be considered in determining the proposed market rental, it is usual practise for the landlord to complete some form of due diligence to determine the current market rent. A registered valuation or, more informally, insight from registered real estate agents working within the relevant sector, are common methods of determining the current market rent.

Bespoke leases, as well as modified ADLS Leases, will often state those factors that can be taken into account and those that must be dismissed when market rent is assessed. For example, a valuer would usually be directed to ignore any goodwill associated with the tenant's business and any items of fit out which have been paid for by the tenant. The 2017 Supreme Court decision of Hubbard v Kiwirail Limited [2017] NZSC 153 provides a useful reminder that any particular elements of the lease which should be taken into account, or disregarded, at rent review time must be expressly stated in the lease. These could include a rent concession or lease inducement, or the fact that there is reduced certainty of tenure for a tenant (such as in the case of Hubbard v Kiwirail where the landlord had the ability to cancel the lease on 24 months’ notice). In theory a market rent review could be an upwards or downwards review, but the ADLS Lease provides that regardless of current market conditions, the reviewed rent must never be less than the rent payable as at the commencement date of the then current lease term. This is known as a ‘Soft Ratchet’. Bespoke leases, and amended ADLS Leases, may contain an even more landlord-friendly ‘Hard Ratchet’ provision, which requires that the reviewed rent must not be less than the rent payable as at the date immediately preceding the rent review.

Market Rent Reviews with ratchet provisions always favour the landlord because, in the worst case scenario (Soft Ratchet), the rent can only drop to what it was at the start of the term (whereas ‘true’ market rents may have fallen much lower than that in a market downturn). The main disadvantage with Market Rent Reviews for both parties is that as the economy swings so will the rent. As a result there is little certainty of what the reviewed rent will be until current market rates are appraised. Increasingly, landlords and tenants are finding that the time and expense of a market rent determination outweighs the benefits, particularly where the parties go to arbitration and or engage registered valuers.

Consumer Price Index (CPI) Rent Reviews

The Consumer Price Index (CPI) is published quarterly by Statistics New Zealand, and is the recognised measure of inflation in New Zealand. Commercial rent reviews which align with the movement in CPI have become increasingly common in recent years, with the ADLS Lease amended in 2012 to include a specific CPI Rent Review formula.

CPI Rent Reviews allow both landlords and tenants a degree of certainty as to the likely rent increase, and do not involve the cost, time, or potential risk of dispute, attached to a Market Rent Review. In recent years CPI increases (in line with inflation), have been low, meaning that CPI Rent Reviews have been more advantageous for tenants than landlords. However, inflation based reviews always contain an element of uncertainty compared to genuine fixed reviews.

As with Market Rent Reviews, CPI Rent Review clauses can be drafted to include ratchet provisions.

Fixed Percentage Rent Reviews

With Fixed Percentage Rent Reviews the lease provides that at the rent review date the rent will increase by a set percentage (ordinarily anywhere between 1% and 4%). Such reviews provide both parties with certainty as to what the revised rent will be after the rent review date, meaning the tenant will know exactly how much revenue they will have to generate to sustain the lease, and the landlord has some certainty of income. This method also reduces the potential for disputes between landlord and tenant.

Fixed Rent Reviews are potentially more favourable for a tenant in a strong economy where there is high demand for commercial property, because increases in the rent are capped at a time when market rents for other premises are increasing much faster. Conversely, in a market downturn where market rents are decreasing, the tenant would be stuck with predetermined rent increases, which could be significant over a long term lease.

Tempering Rent Reviews with Collar and Cap restrictions

The reality is that without the advantage of foresight there is no real way to predict which rent review mechanism will best favour a landlord or tenant. Often a mixed approach will be adopted. For instance, it is common to see CPI Rent Reviews or Fixed Percentage Rent reviews followed by a mid-term Market Rent Review to enable a ‘reset’ of rent back to market norms.

Another approach is to temper rent reviews by including ‘Collar and Cap’ restrictions. Collar restrictions prevent the rent from falling below a predetermined amount, and Cap restrictions prevent the rent from increasing above a predetermined amount. With careful drafting, these can be used in conjunction with both Market and CPI Rent Review provisions.

Rent Reviews form only one part of good lease due diligence and negotiations, but it is important for both parties to understand the long term implications of whichever mechanism (or combination of mechanisms) is adopted. Whether you are a tenant or a landlord, one of our experts will be happy to assist you to try and ensure the best outcome for you.

Footnotes

[1] Sixth Edition (2012) (5)

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