An integral aspect of commercial leases is the configuration of ‘rent reviews’ according to which rent is adjusted and agreed intervals during the lease term.
These intervals are the agreed review dates. The rental payable by the tenant after each scheduled review date is adjusted in accordance with an agreed formula that is set out in the lease.
The purpose of the rent review is to keep the rent that is payable from time-to-time at an appropriate amount taking into consideration the market for comparative properties and other factors such as inflation and perhaps even a landlord’s desired future return for the property.
Subject to the relevant retail leases legislation in the applicable state, parties can agree on any schedule and frequency they prefer for reviews. For example: annually, only upon the commencement of renewal (option) periods or both annually and upon renewal of option periods.
By way of illustration, on a lease duration of 5 years with a subsequent option period of an additional 5 years, the rent might be reviewed:
- once upon each anniversary of the commencement date by a fixed percentage increase;
- upon renewal of the lease for the option period according to market value; or
- both by a fixed percentage annually and then assessed against market at the commencement of the option period.
There are 3 principle types of review:
- Market Review;
- Fixed Review; and
- Consumer Price Index (CPI) Review.
A Market Review is in essence a review of the rent taking into account the comparable rental for similar properties on the market when compared on a like basis. Often, the process outlined in the lease provides that the landlord will, at the appropriate time, propose what it considers to be the market rental for the premises and the tenant can either accept that assessment or challenge that assessment. If challenged then generally (but not always) an independent rental valuation must be conducted.
The relevant Retail Leases legislation in each Australian state will generally be quite prescriptive about what can be taken into account when assessing market rent. For example, in Victoria, section 37 of the Retail Leases Act 2003 provides that:
“…the current market rent is not to take into account the value of goodwill created by the tenant’s occupation or the value of the tenant’s fixtures and fittings.”
Thus, the fact that the tenant has created a loyal clientele and the value to the tenant in keeping the premises is to be disregarded.
In a booming property market, landlords will often prefer a Market Review as it will mean that rent is often reviewed upwards, sometimes by exponential amounts if an area is experiencing particularly strong gains or becoming more affluent.
A fixed review generally consists of an increase to the rent by a pre-agreed percentage, for example, an annual increase to the rent of 3%. Therefore, if the rental was $100,000 per annum prior to the review, then subsequent to the review the annual rental would become $103,000.
Fixed reviews can be helpful to both tenants and landlords, but in particular, can offer certainty to tenants in buoyant markets that their rental will not increase by more than the agreed amount of the fixed increase (regardless of what is happening in the market).
A CPI review means that the rental is tied to movements in inflation and costs of living. The Australia Bureau of Statistics publishes the CPI and often the lease will specify the particular CPI that shall be the reference point (for example, Sydney, Melbourne or Perth).
Such a measure might be attractive to the parties as it ensures a level of fairness that the rental will remain in line with the cost of living at the time the lease was agreed. However, in times of historically low inflation, landlords have tended to prefer alternative methods particularly when demand in a particular area for properties is likely to increase (as CPI will not directly take account of the market for a particular property).
Which is best for me?
Well it depends. Not only on whether you are a landlord or a tenant, but also on your business objectives, market prospects and wider economic considerations.
If you are a tenant it might be vitally important to lock in overheads (and thus you might press for low fixed increases). However, this is not always the case. For example, if you believed that you have secured a location that is likely to only deteriorate in desirability over time, you might prefer that reviews regularly go to market to ensure you are paying a fair rent throughout the term.
An important thing to remember for tenants is that small, fixed increases add up over time, particularly because the increase percentage is generally calculated on the basis of the previous year -not the original rental. Thus caution should be exercised in agreeing to higher fixed annual increases on longer term leases. For example, a 5% annual increase on a 10 year lease term would mean that a rental which started off at $100,000 per annum would exceed $155,000 by the 10th year.
For landlords, your preference might change depending upon your desired returns for your investment, the nature of the property market and the desirability of comparable properties in a particular area.
Landlords might often seek to hedge their bets with a mixture of fixed increases and market reviews. However, in a market where commercial space is increasingly abundant and inflation is not particularly high, then locking in a fixed increase may be a preferable safe haven.
A landlord’s choice of review type may also be impacted by whether the lease is one which is covered by the applicable retail leases legislation in the relevant state. For example, most states in Australia have provisions in their retail leases legislation which prohibit a landlord from relying on a clause which allow increases but prevent decreases (often referred to as ‘ratchet clauses’). Thus in an unstable or weak market, a landlord with a ‘retail lease’ may want to avoid the risk of a market review dragging the rental downwards.
If you would like assistance in negotiating the right rent review regime for your business or require advice on commercial leases generally, get in touch for some practical, commercial legal guidance.