Market rent review clauses – the devil is truly in the detail
Rodney Timm, director of Property Beyond, shines a light on these critical clauses.
Many commercial lease agreements have market rent review clauses, either in the middle of the initial term of the lease, or at the time when an option to renew the lease is being exercised. In a long lease, a mid-term rent review – although irritating to a tenant – is probably understandable from an owner’s perspective in terms of wanting the lease rental to reflect market value as the dynamics of supply and demand push rentals up. Should the market be deflating, the owner will obviously not want the rent to go down, and is usually protected by some form of ‘ratchet’ clause.
Aside from the administrative problems that arise in the process of landlords issuing market rent review notifications and tenants responding, the interpretation of a market rent review clause can cause significant problems. Too often, these clauses are drafted by solicitors who don’t fully understand the dynamics of the property market with regard to how incentives work and market rents are determined. Consequently, the clauses can be ambiguously or incorrectly worded and open to a range of interpretations. A good check of a market review clause is whether you need a solicitor to interpret it – if this is the case, it is probably not as clear as it should be!
To avoid these complications, it is best for both parties to have the market rent review clauses drafted, covering the specific details that the valuer appointed should take into account in determining the market rent. Whether the key components of the market rent review clause favour the landlord or the tenant is usually determined by the bargaining of the initial lease negotiations. The key focus should be that the criteria are agreed upon, clearly defined and understood by both parties at the commencement of the lease. Any future debate in the process can then be focused on the ‘true’ market rent in terms of the definition, and not the ambiguities of what should and should not be included.
Typically the types of criteria that should be considered in determining the new market rents at the review date, and therefore noted in the review clause, should include the following:
Willing but not anxious parties – noting that the lease arrangement is between a willing but not anxious lessor and a willing but not anxious lessee as at the market review date and any special needs should be ignored.
Comparable premises descriptions – including building grade, presentation, amenity, location and similar aspects in respect of the premises in which leasing transactions are to be used as comparable rental evidence.
Rent structures – ensuring that all comparable rentals are adjusted appropriately to reflect the type of rent structure of the subject lease and premises related to outgoing recoveries, general maintenance, cleaning and other property services obligations.
Goodwill–attached to the premises due to the lessee’s occupation of or business in the premises and whether this should be taken into account in the review process. Generally this goodwill value will be excluded.
Ready for occupation – on the basis that the premises are assumed to be ready for immediate occupation and use by the lessee and not requiring a period for fitout.
Use of premises – under the permitted use clause of the subject accommodation is the same as the permitted use of the comparable premises being used as evidence.
Condition of premises – noting that any adverse condition that will likely affect the rental value of the premises arising out of a breach by the lessee or lessor is deemed not to have occurred and should be ignored in the review process, as such breaches should be rectified in terms of other remedies within the lease agreement.
Lessee’s fixtures – including the value of the lessee’s equipment and any improvements to the premises or the building made by the lessee or provided by, paid for and owned by the lessor, should generally not be taken into account in determining the market rent.
Destruction or damage – noting that if the premises or any other parts of the building have been destroyed, damaged, in need of repair, or are being refurbished, that these parts are deemed to have been fully repaired and restored for the purposes of the rent review process.
Single or multi-level lettings – evidence being able to be used although the premises, possibly leased over many levels can or cannot be valued on a floor by floor basis, without premium, discount or deduction due to the fact that the premises may comprise more than one level. This can work in the favour of the lessee or the landlord dependent on the demand and supply dynamics of the market at the time of the review.
Sub-lettings rentals – in sub-leases or other concessional occupational arrangement within the premises, building or comparable properties should or should not be excluded as evidence in the review process.
Period between reviews – which will elapse between the current and the next review date should or should not be ignored and impact the determination of the market rent.
Length of term – applicable in the review should or should not relate to the entire term of the lease agreement and may even include further terms covered by options for further terms, despite the fact that part of the term may have elapsed as at the review date.
Ancillary rights granted – that should or should not be taken into account, such as naming or signage, installation of communications equipment, storage areas and similar should be clearly be defined.
Make good – obligations of the lessee whether standard, reduced or negligible and whether these make good obligations at the expiry of the lease should or should not be considered in the review process.
Ratchets, caps and collars – that may be applicable in the final determination of the market rent for the premises need to be specifically detailed so that the rent payable going forward can be adjusted appropriately as agreed.
Submissions and evidence – related to review process that may be provided by either or both parties as to their assessment of the market rent and whether this evidence should be considered or not.
Abatements and incentives – with specific and clear direction as to whether there should or should not be any reduction in the rent determined, taking into account market incentives, abatements, concessions, inducements or reductions paid, payable, granted or allowed in the subject premises lease or any lease of the comparable premises being used in the process.
As a closing note, the last consideration related to abatements and incentives will determine whether the rent determined is ‘effective market rent’ – that is, calculated after adjustments are made for incentives, or ‘face market rent’ – ignoring such payments and inducements. As a general rule, mid-term rent reviews should be based on ‘face market rents’ while rent reviews at the exercise of an option should be based on ‘effective market rents’. However, as landlords tend not to favour ‘effective market rents’ the review process may result in a ‘face market rent’, with the landlord required to provide a market-based incentive to the lessee to induce the tenant to exercise the option.