Commercial Rent Review Clauses Explained

Rent reviews in commercial leases are generally carried out when a landlord wishes to bring the rent in line with the current market level.

The following guide explains how rent reviews work in practice and what they mean for the landlord and tenant.

 

What is a rent review clause?

 

A rent review clause is a contractual mechanism contained within a commercial property lease that enables a landlord to periodically adjust the rent during the lease term. This means that, in certain circumstances, the rent can usually be increased by the landlord in most cases to bring the rent in line with the open market rental value, ie the rent the landlord could receive if the property or premises were rented under the same conditions to a third party. Rent reviews usually take place every three to five years.

The lease is a legally binding agreement between the landlord and tenant, or the lessor and lessee, and sets out the terms and conditions that regulate that contractual relationship. The lease essentially represents the principal document governing the lessee’s occupation of the business premises in question. In addition to setting out the parties to the lease, and the term of the tenancy and amount of rent payable, the provisions of a commercial lease will also set out the legal rights and responsibilities of both parties for the duration of the lease term, including the right of the landlord to review the rent at specific intervals.

 

What does a rent review clause do?

 

A rent review clause is an important tool for landlords, especially in the context of long leases, where a landlord may want to ensure that they are not undercharging later on in the lease term, and have the contractual right to increase the rent, where appropriate to do so. Typically, a longer lease of commercial premises will incorporate one or more rent review intervals during the lease term, for example, a commercial lease with a term running for a period of 15 years may have rent review intervals every fifth year of that term.

From a tenant’s perspective, where a rent review clause is included within the terms of the lease, whilst they may be at risk of having to pay a higher rent later down the line, it can often mean that the initial rent payable is lower. This is because the landlord is not having to factor in any increase in market value or inflation from the outset. As such, rent review clauses can often represent a useful negotiating tool for both parties to the lease.

So, when negotiating the terms of a commercial lease, how do the parties establish a fair balance when it comes to rent review clauses? And what type of rent review clauses can a tenant expect to find within any existing commercial lease agreement?

 

What should a rent review clause include?

 

The commercial lease should state any assumptions that apply to the agreement, such as drawing comparisons with similar premises and that where a property can be used for different purposes where one purpose is of higher value than the other (the difference between the value of storage space over factory space, for instance) the rent will be charged at the higher value.

When it comes to what an effective rent review clause should include, much will depend on what best reflects the parties’ respective interests, although this type of clause is typically designed to favour the landlord. Fixed or stepped rent review clauses are the easiest and cheapest form of rent review, where the rent is not so much reviewed as increased by a set amount at pre-agreed intervals, for example, a £1,000 increase per year. Rent can also be linked to the tenant’s turnover, although this is not technically a rent review, but rather a mechanism whereby some or all of the rent payable by the tenant is determined by their takings, in this way allowing a landlord to potentially benefit from the tenant’s success.

However, the two most common types of rent review clauses used to assess any potential rental increase are open market rent review and index-linked rent review clauses.

 

An open market rent review clause

 

This is the most commonly used rent review clause within commercial leases. This is where the review takes place based on what the open market would consider the rent to be for a new hypothetical lease on exactly the same terms as the existing lease, if it were to be granted on the date of the review. In this context, when the time comes for a rent review, the landlord and tenant will attempt to agree to any rent increase between themselves, but if they cannot agree, the parties will refer the matter to an independent surveyor to assess the rental values with reference to similar sized-properties in the same or surrounding area.

However, it is usual to include in the lease certain things that must be assumed or disregarded by the surveyor when valuing the rent at the review date. These assumptions and disregards refer to what factors should be both assumed by the surveyor when conducting the rent review and what should be ignored. For example, an assumption can be made that the property is in a good state of repair, even if it is not, whilst a disregard might operate so that any improvements made by the tenant must not be taken into account.

In many cases, open market rent review clauses will be on an ‘upward only’ basis. An upward only clause will mean that even if the market rents in the area in question have fallen, such that a higher rent cannot be justified, the rent will not decrease. In this way, even though the rent may stay at the same level, rather than increase, the landlord has still protected their financial interests moving forward into the remainder of the lease term.

 

An index-linked rent review clause

 

For those landlords who prefer more certainty when it comes to rent increases, an index-linked rent review clause will be calculated in accordance with a form of index, typically the Retail Prices Index (RPI). This means that the rent will increase by the same percentage as any RPI increase over the rent review interval, not only keeping the rent on business premises in line with inflation, but providing a fair and equitable way of reviewing the rent.

The lease itself will typically contain a calculation enabling the parties to precisely determine what the rent will be on the set review date, enabling both the landlord and tenant to monitor inflation and forecast any pending increases in rent.

 

Giving notice of a rent review

 

The Law of Property Act 1925 section 196(1) states that any notice or counter-notice (reply to the notice) must be given in writing. The landlord should include the proposed change to the amount of rent in the notice so that the tenant can respond. Notice should be given around three months before the rent review begins. This allows the tenant sufficient time to gather any supporting documents should they wish to negotiate the new rent.

There will generally be a deadline for the tenant to respond by. If the tenant wishes to reject a proposed rent increase and enter into negotiations, then they must reply before the deadline.

Any communication rejecting the proposed rent increase should be made in writing before the deadline, giving the tenant’s reasons.

 

If the rent review is agreed

 

When the rent review is agreed, the relevant documentation should be signed by both the landlord and the tenant. A copy of the signed agreement should be attached to the tenant’s commercial lease as proof that both sides have agreed on the new rent.

Until the landlord and tenant have reached an agreement on how much rent should be paid, the tenant will continue to pay the old rent amount.

 

If the rent review is not agreed

 

If the tenant objects to the rent increase they will need to provide evidence to negotiate a lower amountm which could include:

 

a. Information on the rents charged for similar premises in the local area.

b. A valuation provided by a professional third party such as a surveyor or commercial estate agent.

 

Rent reviews may also give rise to reviewing or negotiating other aspects of the commercial lease.
If the landlord has not fulfilled certain obligations, for instance, not maintaining the electrical system of the building to a safe standard or not repairing a faulty roof, the tenant may use this as bargaining tool, either to retain the rent at its current level or to have the required works carried out before the rent is increased.

 

Involving a third party in rent review negotiations

 

If the landlord and tenant cannot agree on a rent review, most commercial leases will state that an independent third party should be called in to resolve the dispute. Generally, this will be a chartered surveyor.

The first step is to agree on who that third party will be. Both the landlord and tenant have the right to reject the other’s suggestion on the third party, but if they cannot come to an agreement, the choice will generally by made by the President of the Royal Institution of Chartered Surveyors.

The third party will take into consideration evidence from both the landlord and the tenant, and either side may also use a professional adviser such as a solicitor to act as a go-between.

The third party will also decide on how any fees or other costs incurred will be shared between the landlord and the tenant, although if one side is seen to be unreasonable in their response to the rent review, then they may be ordered to pay the total costs.

The main issue of involving a third party is the expense incurred, plus the costs of any legal advice. However, where the landlord and tenant cannot agree, it may be the only option.

Once the third party has come to a decision, the new rent amount will be set in place and should be paid from then on. At that point, the new rent will be backdated to the rent review date, possibly with interest charged.

 

Common disputes relating to rent review clauses

 

First and foremost, regardless of how rent is calculated on review, any rent review clause contained within a commercial lease must be clear and precise in its scope. A poorly drafted clause is one which is most likely to lead to a dispute between the parties, where it is unclear as to when or on what basis a rent review can contractually come into play. The lease will need to specify when the rent review can be exercised, the exact basis on which this can be calculated, as well as any procedural requirements surrounding this. In the context of an open market rent review clause, this would need to start with, for example:

“It is hereby agreed that at each review date the yearly rent first reserved and payable shall be reviewed and, on or after each review date, the yearly rent payable in respect of the premises shall be such sum as agreed between the landlord and tenant, or to be determined by an independent surveyor if the landlord and tenant are unable to agree, as representing at the relevant review date the yearly rent at which the premises might be expected to be let in the open market for a term of years equivalent to the term as between a willing landlord and willing tenant on the same terms in all other respects etc”. This already complex clause would then need to stipulate in detail any assumptions and disregards, such as any works carried out by the tenant, as well as the relevant procedural requirements.

It is also important to bear in mind, especially from the landlord’s perspective, for whom the rent review clause is often an important tool, the complexities, costs and time involved in exercising this type of clause. For example, where the lease incorporates an open market rent review clause, if a rental increase cannot be agreed between the parties, this can involve a lengthy process of instructing and contributing to the cost of a surveyor. There is also no guarantee, even having embarked on and paid for this process, that the rent will go up. In some cases, despite the passage of time, market rents may have remained the same or gone down in value, and whilst an upward only clause will protect the landlord by preventing any decrease in rent, an increase is by no means a foregone conclusion.

Equally, landlords must factor in the risk that where the rent does go up, justified on the basis of either an increase in open market values, or in line with inflation, a tenant who is already struggling to meet their existing rent may find themselves in even greater financial difficulty when faced with a higher rent. This may leave the landlord without a tenant altogether, plus rent arrears, if the tenant can no longer afford to pay their outgoings.

Increasing rent on commercial premises can even lead to established and solvent business tenants looking for alternative places from which to run their business, and exercising any break clause within the lease as soon as possible. A break clause, also known as an option to determine, is a contractual provision that can provide one or both parties with a pre-defined mechanism to terminate the agreement early. This is a way of offering either party to whom the option applies the flexibility to lawfully bring to an end their contractual obligations if their circumstances change or they just want out.

As with rent review clauses, break clauses are common in longer leases, where an option to terminate the lease prior to expiry of the fixed term is either provided for on a specified agreed date, such as the mid-way point of the lease term, or at any point after a certain number of years and, in either case, on notice. By exercising the right to terminate the lease under a break clause, the lessee looking to downscale to save money, or simply to stay in business, may be easily able to terminate the lease early following a rental increase.

A commercial lease is a legally binding document with potentially far-reaching implications for both parties, where it is important for any prospective landlord or business tenant to secure specialist advice regarding their rights and responsibilities before signing a lease.

In particular, when agreeing to the terms of a commercial lease, one of the key clauses to be decided upon is the level of rent, as well as how and when this is to be reviewed. As such, before formally entering into a lease agreement, both parties should each seek independent legal advice as to the terms and provisions that may need to be included, and by which they will be contractually bound, including the provision and scope of any rent review clause.

As with any other lease clauses, a rent review clause will initially be a matter of negotiation between the parties. However, the clause must be clear and transparent, and not open to interpretation, in this way minimising the possibility of any potential dispute that may arise over when a rent review clause can be exercised and on what basis. Equally, in any scenario in which a rent review clause has been included within a commercial lease, and is due to be exercised, expert legal advice again may need to be sought by the parties where there is any dispute as to how that clause should operate in practice and the scope of its provisions.

A specialist property solicitor can provide both legal and practical advice in the context of commercial leasehold premises, helping to negotiate acceptable terms to suit a parties’ business needs and/or helping to resolve any existing dispute around a rent review. A specialist solicitor can also advise on various other potentially problematic provisions found within commercial leases, including provisions for alterations, repairing obligations, insurance provisions, provisions dealing with the tenant’s interest in the lease, provisions for lease renewal and provisions for termination of the tenancy, including break clauses.

 

Legal disclaimer

 

The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.