Two months into the year, the outlook for the Victorian industrial market in 2015 looks to be positive. A depreciating Australian dollar has given manufacturing and exports a better platform for growth, stimulating further activity in the industrial market. Structural changes in the retail sector are benefiting the market, alongside the evolving ‘clicks and bricks’ online retailing business model.
With the likelihood of increased transactional activity, and continued interest from funds and trusts, it is a timely reminder for industrial developers and investors to cut deals that will maximise asset value, and stand up to valuation and operational scrutiny in the long term. In other words, sustainable deals.
During 2014 there were a number of cases which provided a reminder that, when tenants face operational stress, they will be more likely to challenge and test lease terms and conditions given the potential financial consequences.
2014 continued to see significant movement in incentives offered to tenants. Compared to a historic range of 5 to 12 percent, we observed incentives of between 5 and 25 percent. Larger incentives were more substantial at the prime end of the market, but filtered through to the secondary market.
It is not unusual for leases to contain incentive clawback regimes for landlords in the event of tenant default or, perhaps, even assignment. However, the 2014 Queensland case of GWC Property Group Pty Ltd v Higginson punctured the enforceability of such clawback regimes.
The Queensland Supreme Court held that incentives could only be recovered by landlords under a clawback regime if the amounts to be recovered were a genuine pre-estimate of loss.
The court held that, as the landlord had agreed in a commercial arm’s length deal the incentives to secure the lease, clawing back some or all of those incentives did not equate to recovering a genuine pre-estimate of loss. The landlord was not entitled to be put in a position as if he had never agreed the incentives as part of the commercial deal. Such a clawback was deemed to be a penalty and unenforceable.
So, what did we learn?
- This was a Queensland case, and so only persuasive in Victoria, but landlords who ignore the outcome do so at their peril.
- Clever drafting (including using side deeds/incentive deeds separate to the lease) will not change the above interpretation.
- Developers and investors may want to consider structuring a different commercial deal to minimise exposure. For instance, can the incentives be provided to the tenant over the course of the lease term, rather than upfront? If the tenant then defaults, such a regime might prevent the tenant from claiming any remaining incentives.
Finger on the price pulse
Market rents rise and fall over time. Landlords will ideally manage these peaks and troughs by including a rental floor in a lease, and landlord discretion whether or not to trigger a rent review. Clarity of drafting of those provisions, and following the mechanics of those provisions carefully, is imperative as can be seen from the following two cases.
In the 2014 case of Growthpoint Properties Australia Limited v Australia Pacific Airports (Melbourne) Pty Ltd the Victorian Supreme Court considered the issue of landlord discretion to trigger a rent review. The leasing documents in question provided, in essence, that the rent could rise or fall on a market review. Market rents had fallen, and the landlord did not want to trigger a review.
The rent review clause of the lease provided that the rent ‘is to be adjusted’ to market in accordance with rent review provisions contained in a corresponding schedule. The corresponding schedule provided that the rent ‘will be adjusted…if’ the landlord served a notice triggering the review. The tenant claimed that the landlord was compelled to trigger a rent review, given the imperative language in the lease rent review clause. The landlord claimed that, given the conditional language of the corresponding schedule, whether or not a market review occurred was at its discretion.
After a tour de force forensic examination of all relevant lease terms, including the meaning of terms ‘shall’, ‘will’, ‘is to be’, ‘must’, ‘if’ and ‘may’ among other terms, the court found in favour of the landlord. It found that the lease, as a whole, provided that the relevant schedule took precedence over the other lease provisions dealing with market rent review.
In Sentinel Asset Management Pty Ltd v Primo Moraitis Fresh Pty Ltd  the tenant failed to respond in time to a landlord’s notice of rent review. The lease provided that within 30 days of the landlord’s assessment of the market rent the tenant was to respond with its assessment of the rent. If it did not, the market rent was deemed to be the rent specified in the landlord’s notice.
The tenant responded after 31 days that it was in the process of obtaining its own market rent review valuation. It did not respond with its assessment of the market rent until 56 days after it received the landlord’s initial notice. The landlord took the view that the tenant was out of time, and that the landlord’s initial assessment of the market rent should be taken to be the market rent.
The tenant raised a number of arguments to try and counter the landlord’s position. The court held that when a lease contains a mechanism which prescribes the consequences for a party which fails to submit its own assessment of the market rent within a certain period, that is indicative that time is ‘of the essence’. The tenant was unsuccessful in its defence. The landlord’s assessment of the market rent in its initial notice was held to be the market rent for the purposes of the review.
Take away two
- Rent review provisions provide fertile ground for landlord and tenant disputes. Absolute clarity of drafting in the lease is essential.
- Timelines in rent review provisions are not to be taken as a guide. They must be followed carefully. The lesson applies to tenants and landlords equally.
Testing times ahead?
Whilst the leasing clauses highlighted in the above cases may not immediately adversely affect any valuation at the outset of a lease, they will become live operational considerations when the time comes to apply those clauses. In challenging economic times, they are more likely to be tested by tenants. At that point, they might have a very real impact on value and income stream.