In the current economic downturn, there has been a lot of focus in the real estate industry on the effect of tenant insolvencies, "pre-pack" administrations and lease disclaimers. However, tenant failures are only part of the story. In a business environment where real estate investment and development opportunities are harder to come by and yields harder to maintain, a fall in the real estate market tends to encourage tighter asset management. This increases the potential for conflict between landlords and tenants.

Conditional Break Options  

Inevitably, the current market conditions mean that many tenants who committed to leases in better days will be looking to down-size or take advantage of a declining property market to find alternative premises. The more far-sighted of tenants may have anticipated a change in circumstances and negotiated break options in their leases that have conditions attached.

The Commercial Lease Code, a voluntary industry code introduced in 2007 seeks to abolish conditional break options altogether in new leases. In the meantime, however, many leases that are subject currently to tenant breaks may have any number of conditions attached.

By far the most common condition requires the tenant to have paid rent and other sums due under the lease up to the break date. In these circumstances, both landlords and tenants may be surprised to learn that if rent is payable quarterly (or by reference to some other period) all rent must be paid on the relevant payment date that precedes the break date, even if the break will terminate the lease part way through a rental period. There is no ability for the tenant to apportion rent and still comply with its break condition, unless it is specifically entitled under its lease provisions to do so. The reason for this is that there is no right to apportion rent at Common Law. The Apportionment Act 1870 grants a statutory right to tenants to apportion rent where they pay in arrears. However, it does not apply to rent paid in advance.

The upshot is that tenants must be very careful to make sure that they pay rent in full on the payment date prior to the break date. Landlords may receive an unexpected windfall in troubled times, and indeed better advised landlords may seek to ensure that future tenants' break options fall on or shortly after a rent payment date.  

More landlord-friendly break clauses may in addition require the tenant to have complied materially with all of his lease obligations, the most onerous of which involve covenants to keep premises in repair. For obvious reasons, in the present economic circumstances landlords will want to wring every advantage they can get out of the departing tenant. Even where a landlord is unlikely to be able to find a new tenant at a decent rent or where it has no intention of carrying out any repairs (but instead intends to refurbish premises while rents remain low), he may nevertheless use such a break condition to seek a favourable financial settlement with the tenant.

In these circumstances this type of break condition is a powerful tool for a landlord, since unlike a claim for dilapidations on contractual termination of a lease, a tenant cannot seek to reduce its liability by arguing that its breach of covenant does not diminish the reversionary value of the landlord's premises. He must simply comply with the break condition. A landlord can drive a very hard bargain in order to release the tenant from this.

Even where a tenant seeks to carry out repair works itself, the issue is fraught with difficulty. The most recent authority on this point remains Fitzroy House, Epworth Street (No. 1) Limited -v- The Financial Times Limited (CA 31 March 2000). This case concerned the test of whether a tenant had "materially complied" with a break condition. It held that materiality must be assessed objectively with reference to the landlord's ability to re-let or sell the property without delay or additional expenditure. Therefore while the obligation on the tenant is onerous (given the financial consequences of failing to operate its break effectively), the landlord when enforcing this kind of break condition cannot rely on trivial or insubstantial breaches of covenant that do not satisfy the Fitzroy House test.

On the other hand, where the tenant has the ability to break its lease but knows that it will not be leaving the premises, this may present a golden opportunity for it to negotiate with its landlord to remove its right to break the lease in return for some other concession. Removal or postponement of the break right will mean that the landlord's reversionary interest is worth considerably more, so the landlord may be keen to enter into discussions and a tenant may be able to obtain a rent free period or convert to a turnover rent in return.

Rent Reviews  

With rents falling, it may be reasonable to assume that few landlords may be inclined to activate rent reviews in the current market, and that many tenants simply may not be able to pay an increased rent. Nevertheless, the area remains an active one, and there are a number of issues that might be of importance to landlords and tenants.

Firstly, if a break option is co-terminus with a rent review date this could have an unforeseen effect on a landlord's ability to activate a rent review. The general position is that if this is not expressly provided for in the lease then time will not be of the essence in relation to a rent review notice. In other words, the fact that a landlord (or a tenant) fails to serve a rent review notice by a date specified in the lease will not in itself prevent it from activating the rent review.

However, where there is an inter-relationship between a rent review date and a break date, this may make time of the essence notwithstanding the lack of any express wording. The rationale adopted by the Courts is that it must have been intended by the parties that the tenant would be able to know what its reviewed rent was going to be before deciding whether or not to break the lease.

For a landlord (and his advisors) preoccupied with falling market rents and rental voids, activating rent reviews may well not be a priority. However, if the last rent review was some time ago, checking the relevant lease provisions may well be important.

Another issue that it is worthwhile both landlords and tenants checking carefully is whether, instead of fixing a rent review date, a lease provides for a "floating" valuation date that is not linked to the review date or to the start of a review period, but instead attaches to the date that the reviewed rent is agreed between the parties or determined by the expert or arbitrator. Other leases may link the rent review date to the date of service of a rent review notice.

These types of leases may give both parties to the lease the ability to affect the outcome of a rent review quite significantly in a rapidly rising or falling rental market. However, parties should be wary of leases where there is ambiguity over the relevant wording. In Glofield Properties Limited -v- Morley (No. 2) [1989] 2 EGLR 118 the Court of Appeal found that on interpreting the rent review provisions there was sufficient ambiguity over the date upon which rent was to be reviewed that it felt able to depart from what on the face of it the lease appeared to say.

In terms of valuation, the pressures of the current property market mean that landlords desperate for favourable comparable evidence to use in rent reviews or lease renewals may be far more inclined to seek side agreements with tenants who are either unable to pay headline rents or have been able to negotiate rent downwards in the knowledge that landlords are under pressure to keep premises occupied.

Conversely, there are likely to be more instances of tenants seeking disclosure of a landlord's documents in rent review arbitrations in an effort to undermine the landlord's comparable evidence and find the true level of the market. Disclosure is not available in rent review arbitrations as a matter of course. Instead, an arbitrator must make an order for disclosure. The arbitrator has a wide discretion in this regard, and while tenants may be inclined to undertake a fishing expedition for relevant information, success will depend on this request being both specific and justified.

Where rent reviews have taken place, then there may well be more attempts to overturn arbitrator's decisions. One area of specific concern for a landlord is where a rent review valuation date arose say a year or eighteen months ago, but he feels that the arbitrator's decision may have been influenced by what has happened to the market during the period necessary for the arbitration to take place and an award to be issued. It should be remembered in this regard that the "hypothetical tenant" to be assumed in determining a particular rent review will exist whether or not there is, in reality, a market for the particular premises at the particular date of the rent review.

An arbitrator's award may be challenged only on the basis of jurisdiction; serious irregularity or on a point of law (Sections 67 to 69 of the Arbitration Act 1996). (The grounds upon which an expert determination can be challenged are somewhat wider).

Dilapidations  

When rents are rising investors are seeking redevelopment opportunities and tenants are short of available space, contested dilapidations claims (damages claims for breach of a tenant's repairing and similar obligations under a lease) are usually relatively rare. However, in recessionary times with landlords seeking to maximise revenue from less valuable investments, the converse is very much the case. Dilapidations claims may be familiar to most real estate professionals, but they are highly technical and there are many traps that unwary parties can fall into.

Perhaps the most misunderstood issue for landlords and tenants alike concerns Section 18 of the Landlord and Tenant Act 1927. This limits a landlord's claim for repairs to the diminution in value of its reversionary interest. This diminution is calculated by assessing the value of the premises on the date of termination of the lease firstly in repair and secondly in the condition in which they were left by the tenant. It is carried out by reference to what a notional purchaser would have paid for the premises.

However, this is not purely a theoretical exercise. A valuer must look at what the notional purchaser would do with the premises. If an antiquated office building or warehouse is located in an area where there is an over-supply of such accommodation, then it may be unrealistic to suppose that a notional purchaser would be an investor rather than a developer, for whom a repaired building may have little or no value. On the other hand, in the current climate a notional purchaser who may otherwise be inclined to develop a premises may well choose to try to secure whatever modest rental income he can until the market improves.

A tenant can even go as far as to relate what a landlord has actually done, or proposes to do with the premises to the notional purchaser for valuation purposes. For example, if the landlord proposes to refurbish it is likely that at least some of the work carried out or contemplated will supercede any works necessary to address the tenant's disrepair.

This was precisely the issue in Latimer -v- Carney [2006] CA EG 86 where it was held (contrary to previous principles) that subsequent events could be taken into account if they related to the basis of valuation and threw light upon it. Refurbishment or sale of the premises after the term date was one of the specific factors that could be considered.

In the present market, this makes Section 18 an even more potent weapon in the hands of a determined tenant, and should be borne in mind by a landlord with a large potential dilapidations claim making future plans for his premises.

Conclusion  

The downturn in the real estate industry has thrown many landlord and tenant issues into sharp relief and where tenants remain solvent, increased the potential for disputes to arise. A proper understanding of a statute heavy and technical area of the law is essential. But for well advised landlords and tenants the current economic circumstances can present an opportunity as well as challenge.