Trips, traps and tips
In most long term leases a mechanism is inserted to increase the rent over time, ostensibly to combat increases in the cost of owning the Premises.
There are typically three ways to increase rent:
- Fixed percentage;
- Reviews to reflect the annual change in the Consumer Price Index (CPI) for the main city in the state where the Premises are located; or
- Market review.
Fixed percentage and CPI increases are most common on lease anniversary dates and allow a tenant to calculate their rental increases and plan for the future.
A market review usually happens when an option to renew is exercised, or in a long term lease at midway intervals such as 5 years of a 10 year lease with a further 10 year option.
The purpose of a market rent review is expressed to be a way to bring the rent back in line with the rents payable in the market however in truth most leases endeavour to prevent the rent following the review from decreasing unless such a tactic is prevented by legislation such as occurs in relation to retail legislation in most states and territories.
The steps to a market review go something like this:
- Landlord provides a tenant with a notice setting out the new rent. If the tenant agrees, the figure proposed becomes the new rent payable from the commencement of the option period and no further steps are required.
- If the tenant disagrees, they have a certain timeframe (set out in the lease, often 14 or 21 days) to dispute the rent. Depending on the drafting of the lease there may be a provision to offer an alternative rent amount to the landlord, but this is rare.
- If there is no agreement between the parties, the matter is generally referred to an independent valuer to determine the rent – with that decision typically being final and binding on both parties.
There are various issues to consider and to be aware of regarding the above points.
- Issuing the notice — where the market rent review is triggered by an exercise of an option to renew the lease a tenant is usually required to exercise that option before the landlord will notify the tenant of the rent they consider is the market rent. This is not ideal for tenants, as they wish to know what their new market rent will be prior to exercising the option.
- Responding to the notice –the timeframe in which a tenant has to respond to a landlord advising if they disagree with the rent is usually short (such as 7 days or 14 days after the landlord advises of the proposed rent). If the tenant fails to dispute that rent during that period they are usually deemed to have accepted the rent. The time period may not provide the tenant with adequate time to consider their position, ascertain current market rents themselves, and if the landlord has provided the notice over a long weekend or holiday period, the tenant’s period to consider the proposed rent and dispute it may be even shorter.
- Disputes – if the parties disagree and the rent review is to go to an independent valuer for determination, there may be a clause in the contract that provides if the valuer returns a rent that is greater than the amount that the landlord had initially proposed, the tenant is required to pay the landlord’s costs of the valuation as well as their own. More often however, clauses are drafted so the cost of valuer is split 50/50 between the landlord and the tenant.
- Ratchet clause – from a tenant’s point of view, a market review, where the market has slowed down, should actually result in a rental decrease. However many leases will include a “ratchet” clause which states that the rent cannot be reduced. Other factors that need to be considered when determining a market rent is whether or not the tenant has been compliant with their lease, any incentives, vacant possession in the building and permitted uses of the building. All these factors together may influence what a landlord considers to be market rent and may not be actual market rent.
- Unfavourable terms – if an independent valuer is appointed to determine the rent the lease sets out guidelines the valuer needs to adhere to that can have an enormous impact on the actual market rent determined by a valuer. Examples of instructions to the valuer include instructions to:
(a) disregard incentives landlords typically offer in the marketplace it can mean that the rent the market rent nominated by the valuer is much higher than would be required if the tenant was to seek new premises in the marketplace as generally a new tenant would receive the benefit of an incentive by way of rental abatement, rent free period or fitout contribution or similar;
(b) disregard the fact that a tenant has multiple floors in the building, thereby disregarding the discount that would generally be obtained for multiple floors; and
(c)take into account any use the premises could be used for, rather than the use permitted by this lease.
Tips for tenants
Some potential amendments a tenant could seek to the lease to combat some of the above issues when dealing with market reviews include:
- Requiring the landlord to provide their notice of their proposed rent either before or during the option period so the tenant can determine whether or not the market review is acceptable prior to determining whether or not to exercise their option to renew the lease;
- Inserting a clause in the lease that despite any market review, if the proposed rent is deemed by the tenant to be excessive the tenant can terminate the lease or alternatively limiting any increase following a market review to a certain percentage increase, such as a 5% increase; or
- Carefully review the instructions to the valuer and ensure that the unfavourable terms set out above are removed from the lease or at least factored into the decision to accept the Premises.
The impact of an unfavourable market rent review can have a devastating effect on a tenant’s business.