Rent Review - Choice of Index in the current market

Rent reviews allow periodic adjustment of commercial rents to the current market level at the date of review. In the current climate, there has been a shift from the traditional upwards only reviews based on open market value to consideration of other alternatives.

Rent reviews are typically triggered every three to five years during the term of a lease, a frequency which reflects the much shorter average lease lengths we are now seeing. Usually it is open to both parties to negotiate and agree the new level of rent, with the option to refer the assessment to an independent third party if agreement cannot be reached. The lease will usually contain provisions setting out how the level of the new rent is to be decided.

Upwards Only

A primary consideration is whether rent is to be reviewed upwards only, or if there is scope for it to fall once rent is reviewed.

Traditionally most rent review clauses have been upwards only to protect landlords from falls in rental value, but this has been challenged by tenants as being unfair. Research shows that, in recent years, there has been a significant change in commercial property leases, with average lease lengths in the current economic climate now less than five years, compared to the average length of twenty five years in the early 1980s. Average rental values have fallen by as much as 30% in some markets, and leases with traditional upwards only rent reviews will not reflect this. Concern has been expressed in the retail sector about the impact of upwards only rent reviews on the sector, and specifically the impact it may be having on the ability of smaller high street retailers to emerge from the recession.

In Scotland and England, most leases still contain upwards only rent reviews, but it is now more common to see leases with alternatives – some provide for the rent to be reviewed in line with inflation, and others provide for fixed increases throughout the term of the lease, so that the parties know exactly how much rent is to be paid for the entire duration of the lease.

Open Market Value

The open market rent assessment remains the norm. This bases the rent on the open market rental value at the date of the rent review, to reflect the rent the landlord could expect to receive if the premises were leased to a third party, on similar terms.

The open market rental value will be affected by a large number of factors associated not only with the general level of rents for similar property in the area but its use, configuration, size and terms of the lease. The variables associated with the assessment of an open market rental value are therefore numerous and often complex. This type of review often ends in arbitration, which can be time consuming and expensive if it is happening every three to five years.

In most arbitrations, and most referrals to an Independent Expert, the third party Arbitrator or Expert has the power to decide which party should pay the costs incurred in the process. So, the landlord or the tenant will often issue a “without prejudice save as to costs” offer (known as a “Calderbank offer” after the case in which the process was first established) on the other party in rent review disputes, as a commercial compromise. A Calderbank offer is an open offer to the other side to settle at a particular rent, and it is binding if accepted. If the Calderbank offer is not accepted by the recipient, the dispute resolution will proceed and the offer cannot be revealed to the Arbitrator or Expert until after their decision as to the rent has been made. If the decision falls above the level of the landlord’s Calderbank offer (or below that of the tenant) then costs may be awarded accordingly.

Indexation

More recently, there has been an increasing trend for rent to be linked to an index such as RPI or CPI. This is already commonplace in Europe. The index tracks changes in prices and alters the rent to reflect the changes in the index. The choice of index can make a considerable difference to the result of the calculation. RPI and CPI both measure the change in prices of goods and services bought by households, so they do not include commercial expenditure such as wages, business rates or commercial rents.

The RPI method of adjusting rent has become popular with investors as it guarantees a continual increase in rental income. The advantage is that such reviews are quick, clear and straightforward and therefore good for business planning. An RPI review also has the advantage that it does not set off any further SDLT liabilities.

However, there are disadvantages too. A tenant who agreed these terms before the recession could now be paying between 25% to 50% per cent over current market rental values. The other downside is if the market is flat. Moreover, as they are linked to the RPI and CPI which both measure the change in prices of goods and services bought by households, they do not account for commercial expenditure such as wages, business rates or commercial rents. For that reason they may not be the most appropriate indices for determining commercial rental values.

A recent consultation on options for improving the RPI has brought the issue to the fore. Following the consultation, the National Statistician concluded that the formula used to produce the RPI does not meet international standards and recommended that a new index be published. She also concluded however that there should be no major changes to the method by which the Index is compiled as there is significant benefit to users in maintaining continuity of the current formula. Instead of abolishing or amending RPI, a new RPI-based index will be published imminently using a geometric formulation (Jevons). This will be known as RPIJ. As this will most likely produce a lower rate of increase, it is not recommended that this index be used in rent review clauses.

This has been a brief overview of rent review clauses. If you wish to speak to one of our team about this is more detail, please contact us and we would be happy to assist.

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Property law