With the changing economic environment that we are experiencing, along with increased land and construction costs, this makes for an interesting discussion when it comes to leases and possible rent reviews outcomes, and how these factors may impact that outcome.
Ratchet Clauses
We have seen commercial ADLS leases move from hard ratchets (where rental could only rise and never fall), to soft ratchets where the rental cannot go below the commencement rental of the then current term, but can otherwise increase and decrease within a lease term. In reality, these soft ratchets appear to be a fairer model that better reflect the ups and downs within a market cycle.
Over recent years and with inflation broadly sitting in the band of 1.5 percent – 2.5 percent, commonplace saw regular rent reviews to CPI, possibly with a plus factor, interspersed with market reviews. Now that inflation is the highest in nearly 30 years at 6.9 percent and likely to remain for some time yet (for whatever reason, it has taken the Reserve Bank and government far longer to see what the general public has seemingly known for well over 18 months now), we are starting to see tenants review how they might want to deal with future rent reviews in new leases.
There are three common Rent Review methods:
Market
This is where the rental is compared to other premises in the current market, when taking into account quality, size, location, landlord improvements etc. Should a Tenant not agree to the Landlords assessment of market rental, disagreement may lead to a time consuming and potentially costly dispute. Invariably a landlord having a market rental valuation undertaken by a registered valuer, will be higher than that conducted by the tenant. While market should reflect “the market”, the element of opinion as to what this should be, will often occur between the assessments carried out between the Landlord’s and Tenant’s respective valuers.
CPI
The CPI (Consumer Price Index) rent review is recognised as an increase (or decrease) measured by the rate of inflation. They are simple to understand and administer, while also being less likely to lead to a dispute – useful, as long as the commencement rental is at or near a market level. It allows both parties to plan ahead and budget for their costs. With CPI having remained low for an extended period, it was not uncommon for the figure agreed to be CPI plus a percentage – +1 percent, even up to +3 percent
Fixed Percentage
This is where an agreed percentage increase will take place and the regularity of those increases. They also are simple to understand and simple to administer. The risk here, is that unless there are interspersed with market reviews, that potentially the rental may end up being significantly higher or lower than its actual market value. One such instance that I am aware of had a 12 year term and annual increases of 5 percent compounding – more than 10 years on, this now has the effect of the rental being some 20 percent ahead of its true market level.
So what are we witnessing today? Increasingly, it’s a combination of the above. This usually provides a fairer outcome when balancing the Landlords requirements for growth and the Tenants desire to keep increases at a minimum.
When assessing the mixture of potential rent review mechanisms, the first question to consider is whether the commencement rental is in fact at a market level”
This mixture of fixed or CPI reviews, interspersed with market reviews, provides growth for Landlords, while providing certainly for both Tenants and Landlords. This combination ensures that neither party is paying significantly above or below market rates. It’s important to note that just because a rent Market Review is due, it does not necessarily mean that there will be an increase.
The mixture of review mechanisms often includes what is referred to as a “Cap and Collar”, where CPI Rent Reviews or Fixed Percentage Reviews are followed by mid term Market Rent Reviews. Collar restrictions prevent the rental from falling below a predetermined level, while the Cap restriction prevents the rental from rising above a predetermined amount. Essentially it reflects the best and worst case scenarios for both Landlords and Tenants.
One recent lease we undertook, had a Cap and Collar clause reflecting that the increase shall be the greater of 2.0 percent per annum or CPI, with CPI to be capped at 8 percent over the two year period. The end outcome under this scenario will see the rental increase by between 2.0 percent – 4.0 percent per annum
So, considering a new lease? Then contemplate incorporating a balance of mechanisms. Leases reflect long term relationships between Tenants and Landlords, so Rent Reviews that look to reduce the potential for disputes between Landlords and Tenants, will likely ensure smoother sailing for both parties.
It is important to seek professional legal advice from a qualified professional, before entering into a lease agreement.
