June 2011 – Regular columnist RODNEY TIMM sets out some of the traps that are embedded in lease agreements, either inadvertently or with due consideration, by more aggressive landlords.
Lease rental structures have changed over the last decade. The incidences of mid-term market rental review – at three or five-year intervals – are less prevalent. Annual rent increases now tend to be fixed percentages, CPI or combination. But virtually all leases with option periods attached are likely to include market rental review clauses. Although these clauses are common and fairly standard, as with most aspects of lease agreements, the devil is in the detail.
UNDERSTAND THE CLAUSE
All solicitors that draft market rent review clauses seem to create their own nuances in defining market rental. The clause is likely to instruct the valuers about what should or should not be taken into consideration in reviewing comparable rental evidence. The clause may stipulate the permissible comparable evidence that may be considered in terms of types of premises and lease structures. Details defined may include the grade of building; geographic locations; multiple, single or part floor leases; types of tenancy covenants; length of lease, etc. Obviously large tenants with a long lease over multiple floors should ensure that evidence to be relied in the process has a similar profile to their lease. Market norms dictate that shorter, smaller area leases with higher credit-risk tenants will likely be at higher rental levels. The evidence in these leases should be deemed as not suitable comparable market rentals. These instructions will impact the interpretation of market rental and ultimately the rental to be paid going forward. A significant impost on the company if not managed properly.
BEWARE THE TRAPS
Although the rent review process is fairly generic, there are traps that can catch out unsuspecting tenants. As often is the case, the devil is in the detail. This can cause major problems if not fully understood and strictly implemented. The traps and nuances that landlords use to their advantage in the process are many and varied. Many leases are structured to provide landlords with the latitude to issue rent review notices during a longish ‘window of opportunity’, either before or after the actual rent review date. This flexibility provides the advantage of assessing market changes and only issuing notices that will likely support a positive rental outcome.
In response, tenants often have unrealistically short timeframes – three weeks or less – to respond to the new rent notice. Beware the tenant that does not have the appropriate processes in place to ensure the response time requirements are met. Usually a non-response within the allocated time results in ‘tacit acceptance’ of the proposed new rental level by default. Taking advantage of this structure, landlords have a habit of issuing rent notices immediately prior to traditional holiday periods – hoping no one will be on watch and no timely response will be forthcoming. It has been known for landlords to send rent notices to ‘old’ or notional postal addresses as contained in the lease agreement, that differ from the usual correspondence address. A rent level determined by default is once again likely.
Other landlord tactics may be proposing excessively high rent levels, knowing further negotiations will eventuate. This may ignore ‘cap and collar’ provisions, landlords knowing that many tenants do not fully understand the implications. Ultimately, the outcome is likely to be a function of which party can hold out for the most advantageous position. Or in a relatively ‘flat’ market, the landlord rent notice may indicate a relatively small – say four to five percent rental increase – with the hope that the tenant will be too busy on their core business to want to become involved in rental disputes.
FACE OR EFFECTIVE MARKET RENTS
One of the most important aspects of the rent review clause, often misinterpreted, concerns rental being ‘face’ or ‘effective’. Face rent is the rental payable as set out in the lease agreement. Effective rent is this rental amount after it has been adjusted over the lease term duration by the quantum of the incentive paid by the landlord to induce the tenant to commit to a lease. Because the incentive is usually calculated on the aggregated rental payable over the initial period of the lease, mid-term market rent reviews should be based on comparable ‘face’ rentals. However, rent reviews at the end of the initial term when an option to renew is being considered should arguably be based on comparable ‘effective’ rentals.
A word of caution: the drafting of the market rent review process can complicate matters. Often, with the intention of clarifying the definition, complexities in drafting can cause confusion, leading to interpretations that may differ from how the market actually operates. Even worse, ‘sloppy’ drafting can result in the incentive component being treated differently from the original intention.
RENT REVIEW PROCESS
Industry market rent reviews practices usually have several steps set out in the lease agreement. The landlord usually provides new rent notice based on his assessment of the market dynamics; the lessee then has the opportunity to disagree or agree (possibly by default) within a given timeframe. If the lessee agrees no further action is required and the new rent level has been established. If the lessee disagrees, the landlord should be notified within the required timeframe, possibly proposing an alternative rental level. If the landlord agrees, no further action is required and the new rent level has been established. If the landlord disagrees, it is likely that both parties will negotiate or be required to each appoint valuers to review the rental and attempt to agree. If there is no agreement then a ‘determining valuer’ is appointed, usually by a nominated industry association. The parties usually make submissions to this valuer, who will also consider market evidence and make market rental determination. This decision is usually final.
OPTION PERIOD REVIEWS
With the rent review process around options periods, there are often issues around when the option is to be exercised. Is this prior to the rental being determined? Or once the rental has been determined? Most lease agreements are structured as the former. This means the tenant does not know the new rental level prior to having to make the decision to stay. Usually this is acceptable if the tenant prefers not to relocate. But there is an advantage in market negotiation to know what the fall-back rental is in the current premises. Obviously, if the rent review clause indicates the rental will be a face rental, then why bother with the process? It is probably better to test the market and invite your landlord to join in the process.
BE PREPARED
Prevention is better than cure. When finalising a new lease agreement, focus on the detail in the clause. Before the deal is committed – and while the landlord is keen to secure your lease commitment – is the time to ensure the rent review clause meets your needs. Once the lease agreement is finalised, the focus should move to internal lease management processes. A critical lease data system providing timely renewal and rent review dates is fundamental to effective portfolio management.
Any rent notice received should immediately be dispatched to the responsible party (with back-up to cover leave periods) so it does not lie around unattended. If possible, prepare for rent notices before they are issued. Timeframes can be short. If rent notices are expected, particularly for a large lease footprint, having a current market overview with comparative rents analysed is handy. Ideally, the focus of the rent reviews should be to agree the new rent before the formal review process. Once commenced, it is often more difficult to influence the outcome.
Understand the terms, requirements and possible interpretations of the rent review clause. With drafting ambiguities, it may be necessary to commission legal and valuation opinion. Most important to minimise occupancy costs, be prepared to play the landlord games. Make sure the landlord’s rent notice has been issued in accordance with the lease requirements. Whatever rent notice arrives, review, analyse and object – even if the increase is only three percent. Landlords rely on tenants being overcome by inertia and the eagerness to avoid confrontation.
Rodney Timm is director of Property Beyond Pty Ltd, telephone (02) 9221 0660, email rodney.timm@propertybeyond.com.au
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