Rent & Financial Obligations
Rent
Rent is a key commercial term. Generally, rents are fixed for the entire term in shorter leases. In longer leases, it has been common for many years, to provide for rent reviews every five years. This reflects the statutory right of renewal of the lease, whereby there is a right to apply for rent reviews, every five years
From the landlord’s perspective, the rent represents its return on the investment. The tenant may have further financial obligations. Longer commercial leases, are typically full repairing and insuring (FRI) leases. The landlord’s expectation is that receives its rents “net”, over and above the operating and maintenance costs of the property. An FRI lease obliges the tenant to undertake all repairs and maintenance and to pay the cost of the landlord’s buildings insurance, over and above rent.
The tenant’s financial obligations will usually include the obligation to pay interest on arrears of rent, VAT on rent, rates and equivalent property taxes, local tax charges, landlord’s insurance contribution and service charge. Where the property is not stand alone, then a service charge will generally be provided in order to cater for the repair, maintenance and management of the common parts.
Default of Payment
Where the rent is not paid, interest is usually payable. The rate of interest will be set by the lease. Failure to pay rent may entitle the landlord to sue to recover the rent and / or terminate the lease itself. Alternatively, it may seek to recover rent and interest in legal proceedings, without seeking to terminate the lease.
If the lease is terminated, the landlord may be entitled to lump sum compensation, for future loss of rent, if it can only re-let the premises at a lower rent. The landlord must mitigate or try to minimise its loss. If the premises can be re-let for a similar or equivalent rent, the liability of the tenant to compensate future loss of rents will be reduced or avoided.
Leases may provide for a guarantor where the landlord deems the tenant to be of insufficient financial capacity. This will often be the case in the case of “smaller” private companies. The guarantee may be invoked if the tenant (e.g. company) encounters financial difficulties and the lease is terminated. The guarantor may be sued for a substantial lump sum based on the landlord’s future loss of rent.
If, for example, rents have fallen by 20% or 30% and the landlord can only relet at a lower sum, the capitalised value of the rental shortfall may be recoverable by the landlord against the tenant, and if there is a guarantor, against the guarantor. Guarantees may also oblige the guarantor to take on the lease or an equivalent new lease.
Upward Rent Reviews
The rental arrangements may be made on such terms as the landlord and tenant contract in the tenancy or lease. Until recent times, the majority of leases of longer term leases, have provided for rent reviews every five years. These are almost invariably, been “upward only” rent reviews. This means that on a rent review, the rent is to increase if the market rent is above the current rent, but is to remain the same, if the market rent has fallen below the current rent.
The recent economic crisis has exposed the potentially adverse effects of “upward only” rent reviews. Where the market rents fall significantly, the tenant remains bound to a higher than market rent, for a period, which may be, 10 to 20 years or more. In the economic crisis, many tenants have successfully renegotiated their rent downwards, with the landlord on the basis that the landlord accepts that failure to do so would jeopardise the solvency of the tenant and lead to a worse outcome.
Pressure for upwards only rent reviews has come historically from landlord’s funders and institutional investors in commercial property, such as pension funds, banks etc. Institutional property investors have a strong preference for a lease with a minimum guaranteed payment. The financial appraisal of the property is premised on a floor or base payment. A more significant factor was the flawed belied that rents would increase indefinitely.
Upwards and Downwards Rent Reviews
It has always been possible to agree upwards and downwards rent reviews. However, in practice, these were rarely found. The UK government attempted to introduce a Code of Practice promoting such leases a number of years back, but they did not receive much support in the property industry.
In 2009, legislation was introduced which applies to all leases entered or agreed after 1st February 2010. In any such lease, where there is provision for rent review, it must be both upwards and downwards. Upward only rent reviews are not permitted. The legislation applies to a lease of a building or lands, where the land is ancillary to the building. The legislation overrides what the lease provides. It is not possible to contract out of it.
The above reform marks a radical change in the law. The likely effect is that shorter term leases will become the norm. This is particularly likely in view of the ease with which it is now possible to contract out of statutory rights of renewal. The effect on the landlord and tenant market has not yet been fully worked out, due to the current economic circumstances.
The provision of the rent clause are a matter for negotiation and agreement. However the provisions applicable to so-called “Court leases”, are highly influential. Where a tenant has a right to a new “Court lease”, the legislation lays out the basis upon which the rent is determined. Rent reviews can be applied for every five years. In practice, the parties almost always agree a new lease based on what the Court might grant, so that very few Court leases are granted.
It has been possible since 1994, for a tenants to claim a Court leases for a term of between 5 and 25 years. Court leases do not themselves provide for rent reviews. Instead, the landlord or tenant can apply to Court for rent review. Therefore to some extent, the new legislation, was not necessary in the case of new leases arising under landlord and tenant legislation.
Criteria for Rent Review
Until 2008, almost all commercial lease provided for review based in market value at the review date. However, it is not necessary to provide for rent review in these terms. It is possible to have a wide variety of rent review clauses. For example, rent review may be linked to inflation or to increases in indexes of property or building prices. The consumer price index was is rarely used, but it has become more common .
Rent may not be fixed but may be linked to the turnover of the business which trades from the building. In the recent economic crisis, it has become common to base rent on turnover. Rent is typically between 5% to 10% of the gross turnover. There needs to be provision, in such cases for the landlord to audit the tenant’s turnover.
Standard Rent Review Clause
There is a relatively standard type of “market value” rent review clause, which was originally agreed between the Law Society and Chartered Surveyors Society. It provides for the review of the rent on each review date. This is commonly each fifth anniversary of the commencement of the term of the lease.
The rental review date is usually measured from the commencement of the term. This date may predate the date of commencement of occupation and payment of rent under the lease, with the result that the first rent review may arise much earlier than five years.
Generally, the leases provide a mechanism for review and ascertainment of rent . There is a provision for initiation of the procedure by one or other party. Generally, the time limits for initiation, are not strict but failure to initiate may mean that the change in rent is not backdated. Under older, leases the landlord commonly has the sole right to initiate the rent review. Under post February 2010 leases, either party should have the right to initiate.
Generally, the rent review clause provides that the parties shall try to agree on the rent in the first instance. If the rent is not agreed, the matter is referred for determination to an independent party, who is usually a surveyor or valuer. It is usually provided that if the parties cannot agree on the appointment of the arbitrator, he is nominated by the President of the Law Society, I.A.V.I., Chartered Surveyors of Ireland or one or more of them.
Under the above standard clause, the revised rent is to be the rent that represents the market rent of the property on the review date. It is assumed there is no “fine or premium” (i.e. that no price / lump sum) is payable, so that the value of the lease is reflected in the rent only. Certain assumptions are to be made under the standard clause, regardless of what the actual case may be. There is to be a hypothetical new leases.
The property is hypothetically let by a willing landlord to a willing tenant. It is usually assumed that the lettings is for a term equal to the greater of 15 years or the remainder of the actual term. The rent under the hypothetical lease itself is subject to review every five years. It is assumed that the tenant and landlord and / or the tenant has complied with their tenant obligations. Therefore, the tenant does not obtain credit for deterioration due to non-repair.
If the property has been damaged or even destroyed, it is assumed to have been rebuilt. (In this case, other clauses will suspend the rent pending reconstruction). The valuer is to have regard is to open market rents of other comparable rents, which the valuer believes to be relevant.
Certain factors are usually disregarded: the tenant’s occupation of the property; the tenant’s goodwill and improvements made by the tenant at its expense, other than those required under the terms of the lease. The first two hypothetical exclusions are intended to exclude value attributable to the tenant’s use of the property and its goodwill. These are fairly referable to the tenant’s efforts.
The third exclusion disregards improvements made by the tenant but not those which he was obliged to undertake under the lease. Generally, only those improvements undertaken with the landlord’s consent following the requisite procedures in legislation, are excluded. Improvements carried out by reason of an obligation in the lease (e.g. requirement by the fire officer) are not disregarded. The tenant is not entitled to the benefit of a reduction in value, attributable to his default
Reviewed Rent
There are usually two alternative methods by which the independent third-party determines the rent. One possibility is that the independent party, commonly a valuer or chartered surveyor, acts as an arbitrator. An arbitrator decides the matter in much the same way as an independent Judge or independent judicial person. He decides on the basis of the evidence put forward by both sides’ representatives (typically themselves, surveyors or valuers). He may only act on the basis of the evidence put before him, and not on his own expertise.
The alternative method is that the market rent is determined by the independent valuer of surveyor acting as an expert. Determination as an expert means that he decides the
revised market value on the basis of his own expertise taking account of the matters which he considers relevant. The expert can hear the submissions of both parties but is entitled to rely on its own expertise and investigation. Sometimes both mechanisms are specified and it is usually the landlord who has the option to decide which option is to apply.
When the rent is reviewed and there is an increase, the shortfall in rent since the review date is payable as a lump sum. Interest (usually at a lower rate than that for arrears of rent) is also payable from each relevant date. There will be provision for payment of the surveyor or arbitrator’s fees. The clause will usually provide that they are shared equally or may provide that the surveyor or arbitrator has some role in determining fees.
VAT on Rent
VAT may be payable on the rent and service charges. Prior to July 2008, there was a mechanism in the case of leases of more than 10 years, whereby VAT could be simultaneously paid and reclaimed as a notional lump sum at the start of a lease, where both landlord and tenant were VAT registered and were entitled to recover VAT in full. No ultimate VAT liability would arise unless and until the lease came to be used by a tenant who did not have full entitlement to recover on its sales.
The effect however of the 2008 reforms to VAT law, mean that in cases of properties developed within the last 20 years, the landlord may be subject to a substantial VAT charge unless there is an election to VAT. Where a pre-July 2008 lease is assigned, this treatment may arise even though it was granted under the older legislation.
An election to charge VAT requires that VAT must be paid on the rent at 21% throughout the lease. If the tenant can reclaim VAT, the liability to account for, pay and reclaim will arise, with the consequent cash flow implications. VAT on rent is payable when due and may be recovered as a credit in the next VAT return.
Where the tenant is unable to recover VAT on its inputs because of the use to which the premises is put, VAT may be a real and substantial cost. It is a matter for negotiation between landlord and tenant as to whether VAT is chargeable. To some extent, this may be reflected in the rent. See our separate section in relation to VAT and the chapter on VAT on property.