Exploring Different Types Of Rent Reviews In Commercial Leases

An open market rent review is the most common form of rent review in commercial leases.

In an open-market rent review, the rent is adjusted to reflect the rent the landlord could expect to achieve in the open market on the relevant review date.

The open market rent is determined by reference to a “hypothetical lease”.

A hypothetical lease is a lease the valuer imagines for the purpose of determining the rent at the review date. The hypothetical lease will typically be on the same terms as the actual lease, but with certain assumptions and disregards.

An “assumption” is something that is assumed to apply to the hypothetical lease, even if it does not apply to the actual lease. A “disregard” is something that is assumed not to apply to the hypothetical lease, even if it does apply to the actual lease.

For example, a common assumption is that the tenant has complied with all of its covenants in the lease.

Why? Because the tenant’s breach could reduce the rental value, it is unfair for the tenant to benefit from its own breach.

A common disregard is any goodwill which has been generated by the tenant’s business carried out at the property. Such goodwill has been generated by the tenant at their expense, so the landlord should not benefit from any rental increase resulting from it.

A properly drafted open-market rent review clause should also include provisions that allow an independent surveyor or arbitrator to determine the rent when the parties cannot agree.

The benefit of using an open-market rent review is that it accounts for sector-specific and local market changes that other rent review mechanisms do not.

Currently, open market rent reviews are almost exclusively upwards-only, which means the rent cannot reduce.

This protects the landlord’s income and the value of their portfolio even if the market falls. Of course, that is set to change, which may result in open market rent reviews offering a fairer outcome for tenants.

The disadvantage of an open-market rent review is that it relies on market evidence to assess the rent.

Reviewing market evidence is a subjective exercise which can in turn lead to disputes. Also, additional costs can arise where the parties cannot agree on the revised rent and an independent surveyor/arbitrator is required.

An index-linked rent review is one that changes in line with an inflation index.

Currently, the most commonly used index is the Retail Prices Index (“RPI”), although the Consumer Price Index (“CPI”) is also used. RPI is a measure of consumer inflation that reflects the average change in prices that consumers pay for a set of everyday items.

CPI is a statistical estimate of the level of prices of goods and services bought for consumption purposes by households. The two indexes are similar as they reflect the monthly change in the cost of goods and services, but they differ because they track different items. RPI generally runs at a higher level than CPI.

Index-linked rent reviews can provide for a simple or a compound rent increase. A simple increase calculates the difference between the index at the start of the lease (or, in subsequent rent reviews, the previous review) and increases the rent by the same proportion.

A compound interest calculates the rent that would be achieved had the rent been reviewed annually applying the index throughout the period between the review dates.

Index-linked rent reviews are often combined with a “collar” and a “cap”.  A collar is a minimum increase, and a cap is a maximum increase. The disadvantage of agreeing a collar and cap is that the revised rent will not accurately reflect changes to the index, which will be to the benefit of one party and the detriment of the other.

Including a collar in the rent review mechanism could be viewed as a contravention of the proposed ban on upwards-only rent reviews as part of the English Devolution and Community Empowerment Bill (“the Bill”).

However, at this stage it is unclear whether collars will be included within the ban and we await further details on how any exceptions might apply. Note: we will continue to monitor the Bill’s progress and provide updates as it moves through Parliament.

Index-linked rent reviews, particularly with collars and caps, benefit from being more predictable than open market rent reviews, aiding the parties' budgeting and financial planning. Index-linked rent reviews are also simpler to resolve than open-market reviews, as they are a mathematical calculation. This (hopefully) avoids costly and time-consuming disputes.

Index-linked rent reviews (with collars and caps) can protect landlords and tenants from local and/or extreme increases or decreases in the property market, which could have a significant impact on open market rent reviews.

The UK Statistics Authority and HM Treasury confirmed in November 2020 that the methodology for calculating RPI will be phased out by February 2030 and replaced with CPIH (being CPI but including owner occupiers’ housing costs and council tax).

This is likely to be a slower increase than RPI. The phasing out of RPI is a reminder that commercial leases with index-linked rent reviews should contain provisions that deal with scenarios where the index is no longer available and should set out any substitute indices or mechanisms for reviewing the rent.

Another method of calculating a fair rent for both parties is turnover rent. This type of review is often found in the retail and leisure sector. Turnover rent is not truly a rent review, but because when used it is often an alternative to open market or index-linked rent reviews, we have included it in this blog.

Turnover rent is based on the income that the tenant makes from their business carried out at the property. In some leases the rent is a pure percentage of the tenant’s turnover, in others there is a minimum base rent, and the turnover rent is a percentage of the tenant’s income insofar as that calculation exceeds the base rent.

It is of course vital for the parties to clearly define “turnover” and set out which sums are included and excluded.

The benefit of using a turnover rent is that it can align the landlord’s and tenant’s interests, as both the landlord and the tenant are mutually interested in the tenant’s business succeeding.

For the tenant, this could encourage the landlord to make investments in the building.

For the landlord, turnover rent provisions could reduce the risk of vacant properties as tenants are more likely to survive a downturn in market conditions where the rent is linked directly to their performance.

The downside of including a turnover rent is that it is a particularly complex area of negotiation and requires very careful drafting.

It is therefore important to obtain legal advice on these provisions in the lease.

Turnover rent can also place an additional administrative burden on both parties as the landlord will want to obtain receipts and accounts from the tenant showing their turnover and the tenant will be required to supply these.

This may become particularly difficult for the tenant where they operate from multiple properties.