From a landlord’s perspective, rent reviews are an essential component of a commercial lease. Reviewing the rent at specified intervals ensures that the rent keeps pace with current market rates.
Rent reviews may be self-executing and provide for a fixed increase, Consumer Price Index (CPI) review or a fixed percentage increase - or contain mechanisms for rent review, as with market rent reviews. This post examines market rent reviews, and factors to consider when finalising rent review provisions in your Commercial or Retail lease.
What is a market rent review?
Market rent reviews are designed to ensure the rent you’re charging remains consistent with rates in the current market. As such, they’re based on the rent paid by tenants in comparable properties in the surrounding area, heavily influenced by supply and demand of similar properties. Market rent reviews can be carried out by you (the lessor), a property valuer or estate agent.
When does a market rent review occur?
While CPI or percentage increase reviews are generally carried out annually, market rent reviews occur at specified intervals during the lease period.
Market rent reviews are commonly carried out every 3 to 5 years and/or at the exercise of an option to renew. That’s because market rent reviews may involve an independent valuation, the costs of which can be high, making them too expensive to carry out annually.
Why choose a market rent review?
In well performing markets, market rent reviews provide a better rate of return. However, in poorer markets, they can result in a decrease in rent. That’s why when considering including a market review in your commercial lease, it’s important to consider the market over the entire lease term - not just at the time of signing.
If the market looks like it will continue moving upwards over the lease term, a market rent review’s a good choice. If things aren’t as certain, a CPI increase or 3 to 5% fixed annual review will guard against rent decreases.
Market rent review process
The review process generally begins when the landlord sends a written notice to the tenant, proposing a new rental amount. If the tenant agrees to that amount, the lessor’s determination is deemed to be the current market rent.
If the tenant disputes the new rental amount, landlord and tenant work together to agree on a fair market rent. However, in the event an agreement can’t be reached, and to ensure the review process is fair to both parties, most commercial leases include a clause allowing the tenant to have a valuer appointed to independently determine the market rent.
If your lease is a retail lease, the retail leasing legislation in your State imposes strict rules on how the market rent review process is to be carried out.
To ensure market rent reviews don’t drag on unnecessarily, it’s wise to include a clause limiting the time the tenant has to dispute the reviewed rent. Most commercial leases with provisions for market rent review state the new rent is deemed to be accepted if the tenant does not challenge the amount within a prescribed period – usually within 28 days of receiving the notice of review.
If an independent review is required, both landlord and tenant have the opportunity to make written submissions to the valuer. A valuer’s decisions are generally binding, and the costs of appointing them are shared equally between landlord and tenant.
Valuers have a wide discretion when applying valuation principles to a market review. That’s why it’s important to ensure rent review clauses contain valuation criteria for the review. These criteria set out the directions the valuer must follow, assumptions they should make, matters they must take into account, and matters they should disregard.
Initiating a market rent review
Who can initiate a market rent review depends on the terms of your lease. However, most commercial leases allow either party to initiate a review. That said, there are some important differences you should note between retail and commercial leases.
Under section 32 of the New South Wales Retail Leases Act, the tenant has the right to request a rental determination. If that determination is not made before the option date occurs, the option period is extended until the tenant is notified of the determination. This is so that the tenant may take into account the new rental amount when determining whether or not to take up the option to renew the lease. In addition, where an early determination is made, the tenant must exercise their option within 21 days of the determination – not the timeframe noted in the lease.
(Note that the requirements concerning the procedure for “retail” market rent reviews will vary slightly from state to state.)
Time is also an important factor in a commercial lease. As a landlord, you should ensure you prescribe a time limit in which you have the right to initiate the review process. Take careful note of these limits, because if you fail to act within that time, your tenant may claim you have lost the right of review. This is particularly so if the lease states that time is of the essence.
Because market rent reviews are based on current market rates, they may result in a decrease in rent. Landlords have been known to guard against this by including a ‘Ratchet clause’ in the lease, prohibiting a decrease of rent after a market rent review.
Once common in commercial leases, it’s important to note that Ratchet clauses are void and unlawful in retail leases under state and territory legislation. Under a retail lease, the market rent review is a ‘true market rent review’, meaning the new rent may be less than the rent prior to review.
Is a market rent review right for you?
Whether a market rent review is suitable for you as a landlord depends on your circumstances.
If you prefer the certainty of fixed rent increases over time, a CPI or fixed percentage increase may be more appropriate. However, if you’re happy with a higher level of risk and the market is performing well, market rent reviews are a great option. If you’d prefer to cover all your bases, you can combine a market rent review with a CPI or fixed percentage increase (as long as this is not viewed as a way to avoid a decrease in rent under retail shop leases legislation if your lease is a retail lease). Just remember to consider your needs before making a decision.
Ian Macleod is the CEO of the legal publisher RP Emery and Associates. They provide cost effective legal contract kits for Individuals, SME’s and the legal fraternity.