Lease rental structures have changed over the last decade with mid-term market rental reviews, at three or five-year intervals, less prevalent. annual rent increases now tend to be fixed percentages, CPI or a combination. but virtually all leases with option periods are likely to include market rental review clauses. While these clauses are fairly standard, as with most aspects of lease agreements, the devil is in the detail.
Beware the traps
Traps in the rent review process can catch out unsuspecting tenants and cause major problems if not fully understood. The traps that landlords use to their advantage are varied. Many leases are structured to provide landlords with the scope to issue review notices during a longish ‘window of opportunity’, either before or after the actual rent review date. This allows landlords to assess market changes and only issue notices that will likely support a positive rental outcome.
In response, tenants often have short time frames to respond, generally in as short as 21 days. Usually, a non-response within the allocated time results in automatic acceptance of the proposed new rental by default. Taking advantage of this, landlords have a habit of issuing rent notices immediately prior to holiday periods or will send rent notices to old or different addresses from usual correspondence. A rent level determined by default is once again likely.
Other landlord tactics include proposing excessively high rents, knowing further negotiations will eventuate. This may ignore ‘cap and collar’ provisions to ensure rents do not rise or fall beyond a specified range, knowing that many tenants do not fully understand the implications. The outcome is likely to depend on which party can hold out for the most advantageous position. In a relatively ‘flat’ market, a landlord rent notice may indicate a relatively small (4–5%) rental increase with the hope the tenant will be too busy to become involved in a rental dispute.
Face or effective market rents
One of the most important aspects of the rent review clause, often misunderstood, concerns rental being ‘face’ or ‘effective.’
- Face rent is the rental payable as set out in the lease agreement before taking into account incentives or increases.
- Effective rent is this rental amount the landlord receives after paying all expenses for operating the property, and any costs for tenant work and amortising incentives.
Because the incentive is usually calculated on the aggregated rental payable over the initial period of the lease, mid-term market reviews should be based on comparable ‘face’ rentals. However, reviews at the end of the initial term when an option to renew is being considered, should arguably be based on comparable ‘effective’ rentals.
Market review process
In the rent review process the landlord usually provides a new rent notice based on an assessment of market dynamics, and the lessee then has the opportunity to disagree or agree within a given time frame.
- If the lessee agrees, then no further action is required and the new rent is established.
- If the lessee disagrees, the landlord should be notified within the required time frame, possibly proposing an alternative rental.
- If the landlord agrees, no further action is required and the new rent has been established.
- If there is no agreement then a ‘determining valuer’ is appointed.
- 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
There are often issues in the rent review process when the option is exercised. Most lease agreements are structured once the rental has been determined. Therefore, the tenant does not know the new rental prior to making a decision to stay. This is acceptable if the tenant prefers not to relocate. But it is important to know what the fall-back rental is in the current premises.
When finalising a new lease agreement, focus on the detail in the clause and reference the relevant legislation. The time to ensure the rent review clause meets your needs is before a deal is committed. Once the lease agreement is finalised, the focus should move to internal lease management. 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. If possible, prepare for rent notices before they are issued. Ideally, the focus of the rent reviews should be to agree to the new rent before the formal review process.
Understand the terms, requirements and possible interpretations of the rent review clause. Most importantly, be prepared to play the landlord’s games. Make sure the landlord’s rent notice has been issued in accordance with the lease requirements. Whatever rent notice arrives, be sure to review, analyse and object even if it is only 3%. Landlords rely on tenants being overcome by inertia and avoiding confrontation.