The retail rent market was one of the sectors to be hit hardest by the pandemic and is still only just re-merging. According to Statista, the headline rate of high street and shopping centre rents rose in the first quarter of 2022 by 7.5%, whilst the net effective rate rose by 9.2%.
In simple terms, the headline rate is that written in the lease and the effective rate includes the impact of incentives such as rent-free periods, rent abatements and fit-out contributions.
The rise followed a sustained period, from the first quarter of 2020, in which the rate fell in every single quarter, with the last quarter of 2020 seeing the headline rate plunge by 24.8% and the effective rate by 31.1%.
Figures of this kind help to set the backdrop, against which current discussions of the difference between index-linked rent reviews and open-market rent reviews will take place.
This represents a new normal for Landlords and Tenants and features changes to shopping and footfall patterns brought about by the shift to working from home and rising inflation. This means the choice between opting for an index linked rent rise or an open market increase is now more important than it has been for years.
The majority of commercial leases contain rent review provisions that allow the landlord to recalculate the rent on specific dates detailed in the lease and typically take place every three to five years.
There are several methods used for calculating the new rent, including turn-over based rent and fixed increase rent, but by far the most popular methods are index linked and open market.
What is an Open Market rent review?
An open market rent review sets the new rent based on what could currently be achieved on the open market if the property were let to a willing tenant on the terms set out in a hypothetical lease.
The open market review lets landlords take advantage of any potential increase in value of the commercial property during the period of the lease, although it should be noted that most open market review provisions contain an ‘upward only’ clause.
This means the rent can only ever increase and if the wider market value has dropped during the period since the last review, the rent charged will stay the same rather than be reduced.
The hypothetical letting considers a series of ‘assumptions’ and ‘disregards’. These simplify the process of reaching a rent increase which reflects the current market without the complication of factoring in particular real-world issues.
The assumptions may be that both parties have complied with all obligations under a lease and the disregards could be instructions to ignore a particular fact. A useful example of a disregard often given is that of a tenant having voluntarily carried out improvements to the property that have increased the value of that property.
If this increase in value was then reflected in the new rental rate rather than being disregarded then the tenant would, in effect, be paying twice for the same improvements.
When a rent review clause is included in the lease it should outline the type of rent review and state whether there is a time limit for the process. The lease will also state whether ‘time is of the essence’ or ‘time is not of the essence’.
If time is of the essence the time frames are strictly enforced. If a party fails to serve a notice within a specific time frame, they will lose the right to either renew the rate or dispute the new rate. If time is not of the essence there is no specific time frame, so tenants need to be aware that the rent review date having passed is no guarantee that the landlord will not review the rent.
What is an Index Linked rent review?
The chief appeal of an index linked rent review is the inherent simplicity, with the new rental rate calculated quickly using a simple formula linked to current inflation.
When agreeing the original lease, the parties will have to agree which index the rent review will be linked to. For many years the Retail Price Index (RPI) was used to track inflation, but more recently this has tended to be replaced by the Consumer Price Index (CPI).
The major difference between the two is that the RPI takes mortgage interest payments into account, whereas the CPI doesn’t and is based solely on a measure of other goods and services.
Although the RPI figure is typically higher, in recent years both have remained steady and offered a degree of certainty to tenants and landlords, but from the beginning of 2022, inflation has spiked around the world and in the UK.
This means index-linked review agreements entered into three to five years ago, may now appear slightly less attractive than they did at the time of agreeing the lease. Whether the current spike in inflation is temporary remains to be seen, but such fluctuations can be addressed by a ‘collar and cap’ provision written into a lease.
This sets a maximum and minimum increase in each review, such as 2% and 5%. This means the rent will not increase by less than 2% or more than 5%, no matter what the index being used is set at. If the rent isn’t reviewed annually then these figures need to be compounded, with 2% becoming 10.4% over 5 years, and 5% rising to 27.6%.
The simplicity of index linking means this is a method more likely to be used on an annual basis, making the collar and cap easier to factor in.
When the parties can’t agree on a rental rate, the rent review provision in a lease should include details of the appointment of an arbitrator or expert to determine a fair rate, often after input from both parties.
The lease will generally state that both parties can agree upon an arbitrator, or that if agreement cannot be reached an application can be made to the Royal Institution of Chartered Surveyors for an arbitrator to be appointed.
If you need advice on a commercial lease, either as tenant or landlord, or need help with any other commercial property matter, please contact Matthew Easter, a Senior Associate in the Commercial Property team here at Ansons Solicitors. You can reach Matthew on 0121 716 3693 or by email: email@example.com
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