CAN TENANTS DREAM THE IMPOSSIBLE DREAM?
18 / 06 / 2020
Is it time for landlords to think the unthinkable and consider upward and downward rent reviews? Ben Dunbar looks into his crystal ball to consider the possible impact of Coronavirus on leases.
To tempt tenants away from the serviced office sector, office landlords were already offering more flexible and creative lease forms than the classic market institutional lease before Coronavirus hit. Coronavirus can only have sped up the process of market acceptance of flexible lease terms.
Flexibility is now going to be even more important to businesses and many are already talking about reducing the size of their premises, with any resistance to employees working from home being a thing of the past.
The trend towards shorter leases and regular tenant breaks is likely to accelerate even further. We will see more inclusive rents, generic Cat B fit-out works carried out by landlords and then rentalised, even final dilapidations liability pre-agreed at the beginning.
If landlords are going to have to make concessions to attract tenants then could some even offer upward and downward rent reviews?
Risk of over-rented premises
No one knows the long term impact on rents of Coronavirus and its economic consequences. But if rents drop heavily then existing leases can become ‘over-rented’ if the actual rent is more than the current open market rent. The tenant will struggle to assign an over-rented lease and, if it underlets, it will not cover its rent as the underlease rent will be at the then current open market rent.
In retail, the impact of upward only rent reviews has been fatal for businesses with large estates. Retailers such as House of Fraser and Debenhams have turned to CVAs in an attempt to fix the problem of vastly over-rented property portfolios.
Even if a tenant has a rent review coming up, then the most they can hope for is that there will be a nil increase at rent review. This is because the rent review is ‘upward only’. The rent paid from the rent review date cannot be less than what it was before. This protects the value of the landlord’s interest and is a key feature of the UK commercial property market and its attractiveness to investors.
Alternative rent reviews
Upward and downward rent reviews are the Holy Grail for tenants; but like the Holy Grail they are never seen in practice. The rent is reviewed to the open market, and could be less than the current rent. Landlords and lending institutions obviously resist them as they decrease capital values.
The Code for Leasing Business Premises in England and Wales 2007 stated that landlords should offer alternatives to upward only rent reviews if requested and give reasons if they are unable to do so. The alternatives that it suggested were indexation or an upward and downward rent review but with a floor set at the level of the initial rent. Following the Code was completely voluntary and this did not happen. RICS has just published the new Code for Leasing Business Premises (first edition, February 2020) intended to promote fairness in negotiations between landlord and tenant. There is no mention at all in this of alternatives to the classic upward only rent review, so the idea appears to have been dropped. This is in contrast to Australia, which legislated against upward only rent reviews and where indexation is used as the usual rent review mechanism. Ireland also banned upward only rent reviews in 2010 following the 2008 economic crash.
In England some retailers with leases inside the Landlord and Tenant Act 1954 are known to seek five year leases, because on renewal under the Act, rent can fall as well as rise to market level: effectively a DIY downwards rent review. This practice requires a strong market position for the tenant, and won’t work for tenants who need a ten year lease to amortise the cost of fitting out works.
It will be interesting to see if Coronavirus and its economic effects bring back pressure from tenants for alternatives to the upward only open market rent review and whether even upward and downward rent reviews can be negotiated by tenants in particularly strong bargaining positions.