What is a Rent Review in a Commercial Lease?

Signing a lease for commercial space is a common occurrence for businesses of all types and sizes. However, once a lease is executed and an enterprise has moved into a location, company leaders rarely give that document another thought, as they shift their focus to the day-to-day operations of their businesses.

Unfortunately, a standard provision in many UK leases - called a rent review - could come back to bite tenants as landlords seek to raise rents throughout the life of the lease. To learn about the process, as well as tactics used by both landlords and tenants, LoopNet spoke with Stuart Powlesland, a London-based director of lease advisory at Avison Young.

What Is a Rent Review?

A rent review is the process of examining current market rents and determining if an existing tenant's rent should be raised so it is in line with rents paid by new tenants for comparable space. Powlesland said there are generally two bases for the assessment of rent reviews.

• Index-based review. The first is an index-based review using an indicator like the Retail Price Index (RPI), which is a measure of inflation. For example, if this index rises by 3%, then the rent would rise by the same percentage.
• Open market valuation. The second is an open market valuation. This process is akin to commercial real estate appraisals, involving a detailed survey or appraisal of a property's value at the time of the rent review, based on an examination of comparable properties in the market or submarket. These valuations can commonly result in significant upwards adjustments, but sometimes downwards, Powlesland said. "Unfortunately, for tenants, landlords rarely enable a downward adjustment in rent, stipulating in the lease that rents will remain flat if this occurs," he added.

Historical Norms

Open market rent reviews are the mechanisms used historically with very long lease terms of 10 and 25 years. Officials put these rent reviews in place to give landlords the ability to raise rents at rates that were tied to market conditions, so they could generate more revenue as expenses increased or buildings needed repairs, Powlesland said.

Based on the language in some rent review clauses, numerous elements of the lease - not just the rent - can be addressed by both landlords and tenants during the open market rent review assessment. This latitude opens the door to conversations about problems with the building or future requirements from the tenant, conditions that can offer leverage to one party or the other as rent increases are being negotiated.

The essence of the open market review is that the rent increase is based on current market rents rather than some arbitrary percentage, Powlesland said. For landlords, this arrangement is generally good because they know the tenant will be on the hook for market rents if they go up. For tenants, this may be problematic because they could suddenly be responsible for significantly more rent.

Today, these very thorough reviews are applied to longer-term leases and generally to prime assets, Powlesland said. This approach is appealing to owners of top assets because they tend to be in sought-after markets or submarkets that evolve quickly and increase in value rapidly.

Can Shorter Leases Avoid the Rent Review Process?

Rent reviews have not been as common in recent years, Powlesland said, because tenants are executing shorter-term leases without rent review provisions, figuring they have more leverage to negotiate a reasonable rental rate if the landlord fears losing them as a tenant.

However, with shorter leases of less than three years, a fixed annual rent increase of some percentage or amount may be agreed upon to avoid a rent review and establish known increases in advance for both tenants and landlords, a standard approach in other European countries that is not the norm in the UK.

Powlesland said that fixed rent increases are relevant when landlords develop a bespoke building for a tenant, and they want to ensure that costs are recovered, and profit is generated. Fixed increases provide the landlord with this comfort.

In some cases, landlords and tenants agree to annual rent increases that are not fixed but tied to an index, either CPI or RPI. "Most tenants would resist annual index increases, however where there is substantial occupier demand for a type of property or location (or lack of supply) then this annual increase would be more acceptable to a tenant," Powlesland said.

Key Parameters and Administrative Components

Key attributes of the rent review provision govern the exchange between landlords and occupiers.

Rent review clause

The rules and processes for carrying out an open market rent review are outlined in the rent review clause of a commercial lease. It is important to note that just because rent review dates are listed in the lease, the landlord is not required to initiate them, but they likely will.

Upwards only increase

Rent increases are typically stipulated as "upwards only" in most leases and therefore initiated by landlords that stand to gain more revenue if a tenant's rent is raised. This provision gives a landlord the right to increase the rent, but it also gives the tenant the right to challenge the increase.

Key dates

The dates for an open market rent review are specified in a lease. For example, a ten-year lease might list rent review dates in years three, six and nine. If the rental amount changes upon completion of the rent review process, the new rate will be effective as of the dates specified in the lease.

Gathering data and documents

Tenants should be given about three months' notice before the rent review process begins, and landlords are encouraged to stipulate this in the lease. This gives tenants time to gather data and documents or hire a professional to dispute the proposed increase. The rent review process tends to take 6 to 12 months, but it could be resolved within a matter of weeks if both sides are prepared, Powlesland said.

Disagreement

If the parties cannot agree, "there is usually a mechanism within the rent review clause of a lease to have an independent person determine the rental review, either an arbitrator or an independent expert," Powlesland said.

All Classes and All Qualities

Rent reviews are typically found in all types of commercial leases for office, retail, restaurant and industrial uses. "In our experience, there is little difference between sector types," said Powlesland. He said that the timing of rent reviews could differ based on asset quality, with the market norm being rent reviews every five years with "significant increases for good quality prime assets rather than secondary assets."

This is because prime assets can be expensive to maintain, and landlords want to know that they can evaluate rents as frequently as possible and be covered should expenses rise. Additionally, prime assets can be in short supply, putting more upward pressure on rents, and landlords want to make sure they have the flexibility in the lease to raise rents along with the market.

Landlords Have the Upper Hand

It's generally agreed that landlords have the upper hand when it comes to rent reviews. Given that landlords are real estate professionals that understand and focus on markets, rents and values as part of their day-to-day work, it is reasonable to conclude that they have an advantage when negotiating rent increases. "This is a correct assumption, and it does lead to landlords being able to negotiate rent reviews over and above the market level," Powlesland said.

To help level the playing field, "tenants need to be proactive in looking at the rent reviews six months in advance and engaging with a rent review specialist rather than waiting for the landlord to trigger the rent review," Powlesland said. Sometimes, landlords trigger the review 6 to 12 months after the rent review date, giving them ample time to create a body of evidence to support a higher rental, Powlesland added.

Be Proactive with the Initial Lease

It's never too early for tenants to pay attention to the rent review clauses being codified in their leases. "Be proactive, engage with an adviser to look to forecast a provision for the rent review at a sensible level rather than an arbitrary level," Powlesland said.

To this end, "cap and collar" provisions in a lease provide some degree of certainty for both tenants and landlords. By negotiating a cap on future rent increases and codifying this into the lease, a tenant can ensure that rent will not rise to an unsustainable level in the future. Similarly, a collar stops the rent from falling below a certain level, supporting landlords.

"Tenants will need to strike a balance between ensuring the right terms are agreed to (including the rent review) as well as ensuring that there are no delays in completing the lease, which may impact the tenant's ability to run its business," Powlesland said.

Hiring and Paying Professionals to Assist with Rent Reviews

If you've ever wondered about how to get into commercial real estate as an agent, one pathway is through becoming a professional who assists with rent reviews. Most agents will be found on the internet or via the Royal Institute of Chartered Surveyors (RICS), Powlesland said. Some agents may be appointed because of previous involvement with the building on behalf of the tenant, "but the process involves referencing case law and interpreting rent review clauses, so engaging a rent review surveyor or a rent review agent specialising in this process is recommended," Powlesland said.

The cost for engaging an expert varies, Powlesland said. It may be a lump sum, a percentage fee, or some combination based on a variety of factors. Those factors include the potential aggregate rental sum, sector type, building size, abundance or lack of data and complexity of negotiations. Most surveyors will pitch a fee based on these components. If the matter is referred to an independent expert or arbitrator, then there is another fee on top of that.

"I do get frustrated when people talk to me about fees because at times the smaller the rental, the less rational the market is. When you are negotiating smaller rents, you are gathering comps from smaller tenants who have committed to a new rental settlement without actually seeking advice," said Powlesland. Chances are that these smaller tenants are paying too much. So, establishing fair market rents in the face of these potentially overpriced comps can require a great deal of time.

In some ways it is easier to assess prime property because there is generally more information available and rent reviews have involved experts that have pressed on behalf of their clients to obtain true market rents, Powlesland said.

Rent Review Dates and Backdating

It is important to note that based on the way some rent review clauses are written, the dates in the lease do not necessarily mean that the review itself will take place on or near those times. Instead, they serve as markers in the lease to indicate the date from which a new rate will commence.

"It is conceivable that a landlord will not trigger a rent review until the very end of a lease," said Powlesland, putting tenants on the hook for increased rent that they are contractually bound to pay, retroactively.

While Powlesland says this tactic among landlords is not the norm, it does illustrate that rent review clauses wield significant latitude for landlords to raise rents and tenants should be keenly aware of this when signing leases.

Powlesland said that he has seen landlords come back to the tenant in year nine of a 10-year lease and say that the rent should have gone up in year five, and that they are raising the rent retroactively.

This "does happen, but it is limited [and] it depends on the landlord's negotiation position for the renewal of the lease," Powlesland said. Tactically, the landlord may want to put pressure on the tenant by leaving the rent review until the last minute, thereby giving themselves leverage during negotiations, so they can pull back and make "rental forgiveness" appear as a concession.

In the end, Powlesland said, "communication with the landlord" is key for tenants. They should focus on knowing when the landlord may trigger the rent review and approximately what level of rent will be sought.