Pros and cons of rent review options
Commercial leases can allow the rent to be reviewed in a number of ways, whether that be to market, CPI, a fixed percentage or even relative to the tenant's turnover. We set out below the pros and cons of each rent review method.
Market rent reviews
Historically the most common method for reviewing a property's rent was to have its market value assessed by a valuer. The lease will often dictate what factors can be taken into account when the market rent is assessed. For example, a valuer would usually ignore any goodwill associated with the tenant's business and any items of fit out which have been paid for by the tenant.
- Pros: market reviews allow the property's rent to keep track with the property's value and the then current market conditions.
- Cons: the cost of establishing the new market rent can be expensive, particularly if the rent is disputed. Engaging a lawyer's assistance
CPI rent reviews
Some leases measure rent increases against the movement in the Consumer Price Index (CPI).
- Pros: CPI reviews leave less room for disputes as the quarterly CPI figures are freely available from the Reserve Bank's website.
- Cons: CPI reviews simply ensure that the rent will increase in line with general inflation. Rather than taking into account any increase in the specific property's value. Accordingly, in a 'normal' inflationary environment the CPI adjusted rent may be less than the property's true market rent. Alternatively in a period of unusually high inflation, CPI rent reviews can result in unexpectedly large increases to the rental.
Fixed rent increases
To add even more certainty the parties could agree that the rent will increase by a set figure or percentage on each rent review date.
- Pros: The tenant will know exactly how much revenue they will have to generate to sustain the lease, while allowing the landlord some certainty of income.
- Cons: There are potential downsides to fixed rent increases, however. If a recession hits, and markets stall or even decrease as a result, then the tenant will still be bound to that fixed percentage increase which could be unaffordable. Alternatively, if the market is hot then any rent increases would still be capped at the agreed percentage.
Turnover rentals are when the tenant pays a set percentage of their business's turnover as rental. These types of rentals are less common in NZ, but they are sometimes utilised if the lease relates to a motel or retail premises.
- Pros: Turnover rentals can be beneficial for a landlord if the tenant is a good operator, although the tenant may feel aggrieved that they are essentially being penalised for their own success.
- Cons: Alternatively if the tenant is not trading well, then a turnover styled rent could result in a lower rental for the landlord than they could have expected relative to comparable properties. Because of this it is common for a tenant to pay a minimum 'base rent' as well as a percentage of their turnover.
Rent review ratchet clauses
Leases will often include a ratchet clause which dictates the amount (if any) by which rents can decrease following a rent review.
For market rent reviews there are 3 possible types of 'ratchets':
- A standard ratchet clause will state that the rent cannot decrease below the level of rent that was paid when the current term of the lease commenced.
- A hard ratchet clause will provide that the rent cannot ever decrease. A landlord will prefer this type of ratchet clause.
- A soft ratchet clause will allow the new rental to decrease if this is what the market is dictating. This type of ratchet clause would obviously be beneficial to a tenant.
Under a standard ADLS lease form all CPI rent reviews are subject to a hard ratchet in that they can only consider increases (but not decreases) in CPI.
The importance of good advice
As you can see there are many advantages and downsides to each particular method of rent review. When working with our landlord or tenant clients, Cavell Leitch will help you tailor a bespoke rent review clause (including rent review ratchets) which suits your circumstances. We can also help resolve rent disputes or help find resolutions if payments are overdue. Please contact us for further assistance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.