Commercial leases can be worded to 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. There are various pros and cons to each rent review method as we set out below.
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 process for undertaking a market rent review will be set out in the lease's terms. A landlord will be able to initiate a market rent review no earlier than 3 months before the relevant market rent review date, and no later than the following market rent review date. It is essential that the landlord carefully diarises the upcoming market rent review dates. Under a standard ADLS lease a landlord will not be able to backdate any rent increase if the market rent review is initiated more than 3 months after its due date. The increase will only be payable from the date of the late notice in that situation.
Once the tenant has received the landlord's rent review notice the tenant will then have a set period of time (usually 20 working days) to decide whether or not they wish to dispute the landlord's proposed rent. It is critical that this timeframe is adhered to – if the tenant fails to dispute the proposed rent in time then the tenant will be deemed to have accepted the landlord's rent.
If the tenant does dispute the landlord's rent, then the parties have an opportunity to get together and try to reach a compromise. If the parties are not able to agree on a new rent, then the new rent rate can be determined by either arbitration or by valuation. We would normally recommend that the parties each appoint valuers to try and reach an agreement on their behalf as the arbitration process can be expensive and time-consuming.
The lease will often dictate what factors can be taken into account and what factors should be dismissed 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.
- The benefit of market rent reviews is that they allow the property's rental to keep track with the property's value and the then current market conditions.
- The downside of the market rent review process is that it can require the parties to obtain often expensive rental valuations, particularly if the rental was disputed. If the proposed rent increase was relatively low to begin with, the parties may find that the cost of determining the market rental outweighs the final uplift in rent.
CPI rent reviews
It has become more and more common in recent years for rent reviews to the movement in the Consumers Price Index (CPI), which is itself a measure of inflation in NZ.
- The benefit of a CPI rent review is that it allows both the landlord and the tenant a degree of certainty as to the rent increase. It also means that the parties can dispense with the need to obtain costly market valuations as the quarterly CPI figures are publically available from the Statistics NZ website . CPI rent reviews are less likely to be disputed as a result.
- A potential downside of CPI rent reviews is that they simply ensure that the rent will increase in line with general inflation. They will not take into account any increase in the specific property's value, so it could be that in time the CPI adjusted rent will be less than the property's true market rent. In order to address this concern a landlord would be better placed if the lease allowed them to alternate between market and CPI rent reviews.
The standard ADLS lease form contains a formula for calculating CPI rent increases. This formula can be modified in a number of ways. A tenant may wish to ask that CPI rent increases are capped at a certain percentage. Alternatively a landlord would prefer to see that the rent is increased to CPI plus a certain margin, or that the CPI increases are compounding in nature.
Fixed rent increases
To add even more certainty the parties could agree that the rent will increase by a set figure on each rent review date, such as a 3.5% increase.
- The potential benefits of a fixed rent increase is obvious. The tenant to know exactly how much revenue they will have to generate to sustain the lease, while allowing the landlord some certainty of income.
- 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 3.5% increase. Alternatively if the market takes off and market rentals go through the roof, then the rent increase would still be capped at that 3.5% maximum.
Turnover rentals are when the tenant pays rental as a percentage of their business' turnover e.g. 35% of turnover. These types of rentals are less common in NZ, but they are sometime utilised if the lease relates to a motel or retail premises. Most commercial leases either explicitly or implicitly state that the performance of the tenant is to be disregarded.
- 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.
- 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.
Rent review ratchet clauses
Lease 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 rental to decrease beyond what was previously payable 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 take into account increases (but not decreases) in CPI.
The importance of documenting the agreed
However the rental is eventually determined, we recommend that the parties enter into a Deed of Rent Review which records the level of the new rent (or even to record that the parties have agreed to keep the rent at its current level). It will be crucial that the rent has been agreed in writing if either party wishes to refinance their business, or wishes to assign the lease to a third party.
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.