Don't forget the rent review clause

With recent destabilising events across Europe causing higher inflation and more volatility in markets, Tracy Cooper, Director - Occupier Advisory, talks about the importance of the often overlooked, rent review clause, and what options are available when agreeing fair terms.

When signing up to a new lease and agreeing heads of terms, occupiers may focus on rent, incentives, term and possibly inclusion of a break option. One key component to the agreement, which is often overlooked, is the rent review clause.

A rent review is a tool enabling landlords to increase the rent in line with market rates and/or inflation.

Time should be taken to agree the finer details at this early stage, as the review mechanism and wording dictates how the rent will be calculated for the remainder of the lease. Typically, a longer lease will involve one or more rent reviews during the term. As a tenant, you will be at risk of the rent increasing. Conversely, as a landlord, you will want to ensure that you are not undercharging later in the term. So how do the parties agree fair terms?

There are a variety of mechanisms used to review rent for example, fixed, turnover, open market, Retail Price Index (RPI) linked or a combination. Below we will focus on the relative merits of an RPI vs open market review mechanism, as we are seeing an increasing usage of RPI across a variety of sectors.

Open Market Rent Review

This is the most common type of rent review clause used in the commercial property industry. The rent review date is fixed, and the parties use comparable evidence to negotiate the revised rent based on hypothetical assumptions and disregards in the ‘hypothetical lease’.

The hypothetical leasing scenario creates a situation whereby both parties agree a new rent on similar terms as if they were entering into a new lease, but reflective of the market at the time of the rent being reviewed being the only variable. It is important to ensure that the hypothetical assumptions and disregards reflect the property and market.

RPI review

Parties use this second type of rent review where they prefer more certainty with the rent increase. It is calculated in accordance with the Retail Price Index (RPI), which in effect keeps rent in line with inflation. As RPI changes on a monthly basis depending on the price of goods and services, care should be taken when agreeing an index linked review clause to ensure that the formula is clear and concise. 

Although in periods of economic stability indexed reviews provide certainty over costs, the opposite is true in periods of economic uncertainty, and in this case, an RPI review may be less attractive. To mitigate some of the potential volatility, RPI review clauses often include a ‘cap’ (upper limit) and ‘collar’ (lower limit) to limit the change in rent between fixed percentages.

So, which is better?

It depends on the length of the lease, wording of the review clause, and crucially, what the market conditions are at the time of review. Recent destabilising events across Europe and the world point to higher inflation and more volatility in markets. Occupiers will want to opt for a rent review mechanism which provides the most certainty – but no mechanism is without its risks.

The benefit of an RPI rent review clause is that businesses can track and predict rental growth. It is a mathematical calculation which shouldn’t require drawn out deliberation. At present, with inflation almost hitting double digits, an RPI linked review would likely reach the upper limit of the ‘cap’ in place, and if over time rents in the property market stabilised or fell, it could lead to a situation where RPI rents are out of kilter with market rents.

An open market rent review provision should ensure that your property keeps pace with the property market and is helpful if an occupier wants to assign or underlet their lease later down the line.

A review mechanism which is the ‘higher of open market or RPI’ is potentially a lose-lose situation for an occupier. If rents fall in the property market, in an open market review scenario, the rent will likely remain unchanged. In an RPI review scenario the rent goes up in line with the ‘collar’ compounded over the review period.

To conclude, some occupiers may still prefer the certainty of an RPI index linked review, however, consideration should be given to prevailing economic conditions to ensure the rent does not become out of alignment with the property market.

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Occupiers will want to opt for a rent review mechanism which provides the most certainty – but no mechanism is without its risks.