If you have a lease. Then you take a lease, rent is set at the start. The landlord knows that rent levels are likely to go up in the future. So, except in the shortest leases, landlords may require a rent review years. Typically, read reviews every five years, but they can be every three years, or any other period.
The most usual type of rent review is aimed at finding the “open market rent” – the rent a willing tenant would pay a willing landlord for the premises at the particular rent review date.
The biggest issue is: what exactly are “the premises”? That is a more complicated question than you might imagine. At the start of the lease, you know exactly what the premises are. But in five years time what are they? You might have taken on a shell and now substantially revamped into into a luxurious spa. Or maybe the inside of your restaurant has been scorched and burned from a fat fire in the kitchen last month.
It is also not only about the premises themselves, but also the terms of the lease. When you were looking at the premises at the start of the lease, let’s say the landlord was offering a 10 year lease. Now at the time of the rent review, at the end of the fifth year, the situation is different – there are only five years left. The length of term would also have an effect on what a tenant would pay in the open market.
These are all issues which have been argued over by competing surveyors and and hammered out in the courts over many years, and some general benchmarks have been established.
Let me now introduce to you, “the hypothetical lease”.
With the hypothetical lease – the clues is in “hypothetical” – is not the actual lease of the actual premises. Instead it is an imaginary lease of the premises with a lot of fictional assumptions. The point of the assumptions is to iron out any effects of extraordinary events (like the fire) and to avoid you paying unfairly (e.g. for the changes you have made to improve the property).
These are some of the most usual assumptions.
It is assumed that no work has been carried out to the premises by tenants during the lease term. The point of this is to make sure that it’s the premises the way they were when the original tenant took them which are considered, not the premises beautified by your expensive fit out works. The only exception to this is for works tenants do under an obligation to the landlord. So if you got a concession on your original rent because you agreed with the landlord that you would bring a dilapidated building up to spec, the result is taken into account in the rent review, because that was all part of the original deal. (You do need to make sure that you are not unwittingly caught out by a clause in the lease obliging you to comply with statutory requirements.)
Another assumption is that if the premises have been damaged or destroyed, that they have been fully rebuilt or reinstated. In other words, if, at the rent review, you’re looking at a smoking pile of bricks, the rent review must assume the building is still standing and spick-and-span. The reason is that you have many other remedies in the lease to protect your position if premises are destroyed or damaged. There is the insurance. Rent is suspended for a period. You may have an option to break the lease in certain circumstances. So, the accepted practice is that none of this should affect the rent review valuation.
It is assumed that you have performed your repairing obligations under the lease. It would be unfair to the landlords for the rent to be depressed at the rent review because you have let the premises fall into a state of disrepair for which no new occupant would pay a full rent.
Another assumption is that the premises have been fitted out and equipped so that they are capable of being used for all purposes required by a tenant permitted under the lease. In other words, it’s assumed that the premises are ready and able to be used for any use which the lease allows. In this respect, whether the use clause is narrow or wide has an impact on the rent.
It’s assumed that the hypothetical lease will be renewed at the expiry of the lease under the provisions of the Landlord and Tenant Act 1954. This is the tenant’s statutory right to have a new lease. There are circumstances – such as the landlord intending to rebuild, or use the premises for its own occupation – when the tenants right might be refused. So this assumption is simply saying that it will be assumed that none of those factors will apply.
It is assumed that every prospective willing landlord and willing tenant is able to recover VAT. The open market rent is being assessed on what tenants in the marketplace do. If you took out of the marketplace prospective tenants who can’t recover VAT, and the building is subject to VAT, that would reduce the pool of potential tenants. So it is assumed that all prospective tenants can recover VAT. That’s a fairly technical point.
As well as items which have to be assumed as part of the hypothetical lease for a fair result – “assumptions” – there are also matters which ought to be disregarded – “disregards”. These are factors which would have a positive effect on the current level of rent for the premises in the real world, but which shouldn’t be taken into account. They are usually disregarded because it would unfairly penalise the tenant for the tenants success. In the rent review, it is not the value of the tenant’s business which is being considered, only the value of the premises themselves.
So, the effect on rent of the fact that the tenants or occupiers have been in occupation of the premises is disregarded. Similarly any goodwill attached to the premises because of the tenant’s business is disregarded.
Importantly, any increase in rental value to the premises resulting from the tenants’ fit-out works or any other tenants’ improvements (except those done under an obligation to the landlord) are disregarded. This is all explained above.
The effects of rent-free periods are disregarded.. They are regarded as one-off incentives, or recognition by the landlords of the time needed to get the premises ready for the first day of trading. It may be unfair to assume that they would be repeated at a renewal.
There are many other assumptions and disregards which can be applied depending on the exact circumstances and you really need professional advice on this.
What is left standing at the end of this process is a hypothetical lease which should protect you and the landlord so that the rent agreed at the start is increased in a way which fairly reflects changes in the market.