With commercial property, the relationship between landlord and tenant hinges upon the terms and conditions of a tenancy, commonly known as a ’lease’ (a lease is the document). When a lease is granted, the onus is on the landlord to draft the wording and the tenant to approve. When the lease contains a rent review, with the rent to be reviewed to the market rent, as distinct from a formula such as index–linked, the lease will incorporate a ’second’ lease known as the “hypothetical lease”.
The hypothetical lease is all about how the market rent is valued. Rent is the product of the terms and conditions of the tenancy upon which the premises are let. The object of the hypothetical lease is to replicate those terms and conditions, but it does not have to replicate precisely. The wording of a hypothetical lease requires careful thought. When landlords and tenants leave the drafting to their respective lawyers, as happens invariably, the draftsmen are likely to follow precedents, often slavishly. Use of precedent is widespread and time–saving, but the snag in following what someone else has agreed involving other circumstances is that the consequences in practice for the parties in question may not be appropriate.
Whether the landlord’s or tenant’s intention could back-fire depends upon whether the wording attracts positive or negative connotations of material importance. Amongst issues where the landlord’s intention can back-fire involves the method of dispute resolution. There are two different methods, commonly known as ‘arbitration’, but whose rules differ. When the procedure is arbitration, any wording in the lease requiring each party to pay half the arbitrator’s costs is void under the Arbitration Act 1996. Also, while an arbitrator can award costs to the winner, it is not only the arbitrator’s costs that the loser could end up paying but also the loser’s costs. Where the procedure is determination by independent expert, whether the expert has jurisdiction on costs depends upon the wording of the lease: where the lease is silent one party could end up paying the whole of the expert’s costs.
If at review the rent cannot be agreed then the prospect of having to shell out an extra several thousands pounds plus vat to have the rent fixed by a third party can be daunting. It may become a question of extra costs versus worthwhile. Since ’armchair’ landlords tend to regard the dispute procedure as a last resort to be avoided if at all possible, many landlords tell their surveyors they do not want to go to ‘arbitration’ it doesn’t take much for a well–advised tenant to prey upon landlord fear by using the ploy of extra costs to obtain no increase. The same goes for tenants that concede more rather than pursue the (lower) market rent, only to find themselves stuck paying the higher amount for the duration of the term.
Costs ought not be considered in isolation. For a landlord, any increase will, provided the rent payable is ‘upward-only’ (not less than rent payable before the review) stay at that minimum level for the remainder of the term, possibly longer. Any uplift in rent can increase capital value and indicate investment performance. For a tenant, paying more than absolutely necessary will, assuming the upward-only proviso, endure for the term and possibly any holding-period after expiry of the tenancy, and can affect the marketability of the lease and sale of the tenant’s business as a going-concern.
Allowing the drafting and approval to lawyers working in isolation without input from surveyors can be a mistake. A lease is a fixed document, whose content may only be changed by mutual agreement (or rectification should a genuine mistake made by the original parties) but the market is continually changing. Wording from the past may not be such a good idea now or in future.
A prudent landlord will want a surveyor to assist the lawyer in drafting the lease, likewise a prudent tenant. Lawyers may have the theory at their finger–tips but surveyors deal with the practicalities. The difference is between the subjective and the objective. The lawyers represent the subjective, namely the actual landlord and tenant respectively, but at rent review the actual parties take second–place to the objective, the hypothetical landlord and hypothetical tenant. For subjective aspirations at rent review to be achieved, the hypothetical lease must be complementary.
Where a property is bought already let, the new landlord could be lumbered with a lease whose terminology is unfavourable to the investor’s expectations. Appraising a proposition without considering the impact of the terms and conditions of the existing tenancy can result in overpaying for the investment. For example, of a building that has been structurally enlarged, the question to whom does the rental value of the enlargement belong can be answered by the documentation.
Ideally, the hypothetical lease should allow for changes in the market, but predicting is not easy even if you think deeply and long-term. For matters shown to be contentious the tendency is to include the best of both worlds. For example, whether the term in the hypothetical lease is the original term or the unexpired term; should the original term run from the commencement of the tenancy or the review date.
Of course, any intention one party has via the hypothetical lease is only likely to succeed when those on the other side are inexperienced or have no choice at the drafting stage. At rent review, anyone can barter but for negotiating a rent review to market rent one needs a grasp of business tenancy law, rental valuation, and tenancy-psychology. For those of us surveyors whose job is to scrutinise ‘small print’ with a view to finding lucrative angles and loopholes for clients to exploit, the leaving the drafting of leases to lawyers can provide rich pickings.
The Rent Review Specialist