Contrary to popular belief, ‘upward-only’ rent review does not mean the rent must increase.
An ‘upward-only’ review means that the rent payable after the review to open market rental is agreed or ascertained would not be less than the rent payable before the rent review, even if the open market rent were lower.
I think the reason for the misunderstanding stems from not appreciating the difference between rent review and rent payable.
Where the review is to open market rent, as distinct from some formulaic change, such as inflation index-linked or percentage uplift, the rent will be the open market rental at the valuation date. The valuation date is normally the same as the review date unless otherwise stated in the lease.
The rent payable is the amount payable after the review is agreed or ascertained. Therefore, depending upon the market rent at the valuation date, it is possible for that rent to either be less or the same or more than the rent payable before the review.
When the market rent is lower than the rent previously payable, an “upward-only” review could in some circumstances still result in the rent payable after the review is agreed or ascertained being less than rent payable before that review.
For example, if at the previous review in say 2009 it was agreed that the increased rent then would be phased over the ensuing period of 5 years, such as £25,000 pa for the first two years, rising to £26,000 at the third year, rising to £30,000 pa at the fourth and fifth years, the average rent over five years is £27,200 per annum.
The passing rent immediately before the 2014 review would be £30,000 per annum, but whether the rent payable after the 2014 review is agreed or ascertained would be defined as £30,000 or £27,200 pa would depend upon what was agreed by the parties when the 2009 review was documented.
Rent review dates are normally at pre-set intervals calculated from and including the commencement of the contractual term. The dates do not have to be at logical intervals: it all depends upon what was agreed by the parties when the lease was granted or subsequently varied. Also, the term commencement doesn’t have to be the same date of the lease: the date of lease is simply the date of the document.
It is irrelevant the rent will be fixed for several years, the duration of the revised rent is built into the rent review system, with adjustments or allowances for variations from the norm, the norm itself depends upon the evidence.
Depending upon the state of the market at each review/valuation date, the timing of each subsequent review might coincide with upturns or downturns in the market and/or a different interpretation of the valuation guidelines in the lease; in the event of downturns or static periods resulting in nil increase.
Hence, when the review is during a downturn or static period, the rent agreed or ascertained at an earlier review could be greater than the market rent at each subsequent review, with the result that the premises could become overrented.
Also, particularly with sale-and-leasebacks and lease restructuring, the initial rent on grant of lease might have been set above the level of market rent at that time, the tenant’s intention that the rent should not increase throughout the term.
In fact, in many locations, no evidential justification for any increase at all in rent throughout the term is precisely the fate that befalls many an inexperienced investor. (A lack of evidence may not mean nil increase; there are other ways of procuring an increase, including having a thorough grasp of the finer points of rental valuation and lease analysis.)
It might be thought that over-renting, as a result of an upturn in the market at some stage followed by a downturn, or a deliberate ploy only creates problems for tenants that cannot afford continuing to pay more or want to assign or sub-let, but it can also affect the capital value of the landlord’s investment because the excess rent would only endure for the remainder of the term and during any holding-over period, if any (before statutory procedures are underway).
On reversion (expiry of the lease), and assuming the tenant wants to renew, and assuming the Landlord and Tenant 1954 procedures are observed, the rent at the commencement of the renewal term will be the market rent regardless of any previous ‘upward-only’ cushion. Therefore, if the rent payable before expiry of the lease were greater than the market rent on expiry, that lower market rent would be the initial rent on renewal.
It is not just over-renting as a result of higher rent at an earlier rent review date that can lead to a lower rent on expiry/renewal of the lease. Where the rent review basis in the expired lease is index-linked or a percentage uplift, the initial rent on renewal, assuming Landlord and Tenant Act 1954 principles, will be the market rent, regardless.
Since index-linked rent review and minimum uplifts can result in the rent payable becoming higher than the market rent, the landlord would be worse off on renewal of the lease and depending on the market rent at the start of the renewal might not recover for years. For example, assuming the initial rent was £50,000 per annum, for a term of 20 years and at each 5-yearly review the rent increased by 5% then after three reviews the rent payable would be £57,881.25.
On expiry, the lease is renewed for another 20 years but even though the same percentage arrangement might continue as the basis for reviews in the renewal lease, the initial rent at start of the renewal lease would be the market rent which might be lower, say £45,000 per annum; if so then at the third review of the renewal term the rent would be £52,093.13 per annum.
Erroneously thinking that ‘upward-only’ rent review is a panacea for successful investment is something that commonly befalls inexperienced landlords and can play havoc with expectations.
Generally, minimum percentage uplifts and index-linked reviews are artificial devices ostensibly to enable the tenant to budget for future increases, but primarily designed to trick inexperienced investors into paying more for the investment proposition than the property would otherwise fetch if the rent review(s) were to open market only.
Consequently, investments whose rent reviews are index-linked or fixed percentage increase make sense for easy management and rental income cash-flow but don’t be fooled into thinking they are also blue-chip for growth and investment performance. At rent review, the likelihood of encountering tenant resolute resistance to any increase over and above the contractual obligation is almost guaranteed.
By Tom Entwistle, LandlordZONE®
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