Annual Rent Reviews….. which mechanism should I seek ?
If your retail business is located in a leased premises, your lease would contain a provision that allows the rent to be reviewed on an annual basis. Rent can be reviewed according to a number of different methods including Fixed Percentage /Stepped Increase, Consumer Price Index (CPI), by a special Formula or it could be reviewed to Market.
Each one of these methods has pros and cons depending upon a number of factors, so I will explain how each method operates and outline their advantages and disadvantages.
Fixed Percentage/Stepped Increase: This is where Base Rent is increased by a specific percentage, commonly around 2% to 5%. For example, let’s say your current rent is $70,000pa + GST and it is increased by say, 3.5% in Year 2 of your lease, the new rent is simply calculated as follows; 1.035 x $70,000pa + GST = $72,450pa + GST. Sometimes this method of review is expressed in dollar terms whereby the actual annual rent is simply stated as $72,450pa in Year 2, rather any mention of a percentage.
The advantages of this type of review is that you know exactly how much rent you are going to pay over the entire duration of your lease term. From an accounting and financial management perspective, this is invaluable. Also, in times of high inflation (such as what we are currently experiencing right now), having fixed increases protects you, as the level of increase is limited.
The downside is when inflation is very low and by extension the CPI growth rate is also very low, you might slightly overpay on your rent. It’s not likely that you will pay a lot more than the prevailing CPI growth rate, but it is a bit of negative in such circumstances.
Formula Review: A Formula Review is not a common method of rent review, however some rents are calculated according to an agreed formula of some description, often involving Turnover Rent. For example, I have seen a lease where the base rent was reviewed according to the average of the last 2 years base rent and turnover rent – in this particular case the retailer actually paid turnover rent during the 2 years leading up to the review, so the retailer had quite a large rent increase.
Generally speaking landlords don’t subscribe to this method and most retailers don’t like them either as they can become too complex. Having said that, during times of slow economic growth where sales are weak or declining, having rent tied to a formula as noted above could actually be advantageous, however in times of prosperity where sales are growing strongly and turnover rent is likely to be paid, well then this would be a distinct disadvantage.
Consumer Price Index: Gearing rent to movement in the Consumer Price Index (CPI) is quite common. In most cases it is calculated by comparing the most recent quarterly CPI figures to the quarterly CPI figures immediately 12 months prior. As noted above in times of low inflation, this method favours retailers, as the CPI is usually very low or in some cases, even negative. This means rents will increase marginally or actually decrease.
Of course the inverse is true in situations where there is runaway inflation like we are experiencing right now. Some retailers have leases geared to CPI and some even have a formula that includes CPI, such as CPI + 1% or CPI + 2%. I am afraid there maybe many retailers in this exact situation right now and will be expected to pay ridiculously high CPI rent increases. As I am writing this article, the All Groups CPI figures for each of the eight Capital Cities for the September 22 Qtr has just been published and the results are absolutely horrifying. Comparing the Sep 22 Qtr to Sept 21 Qtr, Year on Year growth ranges from 6% in Perth to 8.4% in Adelaide ! What this means is, if your rent is geared to CPI and is due to be reviewed during the Sept 22 Qtr, it will increase between 6% and 8.4%, depending upon which area of Australia your business is located. Some retailers might have even have heftier increases if their lease contained a combination formula such as CPI + 1% or CPI + 2%. For example if you are based in Adelaide and your lease is geared to CPI + 2%, your rent will actually increase by over 10%!
Market Rent Reviews: A Market Review is where the Landlord and Lessee attempt to agree on what they believe to be a fair rent for the premises. The definition of Market Review is marginally different depending on which state or territory your business is located, however the principles are pretty well the same. In essence a Market Review seeks to establish how much rent could be obtained by the Landlord for your premises if it were vacant and on the open market. Generally speaking the Landlord is to assume that the Permitted Use is similar or the same as is present, but they should not have any regard to Goodwill that your business has.
A Market Review allows the rent to remain the same, to go up or to go down, depending upon market conditions prevailing at the time of the rent review date. Retail lease legislation in most states and territories also forbids “Ratchet” clauses that attempt to hold rents at the same level and only movement in one direction (usually upward). In principle this is probably the fairest method of rent review, however they can be risky for retailers in certain circumstances. If the local market where your business is located in is very hot with low vacancy rates and experiencing high rental growth, then a Market Rent Review could see your rent skyrocket upwardly – remember there are no limits on how high (or low) your rent can move.
As a Market Review is a process that involves the Landlord and the Lessee to negotiate, sometimes the parties disagree as to what they believe fair Market Rent is. Funnily enough Landlords tend to believe that rents should be higher and Lessees tend to believe that rents should lower. In such circumstances most leases have a clause that allows the matter to be referred to a third party, usually a professional Valuer who will determine what the rent will be. If it gets to this, the Determining Valuer is usually the final arbiter, so whatever they assess the rent to be, will be the final binding new rent, irrespective of whether this represents an increase, a decrease or remains the same.
So…. after considering all the above methods of Rent Review, which one should you press for when negotiating your new lease ? The answer to that is, it depends on your individual circumstances and what your outlook is economically – honestly it’s a very tricky question as you need to have a crystal ball to predict the future.
Personally, I like certainty, so for the past several years I have been recommending Fixed Annual Rent Increases to my clients wherever possible and Market Reviews where appropriate (such as during an exercise of a Lease Option). Of course some landlords do not always agree to fixed increases and insist on CPI Reviews, so some of my clients have reluctantly agreed to CPI reviews, however for the most part we have been pressing for Fixed or Stepped Increases.
As everyone who is reading this article knows, we are currently in a high inflationary environment the likes of which we have not experienced in over 30years. Unfortunately no one knows how much longer this will last for or how high inflation will go, so my preference for the immediate future is to continue to try and lock in fixed annual increases wherever possible, at least you know exactly how much rent you are going to pay in future, no matter what happens.