‘Face’ and ‘effective’ rent reviews: What’s the difference? (+ VIDEO)
COVID has already had a catastrophic effect on a Landlords’ budget and the worst is yet to come. Sublease availability is driving the leaseability of actual vacancies down, and so too are rents dropping. The Landlords’ planned saving-grace will be tricky Market Review clauses upon exercise of lease options.
It’s essential for a tenant to make sure that proposed commercial rent reviews are fair and commercially viable before entering into an agreement. And the first step is to understand the process and the difference between ‘face rent’ reviews and ‘effective rent’ reviews.
How does the market review process work?
While mid-term rent reviews have been less prevalent in recent years, COVID could see these emerge more commonly. Certainly, most commercial leases with an option to renew will include a market rent review clause. Here, the landlord will send written notice to a tenant proposing a new rental amount. The amount is usually in line with the current market conditions – that is, what are tenants in the area paying for similar spaces.
The lessee is then given some time to agree with, or dispute, the new rental amount. If the tenant agrees to the proposed figure it is taken as the new rental amount. Alternatively, if the tenant contests, then the tenant and the landlord must negotiate until they can agree on a fair market rent. And once all parties agree, or the tenant hasn’t responded by the due date, the amount is deemed to be the current market rent.
If the parties cannot agree, most leases allow a valuer to be appointed to determine the market rent independently.
When it comes to option market reviews, most commercial leasing agreements require the tenant to enter into a binding agreement to enter into an option term before a new rent has been determined. That means, the tenant likely won’t know the amount that they will have to pay for the space before making the decision to stay.
How often is a commercial rent review carried out?
It really depends on your lease.
Mid-term rent reviews usually only take place in the middle of long-term leases, say 5 years into a 10 year lease, but they most often feature when a tenant exercises an option to renew, regardless of the length of the lease.
However, commercial rent reviews can trip up tenants and cause issues if the process and terminology are not entirely understood. This can be particularly problematic when it comes to differentiating between ‘face’ and ‘effective’ rent. Tenants are often unaware of the difference between these two terms, but it’s vital to understand.
Face rent is a rent figure that disregards incentives such as rent-free periods, rent reductions (a.k.a rent abatements) and fit-out contributions.
You can read more about commercial lease incentives and what to look out for here.
Effective rent accounts for any incentives provided to you as the tenant. Under an effective market rent review, your rent would be lower than it would be under a ‘face’ market review.
Face or effective rent review – which path to take?
At Tenant CS, we strongly advise our clients to undertake an effective market rent review (i.e. factoring in all incentives) when exercising their option or weighing-up market alternatives. This helps to ensure that their rent is not subject to false inflation
What are the problems when it comes to market rent reviews?
Although the market rent review process is quite standardised, negotiating a market rent review is not straightforward. And there are some traps that can trip up tenants – the devil really is in the detail. Here are some things to look out for:
Commercial leases often afford the landlord a reasonably long ‘window of opportunity’ to issue a rent review notice. That means landlords can keep an eye on the market and only send out a review when it likely results in a positive rental outcome for them.
What’s more, landlords often only give tenants a short time frame (usually as little as 14 days) to respond to their offer. They may also actively choose to issue rent notices around holiday periods to catch tenants off-guard.
To make things even more complicated, the period in which the rent can be reviewed often extends into the new lease term. And this means that tenants only find out what the new rent will be after a lease extension.
If a tenant does not have a process in place, or market knowledge, to respond to rent notices promptly, it’s likely to result in a rent level that is determined by a valuer – which can be costly. If a tenant does not, or cannot, respond within the allocated time frame, the non-response is taken as ‘tacit acceptance.’ That results in the Landlords’ assessed Market Rent being automatically accepted.
Landlords may also propose an excessively high rent, knowing full well that the tenant will dispute the amount but not have the upper hand at the negotiating table. Here, the outcome of the lease negotiation will likely come down to which party can hold out the longest.
If the market is relatively ‘flat’, the landlord may propose what seems like a relatively small increase – say four to five per cent – in the hope that the tenant will not see the value or have the time for a rental dispute.
The type of rent review
Landlords also tend to favour ‘face’ market rent reviews. This is because ‘effective’ reviews may require an incentive to entice the tenant to exercise their option. Effective reviews can also result in a lower rental outcome for the landlord, which they try to prevent by adding a ratchet clause – a clause in a lease which prevents the rent from decreasing.
How to negotiate tenant incentives
There’s an old saying that “you don’t get what you deserve, you get what you negotiate”. This saying certainly applies to negotiating commercial leases and rental rates.
Landlords are inevitably keen to attract high-quality tenants on long leases, especially in markets where there are high vacancy rates.
There are some smart negotiating steps you can take to help you secure the best possible commercial lease deal, including:
- Working out what types of incentives best suit your business. For example, rent-free periods and rent reductions will help with your cash flow. On the other hand, landlord fit-out contributions can assist with the reimbursement of up-front costs. Which of these types of incentives are more important for your business?
- Thoroughly researching current market conditions (or talking to professionals who work in the leasing market day-in and day-out).
- Hiring professionals to do the lease negotiating on your behalf. A good negotiator will be able to secure you the best possible deal.
Get in touch with Tenant CS
When it comes to market rent reviews, it’s important to understand the process and the fine print. Tenants must stay aware of landlord tricks. They should also be prepared to dispute, even if the proposed increase is small.
Luckily, whether you are negotiating a new lease, exercising an option or undertaking a mid-lease rent review, appointing a tenant representation specialist can save you thousands of dollars and protect your interests.
The team at Tenant CS are skilled negotiators and can handle your lease negotiations from start to finish.
Get in touch with us today to find out more!