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'Face' And 'Effective' Market Rent Reviews: What's The Difference?

Last updated:
Jan 31, 2023
|
Commercial Real Estate

2023 will be the year for tenants.

Subleasing is driving the leaseability of direct stock down, putting pressure on total vacancy. And this year, even more companies will downsize and give back space through subleasing as the realisation sets in that working from home is here to stay. 

A landlord's only saving grace will be tricky market rent review clauses upon the exercise of lease options.

Before entering new leasing agreements, tenants must ensure that proposed commercial rent reviews are fair and commercially viable. And the first step is to understand the process and the difference between 'face rent' reviews and 'effective rent' reviews.

How does the market rent review process work?

While mid-term rent reviews have been less prevalent in recent years, they give landlords a chance to secure their tenants on longer terms. And in the current conditions, the same income, guaranteed for a longer period, is worth more to a landlord. 

Most commercial leases with an option to renew will include a market rent review clause. Here's how it works:

  • Step 1: The landlord will send a written notice to a tenant proposing a new rental amount. The amount is usually in line with the current market conditions (i.e. what are tenants in the area paying for similar spaces).
  • Step 2: The tenant is given some time to agree with or dispute the new rental amount. If they agree to the proposed figure, it's accepted as the new rental amount. But if they contest, negotiations will continue until both the tenant and the landlord agree on a fair market rent. 
  • Step 3: Once all parties agree, or if the tenant hasn't responded by the due date, the amount is deemed to be accepted. If the parties cannot agree, most leases allow a valuer to be appointed to determine the market rent independently. 

Regarding option market rent reviews, most commercial leasing agreements require the tenant to enter into a binding contract before determining a new rent. That means the tenant often doesn't know the amount they'll have to pay for the space before deciding to stay.

How often is a market rent review carried out?

It depends on your lease.

Mid-term rent reviews usually only take place in the middle of long-term leases, say five years into a 10-year lease. However, rent reviews often feature when a tenant exercises an option to renew, regardless of the length of the lease.

What's the issue?

Commercial rent reviews can trip up tenants, particularly when differentiating between commonly misunderstood terms - 'face rent' and 'effective rent'. 

Face rent

Face rent is a rental 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

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.

image of arrows pointing in different direction to indicate a decision between face and effective rent reviews

So what's better? A face or effective market rent review?

At Tenant CS, we strongly advise our clients to undertake an effective market rent review when exercising an option or weighing up market alternatives. 

This helps to ensure that their rent is not subject to false inflation and factors in all incentives.

What are the problems when it comes to market rent reviews?

Although the market rent review process is relatively standardised, negotiating a market rent review is not straightforward. 

Here are some traps that can trip up tenants:

Timing

Commercial leases usually afford the landlord a reasonably long 'window of opportunity' to issue a market rent review notice. 

That means landlords can keep an eye on the market and only send out a review when it will result in the most favourable outcome for them.

On the other hand, tenants are usually given a short time frame (as little as 14 days) to respond to a landlord's offer. The landlord may also actively choose to issue rent notices around holiday periods to catch tenants off-guard.

The rent review period can also often extend 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 or the proper market knowledge to respond to rent notices promptly, a valuer will likely determine the rent level – which can be costly. 

And if a tenant does not, or cannot, respond to the notice within the timeframe?

In that case, the non-response is taken as 'tacit acceptance,' which means the new Market Rent is automatically accepted.

Negotiating tricks

Landlords may 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 is likely to 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 market rent review

Landlords 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 that prevents the rent from decreasing.

close up of two people negotiating tenant incentives in a commercial rent review

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 keen to attract high-quality tenants on long leases, especially in today's market. But 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. But 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 
  • Hiring professional professional tenant reps who'll do the research and lease negotiating on your behalf. A good negotiator will be able to secure you the best possible deal.

Get in touch with Tenant CS

In a tenant's market, we generally advise our clients not to exercise their option unless they already have a tenant-friendly lease. However, if you are planning on exercising your option, stay aware of landlord tricks and be prepared to dispute, even if the proposed increase seems negligible.

Level the playing field by getting a tenant rep in your corner. The team at Tenant CS are skilled negotiators and can handle your lease negotiations from start to finish. 

Whether you are negotiating a new lease, exercising an option or undertaking a mid-lease rent review, appointing us can save you thousands of dollars and protect your interests.

Get in touch with us today to find out more!

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