COVID has had a catastrophic effect on a Landlords’ budget, and sublease availability is driving the leaseability of actual vacancies down, as well as rents. So, a Landlords’ only saving-grace will be tricky Market Review clauses upon exercise of lease options.
That means tenants need to ensure that proposed commercial rent reviews are fair and commercially viable before entering into leasing agreements. And the first step is to understand the process and the difference between ‘face rent’ reviews and ‘effective rent’ reviews.
While mid-term rent reviews have been less prevalent in recent years, in a post-COVID market, they may be able to secure their tenants on longer terms. That's because, in the current conditions, the same income, guaranteed for a longer period, is worth more to a landlord. And, indeed, most commercial leases with an option to renew will include a market rent review clause.
Here, 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 – 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's taken as the new rental amount. Alternatively, if the tenant contests, the tenant and landlord must negotiate until they agree on a fair market rent. And once all parties agree, or if the tenant hasn't responded by the due date, the amount is deemed 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 determining a new rent. That means the tenant often doesn't know the amount they will have to pay for the space before deciding to stay.
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, 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 if the process and terminology are not entirely understood. This can be particularly problematic when 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.
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.
Although the market rent review process is relatively standardised, negotiating a market rent review is not straightforward. And some traps can trip up tenants – the devil 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 the proper market knowledge, to respond to rent notices promptly, it's likely to result in a rent level that's determined by a valuer – which can be costly. Suppose a tenant does not, or cannot, respond within the allocated time frame. In that case, the non-response is taken as 'tacit acceptance,' which means the new Market Rent is 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.
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 that prevents the rent from decreasing.
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.
But there are some smart negotiating steps you can take to help you secure the best possible commercial lease deal, including:
When it comes to market rent reviews, it's important to understand the process and fine print. Tenants must stay aware of landlord tricks. They should also be prepared to dispute, even if the proposed increase seems negligible.
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!