Almost all leases, whether commercial or retail, will contain a process for increasing the rent once every year. This is known as the rent review clause. These clauses can be quite technical and hard for tenants to understand. There are three common methods of commercial rent review, namely:
- fixed percentage increase;
- consumer price index (CPI) increase; and
- market rent review.
This article will discuss the advantages and disadvantages of each method to allow you, as a tenant, to make informed choices about your lease agreement.
1. Fixed Percentage Increase Review
A 'fixed percentage increase review' is a fixed rent increase that takes place on specified dates during the lease term. Usually, this will be each anniversary of the commencement date of the lease. In practical terms, this means that the rent will increase by the amount of the fixed review every year on the anniversary of the commencement date. This amount is usually between 2-5% of the current rent per year.
Advantages of a Fixed Percentage Increase Review
Calculating and applying a fixed rent increase is generally straightforward. Therefore, it leaves little room for disputes. The fixed percentage increase occurs automatically on each of the specified dates.
Also, a fixed percentage increase review provides certainty for both your landlord and yourself. You know how the rent will increase each year and, therefore, can budget accordingly.
In fact, you may be able to calculate the total rent payable for the duration of the lease upfront. Therefore, this is a favourable option if you value certainty.
Disadvantages of a Fixed Percentage Increase Review
As a tenant, you may want to negotiate a lower percentage rent rate. However, the end figure will usually come down to supply and demand. Currently, a percentage rent increase rate could fall anywhere between:
- 2% (this is near the consumer price index); and
- 5% (this is on the high side of the market).
Another disadvantage is that if the economy experiences a downturn or recession while you are paying a high rate (e.g. 5%), your rent may be increasing disproportionately to your business growth.
2. CPI Rent Review
A CPI rent review is directly related to the movement in the consumer price index (CPI). The CPI is a measure of inflation. It is applied according to a complex formula (usually related to the city or state that the premises are in) contained in the lease. The Australia Bureau of Statistics (ABS) publishes the CPI for each location in Australia.
Advantages of a CPI Rent Review
CPI represents the fairest commercial rent review method for a tenant. This is because it:
- keeps pace with the economy; and
- is less likely to be disputed compared to a market rent review.
If the CPI increases or decreases, the rent will change in line with the CPI. Although this method lacks the level of certainty of a fixed increase, there is still some degree of certainty. You will generally also be able to predict future CPI.
Lastly, the annual increases have been quite small in recent years.
Disadvantages of a CPI Rent Review
Most landlords with high demand premises would be reluctant to agree to this method. This is because it:
- provides a small return on investment; and
- does not take into account the relative demand or value of the property.
To address this, many landlords will either:
- include a CPI increase plus a fixed percentage increase (e.g. CPI + 2%); or
- provide that the review will be the higher of CPI and fixed percentage.
It is also possible to have a combination of a CPI rent review and a fixed percentage increase review. For example, the rent review may be CPI + 3% or the higher of CPI and 4%.
3. Market Rent Review
A market rent review means the rent for your premises will change in keeping with the current market. Generally, market rent reviews are not undertaken during the term of the lease. Instead, they will only occur if your lease has an option and you choose to exercise that option. This will trigger the market rent review provisions so the rent can be 'reset' to reflect the market at the commencement of the further term.
Advantages of a Market Rent Review
A market rent review can be a double-edged sword for both you, the tenant, and the landlord. This is because the movement in the market can go either way. If the market does not move or even decreases, your rent may decrease as a result. The rent will keep pace with the market and could actually work out to be less than a fixed price increase. In addition, market rents are generally determined by an independent third-party valuer, rather than the landlord (unless the market rent has otherwise been agreed between you and the landlord).
However, to avoid falls in the market, some landlords will include a 'ratchet clause' in the lease. This clause says that your rent cannot be less than the rent you were previously paying. Retail leasing laws across Australia prohibit ratchet clauses in retail leases. However, there is no such prohibition in commercial leases.
Disadvantages of a Market Rent Review
The market rent might increase rapidly in some markets and create uncertainty for your rent budgeting. Also, any sudden growth in the market could mean that you find yourself paying a significantly higher rent than you were previously. This, in turn, could also have consequences if you wish to assign the lease.
In addition, the process of determining the market rent can be time-consuming and costly. At first instance, the landlord or the landlord's agent will conduct their market review and advise their results to you. If you do not agree with the landlord's assessment of the market rent, you may need to ask a third-party valuer to assess the results. The valuer may require submissions from both you and the landlord and any additional valuation will have associated costs.
In some instances where the proposed rent increase was low, you may even find that the cost of determining the market rent outweighs the benefit to be gained by the increase in rent.
Key Takeaways
Entering into a lease can be risky if you have not carefully considered the rent amount and how it might change throughout the lease term. There are three main ways to structure your commercial rent reviews to ensure a fair outcome, being:
- fixed price increase;
- CPI increase; and
- review to market.
