Unravelling rent reviews

Introduction

Love them or hate them, rent reviews are typical – and crucial – under most leases. This paper focusses on ground leases which, despite some growing market scepticism, remain a fairly common form of land ownership in New Zealand.

In practice, rent review disputes can be the most costly and aggressive proceedings that parties to a lease (and lawyers) ever experience. Often, landlords have a portfolio of leasehold properties to protect, and securing a favourable outcome at arbitration or in a settlement has significant consequences for them beyond the matter at hand. By contrast, the lessee wants to maintain a favourable return on their leasehold investment in a market where land values (and rents) have drastically escalated over the last 20 years.

Lessees that are willing and able to dispute the rent advanced by landlords in rent reviews are usually well-resourced. Less well-resourced lessees will often have to deal with a subpar process from their perspective, and in turn, subpar results.

The purpose of this paper is to highlight key concepts and issues in rent reviews. The paper is by no means intended as a comprehensive guide to rent reviews, but a lens on some key points and food for thought.

The paper will be broken into three parts and will cover:

  1. Rent review basics – how rent is assessed and the principles that apply.
  2. The rent review process.
  3. Alternatives for rent review clauses when preparing your lease – how to minimise the cost of future disputes (or avoid them altogether) at the contract negotiation stage.

Part One: Rent Review Basics

Concepts and principles of rent reviews can sound like a foreign language to those new to the game. However, they stem from well-established principles of law and valuation.

In this section we highlight some key concepts that are commonplace and important in most rent review disputes.

Many historic leases that remain in play today expressly provide that “the lease is granted under and subject to the provisions of the Public Bodies Leases Act 1969” (PBLA). For such leases, the purpose of a rent review is to determine the “fair annual rent” of the land in accordance with the First Schedule of the Public Bodies Leases Act 1969 (PBLA). It is settled practice that the test for determining the “fair annual rent” is what a “prudent lessee” would offer for the ground rent of the land for the term and on the conditions of the lease.

The definition of “prudent lessee” is closely intertwined with the concept of “highest and best use” because the prudent lessee is the party who will put the land to its highest and best use (i.e. what the parties expect the lessee to do with the particular site). To ascertain who the prudent lessee is and what it would do, the proper course is to judge the character of the prudent lessee in relation to the particular premises by inferring from the evidence what the parties expected that a lessee would do with the particular site.[1]

We outline below in more detail each of these key concepts and also discuss the two main approaches – classic and traditional – valuers use when establishing the fair annual rent.

Fair annual rent

As noted above, the PBLA sets the test for establishing the rent as “the fair annual rent”. The test for fair annual rent is what a prudent lessee would give for the ground rent of the land for the term as at the rent review date, taking into account the conditions as to renewal and other terms of the lease.[2]

It is an objective assessment of rent with reference to the market, and does not permit reference to the particular qualities, circumstances or expectations of the actual lessee or lessor.

Arguably, the test of “fair annual rent” is specific to the highest and best use and will result in a rent that the identified prudent lessee will pay.

Prudent lessee

The accepted test for determining the prudent lessee is:

“…the notional prudent lessee is assumed to be a person of reasonable prudence who has informed himself or herself with regard to all the relevant facts affecting the property including its potentialities”.[3]

There is an element of the valuer’s subjective opinion (when advancing their view of rental values) as to what the prudent lessee would accept as an appropriate rental rate, including a consideration of economic factors, specific lease term variations and/or site-specific issues, the location of the land, and general market conditions.[4] The prudent lessee would not blindly accept a rental rate which might prevail in the market in general, or offer to pay a rent that was not affordable.

Highest and best use

“Highest and best use” is a fundamental concept in rent review disputes.  Opinion on the importance of establishing the highest and best use can vary depending on the particular lawyer and/or valuer you are speaking to in the field.  Nevertheless, it is well-established in legal precedent and the International Valuation Standards that in undertaking a valuation of market rent, or the fair annual rent, determining the highest and best use of the land is crucial.

Highest and best use is defined as the probable use of a property that is:

  • physically possible;
  • appropriately justified;
  • legally permissible; and
  • financially feasible,

which results in the highest value of the property being valued.[5]

The factors of physical possibility, legality and feasibility are expanded on in International Valuation Standards as follows:[6]

  • to establish whether a use is physically possible, regard will be had to what would be considered reasonable by participants;
  • in terms of legality, relevant considerations are any legal restrictions on use e.g. town planning / zoning designations such as height restrictions; and
  • financial feasibility is assessed by comparing the financial return and cost of other alternative uses that are physically possible and legally permissible.

Determining the fair annual rent

In determining the fair annual rent, valuers will adopt a particular methodology to reach their opinion.  While there are a range of options, the most recognised are what are known as the “classical” and “traditional” approaches.

The classical approach involves identifying market rentals for other comparable properties and then making appropriate adjustments to reflect differences in the physical characteristics of the land, the terms of the lease and risk (security of return).[7]

On the other hand, the traditional approach involves determining a market value for the freehold interest in the land and ascribing a market return taking into account the lease terms.[8] It is a two-step process that assesses:[9]

  1. the freehold value of the land and adjusting for matters such as zoning, location, size, contour, and development potential; and
  2. a rental rate – a rate of interest appropriate in the circumstances which, applied to the unimproved value, would fix the rent to be paid. The rental rate has been the subject of significant litigation through arbitration and at times the High Court over the last thirty years.

In practice, the classical and traditional methods are well-recognised ways in which the fair annual rent can be determined. Arguably, a highest and best use assessment is integral to both. Historically, the traditional approach is followed only where it is not possible to use the classical method of comparing other rentals obtainable for similar properties in the neighbourhood.[10]  However, there has in more recent times been an absence of new lettings which has seen the classical approach lose some focus. Although the absence of new lettings does not prevent the application of the classical approach, it can affect the weight and credibility of the approach in some, but not all, instances.  The best evidence is generally rentals which have been agreed in comparable tenancies, at the relevant date with vacant possession (i.e. new lettings between arms-length parties), and in particular, where the use is the same (or a substantially similar use) as the permitted use under the lease.[11]

When considering the rental factor comparables for the purpose of the traditional approach, and comparables for the purpose of the classical approach, there is a hierarchy in the weight that is attributed to evidence as follows:[12]

  1. New lettings
  2. Rent renewals
  3. Rent reviews
  4. Arbitrated agreements

Overall highest and best use is of significance to:

a) the relevance of comparable evidence in the application of the classical approach; and

b) the relevance of comparable evidence in determining the underlying land value in the traditional approach, and then the appropriate rental rate to apply to that land value. For example, lessees would argue that a residential highest and best use would attract a lower rental rate. Landlords could alternatively argue that the distinction between residential and commercial rental rates is not relevant – nevertheless it is likely to be an issue in any arbitration.

Part Two: Rent Review Process

The rent review process can vary depending on whether the review is still subject to the provisions of the PBLA, or the lease has been varied by parties over time.  This section assumes the PBLA applies.

Typically rent review periods range from 7 to 21 years in ground leases. The process usually starts with the landlord serving a notice of rent based on a valuation of the fair annual rent by a competent valuer.  If the lessee disputes the rent as the fair annual rent, they will serve a notice in response specifying the disagreement and notifying the landlord that the lessee requires the rent to be determined by arbitration.

Timeframes for service of the requisite notices are as set out in the PBLA (see Schedule A).

In some cases the PBLA has been varied to include a compulsory negotiation period between the parties and/or their respective valuers.

The two most common processes involve the selection of either a single arbitrator or a panel, where each party selects an arbitrator and those parties then select an Umpire between them.

The selection of the arbitrator/panel can often be one of the most contentious parts of the rent review arbitration process.  Because the New Zealand market is relatively small, and potential arbitrators are reasonably well known, there is a perception that certain arbitrators will hold particular views on matters that are fundamental to the ultimate determination of the fair annual rent.  While each arbitration should be decided on its own merits with reference to the evidence before the arbitrator, parties’ perceptions of potential views held by arbitrators heavily influence (and arguably impede) the selection process.

Once the arbitrator or panel is confirmed, the arbitration itself begins. Based on experience, arbitrations can take 3 – 12 months to come to hearing – depending on the capacity and availability of the arbitrator and the complexity of the issues that will be relevant to the determination of the fair annual rent.

Some key points to be mindful of during the selection process and the arbitration itself are:

  • If the lease requires an arbitration panel, but parties prefer a single arbitrator, they will need to agree to expressly depart from the process set in the lease.
  • There are pros and cons to a single arbitrator versus a panel. On the plus side these include cost savings, timing of the award, and potential process efficiencies. On the downside a single arbitrator can reduce the extent of expertise and breadth of experience and perspective on the panel.
  • Based on experience, parties often underestimate the relevance of discovery in rent reviews and overestimate the relevance of pleadings. However, ultimately the process should be tailored to fit the particular rent review in progress.

Part Three: Alternatives for Rent Review Clauses

There are steps both parties can take at the outset – when they are negotiating the terms of the lease – to minimise the chance of a rent review dispute down the track. However, getting the rent review provisions of a lease “right” when negotiating the lease contract requires a degree of crystal-ball gazing – you cannot know what the property market is going to do in five or ten years’ time.

In the context of a ground lease, it is even more difficult to suggest alternatives to rent review clauses or steps to ensure a dispute-free rent review process – most times a lessee will be dealing with a ground lease that is already in place with antiquated rent review terms, while the pool of landlords that hold ground leases is relatively small, they are well-resourced and astute, bringing another unique set of challenges from the lessee’s perspective.

Our top tips are:

  • Do your homework. Although there will always be an element of luck and risk, you can make an informed decision as to what property values are going to do in the future. Before you sign up to a lease, talk to trusted agents and consultants about their view of the market, in the area where your premises are, and find out what is the current market standard for rent review frequencies and types. If you sign up to an onerous deal in the first place, you are going to be on the back foot when a market rent review rolls around.
  • Think about the benefit of certainty. It may seem trite to say, but you will minimise rent review disputes if you minimise the frequency of market rent reviews. Of course, this may not be the best way to structure your rent reviews – whether you are a landlord or lessee, you need to weigh these considerations up. Bear in mind what is market standard – it will likely require a market rent review at some point in the life of the lease, but there is something to be said for the certainty of fixed and CPI rent reviews.
  • In a ground lease context, consider the pros and cons of fixing the rental rate and reviewing the market value of the land as opposed to the rent. Again, it is a balance – this could save costs on rent reviews but could also be perceived as benefiting one party depending on the market. You could also consider:
    • prescribing the valuation methodology to determine the fair annual rent.
    • strict CPI adjustment or otherwise a pro-ration if return on the lease – again, the benefits of this will vary depending on the nature of the lease itself.
  • Get the drafting of the rent review clauses right. It is surprising how often we come across rent review clauses that do not reflect what the parties think they have agreed, or just do not work. This adds another complication to a rent review dispute that really could be avoided with good advice at the outset. Also consider including regards and disregards into a lease to ensure a valuer takes the right things into account when assessing the premises’ value.
  • If you are a lessee facing a market review on renewal, know the rent before you renew. If you are not wedded to staying in the particular premises, it pays to do some research on what the rent will likely be before you exercise your renewal right – if you think it is going to increase too much, don’t renew. Even better, if you are a lessee with leverage, you may be able to draft the clause so that the landlord must give you notice of the reviewed rent before you have to exercise your renewal right.
  • As much as possible, keep open lines of communication and accept that you might have to compromise. We often see landlords go into a market rent review expecting it to be difficult or contentious. It is common that a landlord, having had its valuer review the premises, will only give the lessee the certificate of valuation. We have found that in cases where the landlord has disclosed its full valuation report for the lessee to consider, there are fewer disputes because the lessee knows the premises have been properly valued and can have an open conversation with the landlord.

Conclusion

Given the payment of rent under a lease is often one of a lessee’s biggest business costs, and a landlord’s main form of income, it is little surprise that the process of determining the rent can be fraught.  This is particularly so in ground lease situations, where parties can be dealing with unexpected hikes in property values, antiquated rent review terms, well-versed and well-resourced landlords and no easy alternative premises. The fact that most rent review disputes are resolved at arbitration or are settled out of court means that the principles that govern concepts such as “fair market rent” are not frequently traversed in public legal proceedings and there is accordingly a dearth of recent case law guidance.

This was first published by ADLS in a CPD Seminar paper.

Footnotes

[1]Re A Lease, Wellington City Corporation to Wilson [1936] NZLR s. 110 at s. 113.

[2]Drapery and General Importing Co of New Zealand (Ltd) v Mayor, Etc., of Wellington (1912) 31 NZLR 598 (CA) at 605;Re A Lease, Wellington City Corporation to Wilson [1936] NZLR s. 110 at s. 111.

[3]Sextant Holdings Ltd v NZ Railways Corporation (1993) 2 NZ ConvC 191,556 (CA) at 191,561.

[4]Paros Property Trust Ltd v Paul Michael Faith [2014] NZHC 2826 at [32].

[5] International Valuation Standards Council “International Valuation Standards 2017” at cl 140.2.

[6] International Valuation Standards Council “International Valuation Standards 2017” at cl 140.5.

[7]Hubbard v KiwiRail Ltd [2017] NZCA 282 at [12].

[8]Hubbard v KiwiRail Ltd [2017] NZCA 282 at [12].

[9]Wellington City v National Bank of New Zealand Properties Ltd [1970] NZLR 600 at 673.

[10] Wellington City v National Bank of New Zealand Properties Ltd [1970] NZLR 600 at 678; Granadilla Ltd v Berben (1999) 4 NZ ConvC 192,963 (CA) at [7].

[11] Australian Property Institute/Property Institute of New Zealand “ANZ Valuation Guidance Note 9” (2009).

[12] Mykonos Property Trust Ltd v Bird [2016] NZHC 173 at [16].

Who can help

Related Articles

Sorry we couldn't find any results relating to your query.

View all