An international perspective on banning upwards-only rent reviews

The introduction in parliament of the proposed ban on upwards-only rent reviews was an unwelcome surprise, lurking in the English Devolution and Community Empowerment Bill. However, the UK is not the first jurisdiction to consider introducing such legislative provisions, so the UK’s real estate industry is looking abroad for advice and inspiration.

The proposals in the UK

In the UK, a ban on upwards-only rent reviews was first contemplated in the 1990s. Since then, the landlord and tenant relationship has been transformed, particularly in high-street retail premises where leases are now significantly shorter. Such tenants often benefit from several incentives, including rent-free periods, break rights and capital contributions to their fit-outs. However, the proposed legislation will apply to all business tenancies including offices, retail parks, industrial/logistics units, hospitality and leisure facilities, and healthcare premises such as GP surgeries.

Investors are concerned about the uncertainty this ban will cause regarding income and funding structures. Pension funds, for example, are drawn to the long-term inflation-linked income from real estate, which may be threatened if rents start to fall as well as rise. These provisions may change lenders’ appetite for commercial rent estate in the UK, which would impact on the cost and availability of funding for development, contrary to the government’s goal of stimulating economic growth.

Business tenants may benefit from rising-and-falling rents, or pre-negotiated rent increases, but they may lose out if landlords respond to the ban by inserting more landlord breaks, setting higher initial rents and offering fewer incentives. This will not help the small businesses with weaker covenant strength who need support from government, landlords and the wider economy.

Ireland

Ireland abolished upwards-only rent review provisions in business leases, entered into after 1 March 2010, as a direct reaction to the global financial crash in 2009/2010, and in an effort to help struggling retail tenants.

As the legislation could not be applied retrospectively, it immediately created a two-tier market where tenants on “new” leases benefited from significantly lower rents (due to the economic crash) and upwards-and-downwards open market rent reviews.

By contrast, tenants on “old” leases were tied to rents set at the height of the market and to upward-only provisions for three or four more rent review cycles, and were not helped by the fact the average lease duration was 20/25 years, sometimes with a 15-year break.

Instead of alleviating the pressure on struggling retailers, the ban made it worse. Tenants with old leases could only escape their onerous rent obligations by exercising a (rare) break clause or by closing down. Meanwhile, new tenants often paid up to 50% less for comparable spaces, putting longstanding businesses at
a significant disadvantage.

There has been an assumption that alternative rent review mechanisms would be used to give landlords certainty on return, including stepped rents, fixed rents, index-linked rent reviews and rent reviews subject to “cap and collar” adjustments. In reality, other than CPI reviews, these alternative approaches still remain relatively uncommon.

Landlords tried to introduce rent review clauses that could only be triggered by the landlord, since the Irish legislation didn’t explicitly address this, unlike the draft UK legislation. It is still uncertain in Ireland whether such clauses would stand up in court.

One notable effect of the legislative change, however, was a shortening of typical lease durations. At the time the law was enacted, leases often lasted 25 years without break rights. Today, retail leases typically span five to 10 years. Office and logistics leases, where currently there is significant development investment in Ireland, still tend towards 15-year fixed terms with open market reviews so developers have some certainty on investment return.

Over the past 15 years, Ireland’s shift to open market rent reviews has become widely accepted, with the broader property sector ultimately embracing this model as the norm. Many of the impacts of the abolition of upwards-only rent reviews were softened because the market was at a historically low point in 2010, so rents have generally been increasing as the market has steadily recovered. However, it remains to be seen how it will respond to any future downturn.

The United States

In the US, most commercial leases typically use fixed base rent throughout the initial lease term, with any increases being pre-agreed – such as annual CPI adjustments or fixed percentage bumps – rather than periodic market-based reviews. When leases include renewal options, these generally fall into two categories: (1) pre-negotiated percentage increases (such as 2-3% annually or CPI adjustment), or (2) fair market value resets determined through appraisal or arbitration processes with a floor being the previous rent (or some agreed on percentage increase in the previous rent).

If the US enacted legislation like the provisions proposed in the UK, it would primarily impact renewal clauses using “greater of” formulations as noted in clause (2) above. However, we suspect such a ban might actually lead landlords to cease giving tenants the benefit of renewal options or abandon market-based rent renewals entirely in favour of predetermined fixed increases, since they would no longer have downside protection in declining markets.

Australia

In Australia, retail leases are governed by similar legislation to the Bill’s proposals, but on a state-by-state basis. Retail leases extend beyond shops to commercial premises used for the provision of retail goods and services. This is consumer protection legislation designed to protect smaller tenants. In Australian states where the retail leases legislation does not apply, there is usually no restriction on the type of rent review that may occur.

Where a tenant has the protection of retail leases legislation, market reviews are allowed during the term or option periods of a lease but there are specific requirements in place for market reviews – rent can go up or down and specific inclusions and exclusions are mandated. In practice, a mid-term market review is rare except for very long-term leases, they are typically only used for option terms.

For example, in Victoria, the Retail Leases Act 2003 applies to premises leased wholly or predominantly for the retail provision of goods or services. This includes businesses providing retail services or goods to other businesses – eg professional services, offices, cold storage facilities, etc. There are some exemptions, such as where annual occupancy costs exceed AUD$1m and for public companies (domestic and foreign) and their subsidiaries. The Act allows rent reviews to be conducted using only one of the following five methods:

1. Fixed percentage increase – eg 3% annually.
2. Indexed review – typically linked to the consumer price index.
3. Fixed dollar or percentage amount – eg $50,000 or 3.5% increase per year.
4. Current market rent – determined by valuation using the method set out in the Act (see below).
5. Prescribed formula – though none have been prescribed to date.

Different methods can be used in different years, as long as only one method applies at any given time. Clauses that prevent rent from decreasing after a review are void, ie no ratchet clauses. A further similarity is that if the landlord fails to initiate the review within 90 days, the tenant may initiate it.

Australian retail leasing legislation has been in place for more than 20 years. It has resulted in a reduction in the use of market reviews and landlords offering option terms, particularly for shop leases. The long-held position and market practice that has developed for retail tenants has not, in practice, flowed through to larger tenants not covered by retail leases legislation, and there would be significant push back if such a change were proposed.

Lessons for the UK

Looking at the impact of legislative bans imposed in Ireland and Australia shows the possible negative and unintentional consequences that could flow from such provision. However, there is comfort to be drawn from the success of pre-negotiated percentage-based rent increases in the US. It is hard to predict how these proposals will be impacted by recent changes at the helm of MHCLG.

Sarah Walker is a real estate partner and Robert Payne is head of real estate disputes at Travers Smith LLP; Brian O’Callaghan is a partner at William Fry LLP; David J Rabinowitz is a director and John Rothman is counsel at Goulston & Storrs PC; Nathaniel Popelianski is a partner and head of real estate at Corrs Chambers Westgarth.