Pitfalls in Lease Rental Review Clauses

The most common forms of Rental Review provisions in Commercial Leases normally provide for annual rental increases during the lease term and for Market Rental Reviews at the commencement of an extended term.

Annual Rental Increases during Lease Term

Annual rental increases during the term of a lease are normally calculated by a fixed percentage increase or in accordance with (usually upward) movements in the Consumer Price Index.

Since the coming of low inflation levels which have reduced a Landlord’s ability to increase rentals by reference to the Consumer Price Index from levels as high as 3% in years past, now to barely over 1% in some instances, there has been a greater push by Landlords to include fixed percentage increase rental reviews in new leases often around 2% at the lower end and up to 4% or even higher at the top end.

The problem with excessively high fixed percentage increases, whilst seemingly resulting in a windfall for the Landlord, may eventually back fire because the rental, over a period of years, adjusted on such basis will inevitably substantially exceed the real market rental of the leased premises and the Tenant will eventually, upon the expiration of a leased term, seek to relocate the business to new premises or, alternatively, will require a substantial reduction in rent in order to take up a new lease term.

Market Review upon exercise of Option to Extend Lease Term

The most common Commercial lease provisions for the review of rental upon the exercise of an Option to Extend the term of the lease will require the Tenant to give written notice of exercise of the option to extend usually no later than three (3) months prior to the expiration date of the current term.   The rental for the first year of the extended term is normally then arrived at by a process of negotiation in the first instance or, if as is often the case, the Landlord and the Tenant cannot reach agreement as to a proposed new first year rental, the matter of such rental valuation is referred to a Valuer to be appointed by the President of one of the Valuers organisations, normally the Australian Property Institute or the Australian Valuers Institute.  The determination of rental arrived at by the appointed Valuer is then final and binding on both the Landlord and the Tenant for such first year of the new lease term

However, in drafting and preparing the relevant Lease provisions for annual rental increases and market rental increases as set out above, Solicitors sometimes fail to make proper provision in leases for all the necessary steps to be taken in the rental review process and the following are some of the errors and inadequacies which cause issues and even the failure of rental review provisions: –

  1. Incorrect or inadequate Consumer Price Index calculation;
  2. Failure to specify which Consumer Price Index outcome is to be utilised (i.e. for which City or Groups to apply);
  3. Failure to properly express and describe how an initial rental negotiation process is to be applied for Market Review upon lease extension;
  4. Failure to specify which party or parties is permitted or required to refer a rental valuation issue for determination;
  5. Failure to specify which party or parties is or are to pay for the valuation and associated costs and in what proportions.

Whilst it may seem that either the Landlord’s solicitor or the Tenant’s solicitor may be “nit picking” at the outset of lease documentation negotiations, the extra time and perhaps the few extra dollars spent at this initial stage in getting the documentation right, may save large sums of money at a later date when issues arise as a result of defective and/or inadequate lease documentation.