Not so long ago rent negotiations between commercial property owners and their tenants were not something that factored on the public radar much, if at all. But New Zealand’s Covid-19 alert level four lockdown earlier this year changed that.

That’s because the rent tussles between commercial landlords and their tenants, big and small on both sides, garnered media attention at the height of the crisis. In many ways, they came to represent the economic dilemmas emerging.

While residential landlords and tenants, by and large, managed to navigate the crisis relatively smoothly, that was not the case in the commercial sector. Various factors contributed to this, but one major factor was no access emergency clauses, or the lack of, in lease agreements.

In turn, this served to highlight that the deed of lease is the cornerstone of the landlord-tenant relationship. As such, it is critical to have a well-balanced, fair agreement in place. And a critical part of that agreement must be clear rent review mechanisms and guidelines.

Rent reviews form only one part of good lease negotiations, but it is important for both parties to understand the processes and mechanisms involved, as well as their long-term implications.

That’s why we thought it was timely to provide a run-down of what’s involved in rent reviews and how commercial landlords can best navigate them.

Review Mechanisms

Bayleys Auckland commercial and industrial director Lloyd Budd says that, first up, there are two “events” that trigger a rent review. “One is a straight up rent review, while the other is a lease renewal. The two can be approached very differently as a lease renewal gives the tenant a chance to exit their lease, whereas a review does not.”

When it comes to rent reviews, there are a number of ways the rents can be reviewed. The three main ways are market reviews, whereby rent is set to current market rates, or “fixed” reviews whereby the rent is either a set annual amount (ie: 3%) or tied to a financial marker (ie: CPI + 1%).

‘Landlords need to have an awareness of supply and demand issues for the type of tenancy in a particular area, as well as the trends facing a tenant’s industry’ JOANNA PIDGEON

It’s worth noting there are pros and cons with each different mechanism. Auckland District Law Society property law committee member Joanna Pidgeon says that with market reviews, depending on the area, and size and value of the tenancy, the cost of a valuation can be prohibitive.

But the positive is that the rent will be set at a level that actually reflects market conditions.

“With CPI reviews, sometimes CPI doesn’t increase and can be negative. Fixed rent review increases give certainty as to what rent increases will be, but they can get out of step with market rents.”

Additionally, leases often include ratchet clauses. Pidgeon says these can be “hard” (meaning rent can’t go down even if market rent drops) or “soft” (where there’s a term commencement level the rent won’t go below). “Most leases have at least a soft ratchet as banks might be reluctant to lend to landlords without knowing what the minimum rent will be.”

Some leases have combinations of review mechanisms, such as a CPI increase each year and to market on renewal, she adds. “Others have a cap and collar or one of them. For example, they’ll have a predetermined minimum increase or a predetermined maximum increase.”

What Landlords Need To Know

Understanding the different types of rent reviews is important, but there’s an additional layer of knowledge commercial landlords should also have down pat.

Pidgeon says they need to have an awareness of supply and demand issues for the type of tenancy in a particular area, as well as the trends facing a tenant’s industry.

They should also know what market rents are for the area, not just their building, and what the outlook is for inflation in the future (if they want CPI as a rent review factor).

“Landlords should make sure that they are ready to start their valuation process on the right date, by obtaining a valuation. They also need to make sure they attach a valuation certificate to their rent review notice so they will be able to charge an interim increase in rent following agreement. And they must ensure they follow the rent review notice procedure set out in the lease.”

It’s not just about comprehending the process, it’s also about understanding the rights of both landlords and tenants while being prepared for some negotiation, according to commercial investor Satyan Mehra.

To start, that means landlords should initiate the rent review in a timely fashion. But he suggests they then need to consider issues such as both parties’ rights under the lease and, if pursuing arbitration, the costs versus benefits.

“If the rent review falls in line with lease renewal, a landlord must consider what happens if the tenant leaves? If they do, how easily could they be replaced? Would you as landlord be in a winning situation or a losing one?

“Also, think about tenant quality – who they are, what’s their past pattern, do they add overall value to your building (ie: are they a national tenant, etcetera), do they maintain the premises well? Because for a small amount of rent increase you don’t want to lose a quality tenant either.”

Negotiation Strategies

When it comes to the negotiations, there are a number of options worth considering, Mehra says. One is whether it’s an option to review the rent without going through a valuation, which could be useful if the likely increase is minimal and the valuation cost would offset a fair bit of rent increase.

“Alternatively, under the lease, you as landlord may have the right to charge for a valuation. If so, then that could be a negotiating thing: trying to save your tenant some cost and mutually agreeing on an increase.”

Understanding if your tenant can easily relocate might help too. “Let’s assume you had a tenant who had an expensive fit out, they may be unlikely to go as the cost of relocation for them could be high. So here you could hold your ground on market rent a little more firmly.”

‘It’s not always helpful to be very rigid – particularly if your tenant is a good tenant. So be flexible, be prepared to negotiate a little’ SATYAN MEHRA

In many ways, the fact that the landlord and tenant need to have an ongoing relationship means that during a rent review there is limited opportunity to negotiate.

That’s because, essentially, negotiation is all about leverage – and who has the balance of power, Budd says.

“However, some landlords may use these discussions to further negotiate other matters. For example: a tenant may want new bathrooms, so the landlord may agree to this assuming the tenant extends their renewal for a longer period.”

When the parties can’t agree on a “market rent” there is an arbitration process that is triggered in the lease, he adds. “If this happens, independent valuers will determine the market rent.

It’s a costly process though – and it can put additional pressure on a tenant/and lord relationship.”

Common Pitfalls & Problems

It goes without saying that there are some potential pitfalls for landlords to be aware of when going through the rent review process. Some of these come down to not following the process correctly or communication breakdowns.

However, Pidgeon cites some practical issues to watch out for. There can be uncertainty as to actual premises size, which can affect rent reviews, for example. “It’s best to have a surveyor measure the rentable area for clarity at commencement. Be clear what belongs to you as landlord and so what can be assessed when calculating rent. Also, make sure your tenant carries out their maintenance of the premises so that you can obtain your best and highest value of the premises in a good condition.”

If a review ends up going to the arbitration process, she recommends that a landlord should get an estimate of costs. “You may find the arbitration costs are more than the proposed rent increase and you might be better to split down the middle.”

Also, landlords must ensure they get all the documentation right. Pidgeon says a fully signed clear lease, with a measured rentable area plan which makes it clear what is landlord and tenant property in terms of valuation, is essential. “And when you have agreed the rent, document it fully and formally.”

Extra Words Of Wisdom

To round off the topic, our interviewees all had some final words of advice. The tip that came from all of them sounds obvious, but – it seems – is something often overlooked. It is that landlords should diarise reminders in advance of all renewal and rent review dates, as well as notice periods, under their lease so they don’t miss them.

Pidgeon says keep an eye on these dates and act promptly as there are often tight time frames for giving notices and approvals or objections. Further, if a landlord doesn’t issue notice in time, rent increases may not always be able to be backdated.

When reviewing rent in a difficult time, such as now, with Covid-19 hurting businesses of all sizes and types, it may be a time to negotiate rather than follow the strict terms of rent review – especially if your tenant is fundamentally reliable and looks after the property well, she says.

“But it is important that a landlord understands the long-term implications on agreeing rent review terms for a lease before setting. So pick up the phone and talk to your lawyer to make sure what you are doing is technically compliant.”

For Budd, getting rent reviews right comes down to collecting market evidence, case studies - and data, data, data! “That’s the key for landlords to ensure fair, transparent negotiations with their ‘customers’, the tenant.”

Meanwhile, Mehra emphasises the importance of following the correct process and doing things formally. Ensure whatever you do is nicely documented and if there is an issue you know you are in the clear, he says.

“Further, it’s not always helpful to be very rigid – particularly if your tenant is a good tenant. Sometimes being too aggressive, especially when a rent review falls in line with lease renewal, could lead to tenants leaving. So be flexible, be prepared to negotiate a little.”