Rental levels in lease renewals: how should rent-free periods be treated?
One area ripe for reform is how the level of rent is determined, and in particular, the treatment of rent-free periods where no binding authority appears to exist - leaving a variety of often conflicting County Court decisions.
Under the 1954 Act, either the landlord or tenant of a protected business tenancy has the right to apply to the Court for a renewal lease.
Section 34 of the 1954 Act states that the level of rent payable under a renewal tenancy will either be agreed between the parties or, in the absence of agreement, determined by the Court.
The exercise for the Court is then to consider what rent the premises might attract in the open market, disregarding factors such as goodwill, tenant improvements or the fact that the tenant has been in occupation.
Consideration by the Courts
Various County Court decisions have considered whether a rent-free period should be taken into account when determining the new level of rent.
The problem is that the rent for the new tenancy is usually determined by considering rents agreed in comparable transactions, and making adjustments to those agreed rents to arrive at a figure for the subject premises. Often, those comparable transactions will include a rent-free period. For example, the term might be 10 years, with a one year rent free period, at a headline rent of £100,000 per annum.
In contrast to these comparable transactions, however, the Court will order a ‘day one’ rent for the new tenancy, without any rent-free period. So, a potential issue is how the rent-free period in the comparable transaction is to be treated or adjusted, so as to arrive at a rent for the new tenancy.
One option is to amortise the full rent-free period over the entire lease term. It is often said that this is because the one year rent free period is an incentive for the tenant to take the lease. So, in the example above, £900,000 will be paid over 10 years, so the adjusted rent is £90,000 per annum. That £90,000 is then used as the starting point to establish the rent for the subject premises.
However, three months of the rent-free period - at least when it comes to retail premises - is arguably attributable to the time it will take the tenant to fit the premises out, during which period it will not be able to trade.
This leads to questions over whether only nine months of the rent-free period is the ‘true incentive’, and therefore whether the first three months of the rent-free period should be disregarded. If so, in the example above, the rent-free period would be treated as only nine months, resulting in an adjusted rent of £92,500.
This presents a conundrum. Should the renewing tenant get the same as any other tenant would, namely a one year rent free period amortised over the term? Or, because the subject premises are already fitted out, and the tenant can trade from day one, should the renewing tenant only get the equivalent of nine months’ rent free?
In the unopposed lease renewal case of Old Street Retail Trustees v GB Healthcare Limited , only the level of rent and interim rent were in dispute - although it was agreed that these should be the same, calculated using the zoning method.
The sticking point was whether a fitting out rent-free period, or a rent-free incentive - or both - should be taken into account when assessing the level of passing rent under the new lease. The comparable evidence showed that nearly all similar lettings had benefited from rent free periods.
Before the case was heard, the experts had agreed in a joint report that the rent-free period should be amortised over the agreed 10 year term of the lease. However, the landlord’s agent retracted this view before trial, stating that it had been brought to its attention that this was a point of law, rather than of valuation.
The judge held that, as a preliminary point, a distinction between a rent free as an incentive and a fitting out rent-free period could not be justified. Either could and should be taken into account when determining the new level of rent.
The Court’s job was to put the parties into exactly the position they would have been in if a new lease had been agreed in the real world, without the current tenant as a sitting tenant.
Here, the six-month rent-free period granted at the commencement of the lease could be easily divided into two - three months for fit-out, three months as an incentive. The judge held that the full six-month rent-free period should be applied to the new level of rent.
In the tenant’s favour was the fact that the leases of all but one of the comparable properties had included a rent-free period, apportioned for fit-out and/or as an incentive.
While the rent was still payable from day one under s.34(1), the level of rent was amortised in order to arrive at a net effective rent for the 10 year term.
The case which immediately preceded Old Street – HPUT Trustee No1 v Boots UK Limited [24 May 2021, unreported] – went the other way. It is important to remember this is another county court decision and so not binding, but there is scope for appellate courts to decide the point.
More recently, the case of Stirling House Estates Limited v Dunhelm (Soft Furnishings) Limited  summarised the decision in Boots but came to the view that whilst the hypothetical tenancy (on which the new rental is based) does not necessarily exclude the sitting tenant, it should reflect the property being offered in the market where every other possible tenant will, on the evidence, seek and be granted a rent-free fitting out period.
The difficulty, of course, is that this issue will normally only make up to five per cent difference to the rent, so parties may not feel justified in pursuing an expensive appeal in order to clarify the law.
For tenants, the Old Street and Dunhelm decisions may feel like a step in the right direction. Where the reality is that a new letting would benefit from a rent-free period, tenants should not be penalised for staying put.
Landlords may, however, feel like tenants are getting a windfall. This was addressed in the judgment in Dunhelm – reaffirming why it is key for the Court to work with comparables that accurately reflect reality for the premises in question.
This issue is mainly focused on retail premises, where the first three months of the rent-free period is generally regarded as being in respect of tenant fit-out. This contrasts with logistics, where a shorter or no period is needed. There is no single hard and fast rule when it comes to valuation: each case will depend upon its own facts.
Reforming the 1954 Act
The market is now awaiting the outcome of the Law Commission’s pre-consultation discussions, which will take place over the summer. A consultation paper is anticipated in late 2023.
Given that one of the specified aims of the consultation is to make sure the legislation is clear, easy to use and beneficial to landlords and tenants, reforming s.34 to clarify the process for valuation of rents would be welcomed by all sides.
Until these issues are determined by the Court of Appeal, it is likely that parties will continue to incur legal fees debating the point.
Kirsty Black is a real estate partner and co-head of Shoosmiths’ corporate occupier group. Ben Faulkner is a barrister at Wilberforce Chambers, specialising in real property and landlord and tenant work and related professional negligence.
This article was first published in EG on 17 July 2023.
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