A sneaky clause means retail rent can only go up, never down
New Zealand is one of the few countries in the world to have ‘upward-only rent review’ clauses enshrined in virtually all commercial lease contracts. If the market goes up, rents go up. But if the market goes down, rents don’t go down. In a post-Covid world, that is bad news for retailers.
“In medieval France,” wrote top Financial Times journalist Jonathan Guthrie back in 2004, “a feudal lord benefited from ‘droit de seigneur’, the right to get jiggy with newlywed brides before their hapless swains.
“The benefits for peasants were doubtful, but it must have been jolly for naughty noblemen. One can imagine their impassioned defence of this proprietorial perk when it faced extinction.”
Guthrie went on to draw a parallel with a fight going on in the UK at the time. Commercial landlords were fiercely defending themselves against a government proposal to ban so-called ‘upward-only rent review’ clauses in commercial leases.
These clauses allow landlords to put up the rent for their retail, office and industrial tenants when the market is strong and property prices or surrounding rents are going up.
But if the commercial property market goes down - as is pretty likely following the Covid-19 lockdown - tenants don’t get a rent reduction.
Rents can go up, but not down.
In New Zealand, upward-only rent review clauses are known as ‘ratchet clauses’, and they are pretty much ubiquitous in commercial leases. Some are tougher than others. A 'hard' ratchet clause is when rents never fall. Each rent hike that is agreed during a lease’s periodic rent review is cemented in for the rest of the lease.
'Soft' ratchet clauses can wipe out a previous interim rent hike if the market falls, but will never see the rent fall below the original level set at the beginning of the lease, even if that means the tenant is paying more than they should.
“There is something richly feudal about the rental ratchet,” Guthrie said. “It benefits the landlord at the expense of the tenant, making humiliatingly clear who has the whip hand.”
And even though the UK landlords won their 2004 battle against the ban in that country, a research paper from the College of Estate Management found that almost 20 years later the government was still trying to get upward-only rent review clauses out of commercial leases there.
“The UK government’s objective is to encourage the use of alternatives to UORRs within the market, as there is a feeling that their universal use is anti-competitive and unfair.”
Ratchet clauses will be particularly harsh for retailers who have been struggling for some years with the impact of online shopping on their bottom lines, and have now been shuttered by the Covid-19 lockdown, says Retail NZ chief executive Greg Harford.
They might be hoping that at least a falling property market and/or a rise in empty shops would bring rents down. But that won't happen unless their lease is due to expire soon, or the landlord is prepared to waive the ratchet clause.
“Over a number of years commercial rents have been increasing quite substantially on the basis of property values having increased. But at the same time revenue growth for some businesses has been glacial to non-existent.
“It’s been harder and harder for some retailers to justify the costs of their leases, and in the current situation it’s nigh on impossible.”
Most commercial leases are for terms of four-10 years, with the most common retail or hospitality lease being six years. Normally the contract gives the landlord (or both landlord and tenant) the right to ask for a rent review every two years.
The new rent level is normally based either on comparable market rents or on inflation-adjusted changes from the Consumer Price Index.
The power rests entirely with the landlord. You can argue but there’s not much you can do.
At least, that’s as long as market rents or the CPI are going up. If they go down, then the rent just stays the same. Or at best goes back to what it was before the last rent increase.
There is also the “de facto ratchet” where the market has fallen and the landlord just doesn’t call for a rent review, says University of Auckland law professor David Grinlinton. As long as the tenant doesn’t have the right under the lease to ask for a rent review (and many don’t), the rent just stays the same.
“The power rests entirely with the landlord,” Harford says. “You can argue about it but there’s not much you can do.”
Ratchet clauses are standard practice across commercial tenancies in New Zealand, he says.
“Change would require a reworking of the whole conversion between landlord and tenant,” he says. And falls in retail/commercial property valuations will be reflected in new leases “but no one has grappled with how to deal with legacy leases”.
Bell Gully partner Jane Holland says ratchet clauses were originally introduced to give property owners and investors certainty they would get a base level of rent to help them get financing. That’s still the argument used. If there was no base minimum rent, it would make it harder for landlords to borrow.
She says the global financial crisis, which precipitated struggling Irish retailers locked into excessive rents to push for the ban in that country, also saw changes in New Zealand.
“There used to be lots of hard ratchets in contracts, now we see more modified ratchets - where rent can go up or down within certain parameters.”
Holland says rent reductions may start coming into the discussion landlords and tenants are having around the lockdown - ratchet clause or no ratchet clause.
Tompkins Wake partner Kate Searancke agrees.
“Ultimately I think this issue will need to be resolved in the same practical way between the parties as the abatement issue.
“Tenants’ leverage will be that their business will fail if a ratchet clause forces their rent to remain at current levels. And landlords will need to decide whether to negotiate outside lease terms in order to keep their tenants.”
Auckland District Law Society’s former president Joanna Pidgeon says the ADLS lease used by many smaller landlords contains a ratchet clause, though it went from being ‘hard’ to ‘soft’ in 2002.
She says the current lease is under review this year, with a new edition due out at the end of the year or early in 2021.
Landlords will be highly resistant
One of the things the ADLS committee takes into account in revising the lease is what its members are seeing happening in negotiations between landlords and tenants, and there could be some big changes, particularly in some of the hardest-hit areas.
“For example, if you have a lease in Queenstown your landlord will be chasing hard, particularly if he or she has empty premises. It might be a good time for tenants to negotiate.”
Still it’s unlikely the ratchet clause will be removed.
“It may be difficult to introduce change to the market, because landlords will be highly resistant.
“But that’s not to say people can’t negotiate it out with their landlord.”
How the ratchet clause works
There are two main types of ratchet clause:
'Hard' ratchet: This is the most commonly-used rent review mechanism. Under a hard ratchet rent review, the rent cannot fall. Period. Take a tenant whose rent was set at $1000 at the beginning of the lease in 2014 and who has seen two market reviews of $100 each in 2016 and 2018, taking the rent to $1200. Under a hard ratchet clause, the rent cannot fall below $1200 at this year’s rent review, even if there is a major slump in the market.
'Soft' ratchet: Under a soft ratchet, the rent can go up or down, but it cannot go below the rent set at the beginning of the lease. So given the same scenario of $1000 initial rent and two market reviews of $100 each, the rent could fall back to the commencement rent of $1000 if there has been a market slump, but it can’t fall further, even if the market would justify a bigger rent reduction.
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