The UK Government has proposed a ban on upward only rent review clauses in new commercial leases in England and Wales. The move, that came without industry consultation, aims to support the struggling high street by ensuring rents can adjust downwards in times of economic downturn, but what exactly does the ban mean for landlords and tenants?
What is an upward only rent review?
Rent reviews in commercial leases in England and Wales allow the rent to be adjusted at set intervals – typically every five years. An ‘upward-only rent review’ is a lease clause that guarantees a tenant’s rent will not decrease when rent is reviewed. It will either increase (if the market rental value of the property has increased) or remain the same, even if the market rental value of the property has declined.
This approach offers landlords, investors and lenders greater certainty, as the assurance that rental income cannot decrease helps support property values and long-term investment decisions. However, for tenants it carries the risk of being locked into above-market rents during economic downturns—a scenario which can affect business viability, or lead to tenants to seeking shorter lease terms.
What is the proposed ban and who will it affect?
The English Devolution and Community Empowerment Bill (“the Bill”) introduced into the House of Commons in July proposes to ban upward only rent reviews for new commercial leases and will apply in both England and Wales despite the Bill’s title.
The proposals apply to future leases whether they have security of tenure under the Landlord and Tenant Act 1954 (meaning the tenant has a contractual right to renew) or are contracted out, where there is no automatic right to renew.
Importantly the proposals will not be retrospective, meaning they will not apply to leases granted before the provisions come into force, nor leases entered into pursuant to an Agreement for Lease dated prior to the provisions coming into force. However, lease renewals and surrender and regrant leases made after the Bill comes into force are likely to be caught.
What are the requirements for the ban to apply:
For the ban to apply there must be occupation under a lease, as opposed to a licence, which only partly needs to be for business purposes. This presumably means it will apply to mixed business-residential leases but note the proposals will not apply to intermediate landlords (where there is a freeholder, a head landlord and a subtenant) as the head landlord will not be in occupation.
A lease must contain a ‘relevant rent review term’ that allows the rent to change during the term of the tenancy but where the exact amount of increase cannot be determined when the tenancy is granted, for example open market or index linked reviews. In these instances, if the figure produced is lower than the current rent, the new passing rent will be the lower amount.
With one or two exceptions rent collars will also be ineffective if the proposals become law as the Government wish to make sure that rent collars, which state a minimum rent, will not be used as a way to avoid the legislation.
What are the potential issues with the ban?
The proposals are part of the Government’s ‘Plan for Change’ to revitalise local high streets and support small businesses. It believes that upward only rent review clauses lead to artificially high rents during periods of economic downturn which results in lower profits for tenants and higher prices for consumers. The idea is to provide tenants with stronger negotiating powers and to protect them from market downturns by allowing rents to fall in line with market movements.
It is always difficult to maintain a balance between the rights and protections of a tenant with those of a landlord, and whilst the new proposals are aimed at protecting a tenant, the flip side is they could undermine investor confidence which is essential for economic growth.
Intermediate landlords who are not in occupation may suffer further as they will not benefit in turn from the proposals as their tenants, who are in occupation, will. This may cause problems in relation to cashflow for such landlords if the rent for any sub-letting has fallen. Although note in the recent committee stage it has been proposed that intermediate landlords are also to come within the new legislation.
It is not just landlords who might suffer though. Incentives typically offered to tenants (such as rent-free periods and contributions to fit-out) are on the understanding a landlord will obtain a baseline rental return for the minimum term of the lease (i.e. prior to the first break or lease expiry). Decreases in such incentives, often significant at the start of a lease, may well start to occur as a result of the changes.
It is also uncertain whether the Government would take into account rent reductions when assessing business rates for properties. – it seems unlikely that the Government would implement the ban in the knowledge that business rates revenue could fall however the position on this is, as of yet, unclear.
What could a ban lead to?
The proposals relate to increases where the amount of rent is not known, they therefore do not apply to fixed increases or stepped rents and it is likely that these could become more popular in the future – a set up that does not protect a tenant should the market fall.
It is also likely we will see an increase in shorter duration 3-5 year leases that typically do not include rent reviews. This however provides less long term certainty for both landlord and tenant.
We may also see greater use of index-linked rents. Linking rents to an inflation measure, for example CPI, may become more attractive for landlords, since these are less likely to decrease than rents tied directly to standard market rates.
Energy Sector Impact
In the energy sector the effects are likely to be less significant compared to tenants in the retail or office sectors although the common use in energy leases of a minimum ‘floor’ rent would be caught by the proposals. Like commercial tenants, developers could also benefit from not being locked into above-market rents during economic downturns allowing rent to decrease in line with market falls. Whether the availability of funding from lenders no longer guaranteed predictable, upward only income streams becomes an issue remains to be seen with energy developers still affected by any broader market shifts as a result of the changes.
What Happens Next?
The Impact Assessment for the Bill suggests its implementation will be in 2027/2028. Whilst there are no similar proposals currently in place north of the border, upward only rent reviews are also common in Scotland and it is it is reasonable to think that if the ban does come into force in England and Wales then Scotland would likely follow suit.
It is still early days at the moment however with the Bill currently at the second reading stage in the House of Lords. For now the jury is out as to whether the proposals will protect the high street as the Government hopes, or lead to a shift in the way commercial leases and their rents are negotiated and structured. Landlords in particular should watch developments closely and begin to assess how the ban would impact future modelling and valuations within their businesses. Agents should also be briefed so that those on the front line of lease negotiations are prepped and ready for the changes.
