As the fifth anniversary of the introduction of legislation to ban ‘upward only’ rent review provisions in new leases created on or after February 28, 2010, fast approaches, ROBERT McHUGH investigates whether landlords and tenants should prepare themselves for the return of rent reviews.
Prior to the economic downturn in 2008, rent increases across every sector of commercial property were commonplace. The vast majority of leases that predated the implementation of S.132 of the Land and Conveyancing Law Reform Act 2009 – banning upward only rent reviews – contained a mechanism that allowed for the passing rent under the lease to be reviewed to market rent but subject to one common proviso: that the revised rent shall equal either the rent passing immediately prior to the rent review date or the open market rent, whichever is greater. This proviso, which effectively prohibits the passing rent under a lease from reducing below its current level, continues to be the subject of much consternation and angst for those who find themselves in the position whereby the rent they pay exceeds the market rent for their property. Despite this topic being the subject of national debate since 2008 – and even weaving its way into the 2011 election manifestoes of the various parties – nothing could be done to retrospectively alter the lease contracts containing such provisos.
Time for change?
As Ireland emerges from a deep recession where, according to the IPD Indices, rental levels for retail fell by as much as 63%, office by 59%, and industrial by 68%, it is time to examine what scope there may be for rent increases at review to once again become a feature of the commercial landscape in 2015 and beyond. To do so, we must first recognise that there is, in reality, a two-tier system currently at play in Ireland: those leases created on or after February 28, 2010, which, from a tenant’s perspective, benefit from the ban on upward only rent reviews; and, those leases created before that date, which, in the vast majority of cases, contain an upward only rent review provision. The latter would, at rent review, be arguably at a distinct disadvantage to the more modern leases, as there is no scope for that rent to fall below the rent immediately preceding the review date. As such, evidence of rents from new lettings that have occurred in, say, 2014 and 2015, should arguably be reduced when seeking to apply the rental tone achieved to comparable properties held by way of historic upward only leases. Ironically, it is those very leases entered into on or after February 28, 2010, and which, from a tenant’s perspective, benefit from the legislation banning upward only rent review provisions, that are most likely to see increases on review in 2015 and beyond.
It is time to examine what scope there may be for rent increases at review to once again become a feature of the commercial landscape in 2015 and beyond.
Ups and downs
To understand why, we must acknowledge that letting activity in the commercial property market in Ireland in the time preceding the introduction of the new legislation was in a state of utter stagnation. The quantity of Dublin office accommodation taken up during the 12-month period prior to February 2010 stood at just 95,800 sq. m. – a reduction of 58% on 2008 levels. Industrial letting take-up fared no better. While specific details on retail take-up levels were not available due to the varied nature of the sector, it was well publicised that those retailers in expansion mode at the time were, in the main, discount retailers or those with the resources who could avail of the competitive terms on offer for some of the key retail locations throughout the country, which were previously more competitive to acquire. However, faced with the reality of a 30% drop in retail sales in the 12 months to December 2010, new acquisitions activity among indigenous retailers was not on the agenda for the majority, resulting in significantly reduced take-up compared to the levels achieved pre 2008.
The low take-up levels across all sectors in 2010 had the effect of swinging the power pendulum in the tenant’s favour when negotiating terms for a new lease. Historically low rents, flexible lease terms with break options, increased rent-free periods, and a shift to turnover rents in the retail sector became the norm. Against this backdrop, any improvement in the property market and wider economy was likely to result in an increase in activity, with the resulting effect of increasing competition for space, which in turn places upward pressure on rents. Nowhere is this more evident than in the office sector – particularly for large, ‘Grade A’ office accommodation. The complete cessation of speculative office construction activity circa. 2008, together with the steady inward trickle of foreign direct investment during the downturn (particularly from large US tech firms such as Facebook, LinkedIn and Google), saw the vacancy rate for large ‘Grade A’ office accommodation drop significantly. Fast forward a few years, and the improving economy, falling unemployment rate, rising consumer sentiment and increased competition among a certain cohort of office occupiers for a smaller pool of available suitable accommodation, results in the double-digit rental growth of 31% recorded by IPD for ‘Grade A’ office space in the 12 months to end Q4 2014.
The pattern in office rental growth that has been emerging since late 2013 has not been mirrored across the industrial and retail sectors to the same degree, with just a 1.3% growth in rents in both the retail and industrial sectors recorded in 2014. Those occupiers whose passing rents were set pre 2008 are, in the most part, still significantly over-rented. The current headline rents for ‘Grade A’ office accommodation are still approximately 13% behind their 2007 equivalent. A similar picture emerges for both retail and industrial, which are 53% and 63% behind, respectively, according to the IPD Indices. That being said, with the IPD Indices recording a return to positive rental growth in 2014 in both the retail and industrial sectors, it’s quite likely that the gap between the historic rents and market rents in these sectors will close further, with a continuing improvement in the economy – albeit at a much slower pace than witnessed in the offices sector.
The pattern in office rental growth that has been emerging since late 2013 has not been mirrored across the industrial and retail sectors to the same degree.
Rent reviews to increase?
In summary, 2015 is likely to see increased activity in rent reviews for certain office occupiers who entered leases post 2008 in particular, and who availed of historically low rental levels, as landlords now seek to capitalise on the well-documented increase in rents within the sector. With certain exceptions, such as Dundrum Town Centre and other prime retail locations, the ability to increase rents at review within the retail and indeed industrial sectors will prove far more challenging.
In many cases, there may well be opportunities to reduce rents for certain classifications of property in some sectors. Therefore, it is incumbent on landlords and tenants across all sectors, who entered new leases on or after February 28, 2010, to seek professional advice in order to establish whether their upward and downward rent review provision affords them the opportunity to review their current rent position.
Robert works with the Professional Advisory Services Team at DTZ Sherry FitzGerald