The Government has proposed a ban on upward only rent reviews in commercial leases. The proposal is at the earliest stages of the Parliamentary process. While lobbying from the real estate sector is expected, the Government's aim of delivering something for occupiers in the context of other Government tax and regulatory policies affecting businesses, might be enough to see this proposal become law.

This article outlines the key provisions, potential market impact, and what landlords and tenants should consider as the bill progresses through Parliament.

Key points – the proposal to ban upwards only rent review

  • The ban would apply to business tenancies.
  • It would not apply to existing leases – but it would apply to renewals (statutory or agreed).
  • Any upward only review mechanism where the higher rent is not known at the time of granting the lease (i.e. open market, index linked) would be banned.
  • The proposals are drafted broadly to catch mechanisms to get round the ban and include anti-avoidance provisions.

Overview of the proposed ban on upwards only rent reviews

On 10 July, the Government proposed a major reform affecting business tenancies. Under the new English Devolution and Community Empowerment Bill (the Bill), upward only rent review provisions will be prohibited in new commercial leases.

The Bill is a broad piece of legislation primarily focused on devolving powers to local authorities and boosting community-led growth. Clause 71 and Schedule 31 of the Bill would amend the Landlord and Tenant Act 1954 to include the upwards only rent review prohibition. The provisions came without industry consultation, which has drawn attention from the sector. According to the Government the proposal is intended to support struggling high street businesses by ensuring rents can adjust downward in tough economic times, rather than ratcheting ever upwards. The Government's view is that previous attempts at self-regulation – such as voluntary codes of practice encouraging alternatives to upward-only reviews – have been deemed ineffective. It is also worth noting that similar prohibitions operate in some other jurisdictions.

How would the ban on upwards only rent review work?

It is proposed that the prohibition on upwards only rent review would apply where four conditions are met.

  • Condition A – the lease is a business tenancy (with very limited exceptions – but the Secretary of State is given power to later grant exemptions in regulations).
  • Condition B – the lease is granted after the prohibition comes into force (i.e. it will not apply to existing leases – but it will apply to renewals).
  • Condition C – the lease contains "relevant rent review terms" – meaning provision for increase of rent to a sum that cannot be calculated at the grant of the lease (which would obviously include open market, index linked reviews and ratchet turnover base rents).
  • Condition D – the method for determining the new rent includes two elements (even if it also includes other elements). Element 1 is that a "reference amount" of rent is calculated by reference to the amount of inflation or any other index or multiplier or the tenant's turnover. Element 2 is that the amount of the new passing rent will be (or could be) different to the reference amount. Condition D is therefore met even if only part of the rent is subject to the method.

The new provision would replace any reviewed rent (whether higher or lower than the passing rent) that was not equal to the "reference amount" with the reference amount (i.e. the open market rent in an open market review, or the index-linked amount in an index linked review).

As initially written, this could cause unexpected outcomes with complex rent mechanisms where some parts are fixed and others subject to increase if the legislation was engaged. We would have thought some of these will be dealt through the Parliamentary process – but in practice if this becomes law, the required upward/downward element would be catered for in the lease.

The Secretary of State would also have wide ranging powers to grant exceptions, make transitional arrangements and add detail to the way the ban would work.

Other proposed provisions include:

  • Tenants would be able to trigger rent reviews (or take action to progress reviews) even though the lease provided that the landlord had to trigger it or take the action.
  • Lease terms (or other arrangements) aimed at avoiding the ban would be void.
  • Put options requiring tenants to take leases at a rent set in a way that would defeat the principle would also be prohibited. (Essentially, the same method of setting the rent proposed for the rent review applies – it would default to the reference amount).

Impact of the upwards only rent review ban on commercial leases

Leases generally have shorter terms than in previous years reducing the number of leases that contain rent review provisions. However, a significant number still do. Generally, inflation and the review periods of 1 or 5 years in index-linked reviews has meant that inflation has pushed those rents in an upward direction of its own accord. 

Some leases already provide for upward and downward review – but there are circumstances, financial structures and commercial agreements where an upward only review (or a collar on an index-linked review) is a key part of the commercial and financial arrangements.

If the upwards only rent review prohibition becomes law, lease terms will adapt to reflect the position. It is generally preferable for a lease to reflect what will happen rather than relying on the legislation to override the contractual position which would cause confusion and uncertainty.

The change is likely to impact the commercial terms on which space is available. Some landlords will accept the position while others will look to grant shorter lease terms with no security of tenure (meaning rent can be re-negotiated on the open market at expiry). The risk of downward review could be priced into the original rent level if appropriate valuation and economic advice is available.

Fixed stepped rents are also unaffected by the proposed prohibition. We may see leases with fixed increases at traditional review intervals with other mechanisms to mitigate the risk of that for the parties (e.g. break rights or top up turnover rent).

Are there potential market implications?

It is likely that commentators and stakeholders will respond over the coming days and weeks from across the market. Organisations and representative bodies are expected to engage with Parliament on this issue, following its unexpected inclusion in the Bill.

Our instant reactions (which we will be reflecting on with clients and contacts across the sector over the coming weeks) are:

  • Impact on negotiations – even before it is law, upward/downward review will become a negotiation point on many lease transactions due to the high profile nature of the proposal. Will tenants look for more concessions if landlords are seeking higher starting rents?
  • Tenant appetite for alternative rent mechanisms may improve with downward review a possibility.
  • The possibility of downward review may lead to fewer disputes and tenant financial problems in depressed markets.
  • Long term valuations may need adjusting to take account of downward review in renewals (although the initial rent sent at renewal should reflect that).
  • Investment strategy may put a higher premium on long term occupation by strong covenant occupiers.
  • Landlords with shorter term occupiers may need to review their proactive property management to ensure that they can demand a higher rent on renewal/re-letting by creating buildings and environments where tenants want to be – rather than relying on upwards only rent review mechanisms for growth.
  • There could be an impact on finance arrangements if upwards only rent review based rental income was being used to service debt with a built-in increase that cannot be matched going forwards.

What should landlords do now?

The first thing to reiterate is that this is a proposal in a bill which has only just had its first reading in Parliament. It is very early in the process and because Government did not consult in advance, it will now have to deal with market reaction and commentary. It is not necessarily essential to take drastic action immediately.

However, as the Bill progresses it is likely to be prudent to start adapting to what is likely to become law as that becomes more certain through the process.

In the meantime, landlords should:

  • Consider at a strategic level how a ban on upwards only rent review would impact modelling and valuation within the business. Some analysts may consider modelling potential income drops at future review points – but remember that the prohibition does not apply to existing leases – so this sort of modelling should only be done to hypothetical future income projections.
  • Ensure agents and asset managers on the front line of negotiation of new leases are briefed to expect an increase in requests for upward/downward rent review – and take a short term position on the point pending progress of the new law.
  • Monitor the Parliamentary progress and engage with industry bodies (and/or lobby the Government directly in relation to specific market or sector issues that may not have been fully considered yet).

What happens next?

The date for the second reading of the Bill has not been set – but is likely to be after the Parliamentary summer break. This will be the first opportunity for MPs to debate the principles and themes of the bill. It will then enter the Committee Stage where the detailed analysis of the provisions takes place – amendments are suggested, debated and if necessary, voted on. Following that there is a third reading (usually a formality) and then the bill will move the House of Lords for debate in that chamber – possibly leading to the Bill moving back and forth between the Houses to consider amendments.

Gowling WLG will be monitoring closely and will publish material updates as appropriate. To stay up to date with the latest developments, sign up to our newsletter.

In the meantime, please get in touch with your usual Gowling WLG contacts to discuss the implications for your business.