Are upward only rent reviews down and out?

This article is provided by BRC Associate Member, Burness Paull.

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The UK government introduced the English Devolution and Community Empowerment Bill.

The overarching aim of the bill, which will only apply to England & Wales, is to “decentralise power and ignite regional growth” by moving policymaking powers away from Westminster to local and regional authorities in areas such as housing, transport and economic development.

A key reform which was unexpectedly included within the draft legislation is a ban on upward only rent review (UORR) clauses in business leases. This, the government argues, will support affordable rents and “help keep small businesses running, boost local economies and job opportunities and help end the blight of vacant high streets and the unacceptable anti-social behaviour that comes with them”. The bill includes the following proposals:

• Where rent review provisions in a business lease are indexed against an economic indicator (such as prevailing market rent or inflation), landlords will no longer be allowed to only track the upwards movements of that index. Under the new regime, any rent reviews must reflect both the upwards and downwards movement of the index.
• It appears that it will still be possible to put a floor on any downside position, with the government suggesting that a ‘cap and collar’ approach might be utilised in order to provide a degree of financial certainty.
• Substantial anti-avoidance provisions have been included, which seek to close out any loopholes capable of being exploited by ill-willed landlords. For example, a landlord will not be able to avoid a review in a depressed market by failing to serve a notice on the tenant; tenants will have a vested power to unilaterally instigate the rent review process.

While the aim of the government is laudable, the ramifications for the commercial real estate sector could be significant.

Developers of office, retail and industrial premises have remained resilient in the face of headwinds over recent years, including higher interest rates, reduced demand following the Covid pandemic, and lower valuations.

However, a ban on UORR clauses would add further challenge, particularly around investment.

The financing of new developments and transactional activity is generally premised on certainty around rental income and an assumption that there will be no downward movement in the rent, other than from arrears or forfeiture of the lease.

Banning UORR clauses could create issues around funders’ risk appetite and willingness to deploy capital.

Early criticisms of the bill have focused on the lack of consultation involved in the legislative process to date and, as part of the lobbying process, we expect to see a number of industry voices object to a perceived stifling of an already challenging commercial property market. It will be interesting to see whether the government addresses any of the following potential impacts of bill: 

• While the bill admirably seeks to protect smaller business with less commercial bargaining power, these tenants are already less likely to have rent review provisions in their leases as they generally take leases for shorter terms.
• If the proposals are introduced, it is hard to see how high streets will be rejuvenated and voids filled if more private landlords leave the sector – that’s likely to de-professionalise the sector, which can only be a bad thing for everyone.
• We do not yet know how valuers will respond to the market shift towards downside risk on leases or how funders will look to mitigate that risk in terms of their funding terms. One plausible outcome is that the investors seek to hedge the risk of any downside and absorb any increased cost of funding by inflating initial rental costs and simply passing on the downside to tenants through other means.
• The bill only affects new leases and will not be applied retrospectively. Therefore, existing leases with UORR clauses baked in may be deemed more valuable from a transactional perspective. Concerns around how to close the gap for occupational landlords on rent review provisions between new occupational leases (entered in after implementation of the legislation) and existing headleases that include UORR provisions will also need to be addressed.
• The variables that govern commercial rents under the bill – inflation and market rates – are unlikely to lead to rents falling in London and other major cities with strong commercial districts. However, rents in less robust markets could feasibly drop  and, while that should notionally benefit regional business tenants, there are real concerns as to how this might impact investor confidence outside of the City.

The bill is still in its early stages and may yet change as it progresses through the legislative process. However, the potential unintended consequences for the industry are clear and significant.

If would you like more information on this subject, please do not hesitate to get in touch.