With the announcement of the Law Commission’s planned consultation on Part II of the Landlord and Tenant Act 1954, can changes be made to clarify and condense the statutory framework for renewals?
One area ripe for reform is how the level of rent is determined and, in particular, the treatment of rent-free periods where no binding authority appears to exist – leaving a variety of often conflicting county court decisions.
Statutory framework
Under the 1954 Act, either the landlord or tenant of a protected business tenancy has the right to apply to the court for a renewal lease.
Section 34 of the 1954 Act states that the level of rent payable under a renewal tenancy will either be agreed between the parties or, in the absence of agreement, determined by the court (see box, below).
The exercise for the court is then to consider what rent the premises might attract in the open market, disregarding factors such as goodwill, tenant improvements or the fact the tenant has been in occupation.
Consideration by the courts
Various county court decisions have considered whether a rent-free period should be taken into account when determining the new level of rent.
Should the renewing tenant get the same as any other tenant would, namely a fitting-out rent-free period amortised over the term? Or, because the subject premises are already fitted out and the tenant can trade from day one, should the renewing tenant only get the equivalent of any pure incentive rent-free period?
Case analysis
In the unopposed lease renewal case of Old Street Retail Trustee (Jersey) 1 Ltd and another v GB Healthcare Ltd [2022] PLSCS 189, only the level of rent and interim rent were in dispute – although it was agreed these should be the same, calculated using the zoning method.
The sticking point was whether a fitting-out rent-free period, or a rent-free incentive – or both – should be taken into account when assessing the level of passing rent under the new lease.
The comparable evidence showed that nearly all similar lettings had benefited from rent-free periods.
Before the case was heard, the experts had agreed in a joint report that the rent-free period should be amortised over the agreed 10-year term of the lease.
However, the landlord’s agent retracted this view before trial, stating that it had been brought to its attention that this was a point of law, rather than of valuation.
The judge held that, as a preliminary point, a distinction between a rent-free incentive and a fitting-out rent-free period could not be justified. Either could and should be taken into account when determining the new level of rent.
The court’s job was to put the parties into exactly the position they would have been in if a new lease had been agreed in the real world, without the current tenant as a sitting tenant.
Here, the six-month rent-free period granted at the commencement of the lease could be easily divided into two – three months for fit-out, three months as an incentive. The judge held that the full six-month rent-free period should be applied to the new level of rent.
In the tenant’s favour was the fact the leases of all but one of the comparable properties had included a rent-free period, apportioned for fit-out and/or as an incentive.
While the rent was still payable from day one under section 34(1), the level of rent was amortised in order to arrive at a net effective rent for the 10-year term.
Implications
The case that immediately preceded Old Street – HPUT Trustee No 1 v Boots UK (24 May 2021, unreported) – went the other way. It is important to remember this is another county court decision and so not binding, so there is scope for the appellate courts to decide the point.
More recently, in Sterling House Estates Ltd v Dunelm (Soft Furnishings) Ltd (9 May 2023), the court summarised the decision in HPUT but came to the view that, while the hypothetical tenancy (on which the new rental is based) does not necessarily exclude the sitting tenant, it should reflect the property being offered in the market where every other possible tenant will, on the evidence, seek and be granted a rent-free fitting-out period.
The difficulty, of course, is that this issue will normally only make up to 5% difference to the rent, so parties may not feel justified in pursuing an expensive appeal in order to clarify the law.
For tenants, the Old Street and Sterling House decisions may feel like a step in the right direction. Where the reality is that a new letting would benefit from a rent-free period, tenants should not be penalised for staying put.
Landlords may, however, feel like tenants are getting a windfall. This was addressed in Sterling House – reaffirming why it is key for the court to work with comparables that accurately reflect reality for the premises in question.
This issue is mainly focused on retail premises, where the first three months of the rent-free period are generally regarded as being in respect of tenant fit-out.
This contrasts with logistics, where a shorter or no period is needed. There is no single hard and fast rule when it comes to valuation: each case will depend on its own facts.
Reforming the 1954 Act
The market is now awaiting the outcome of the Law Commission’s pre-consultation discussions, which will take place over the summer. A consultation paper is anticipated in late 2023.
Given that one of the specified aims of the consultation is to make sure the legislation is clear, easy to use and beneficial to landlords and tenants, reforming section 34 to clarify the process for valuation of rents would be welcomed by all sides.
Until these issues are determined by the Court of Appeal, it is likely that parties will continue to incur legal fees debating the point.
How is rent determined?
- Rent for a new tenancy is usually determined by considering rents agreed in comparable transactions, and making adjustments to those agreed rents to arrive at a figure for the subject premises.
- Often those comparable transactions will include a rent-free period. For example, the term might be 10 years, with a one-year rent-free period, at a headline rent of £100,000 per annum.
- In contrast to these comparable transactions, the court will order a “day one” rent for the new tenancy of the subject premises, without any rent-free period. A potential issue therefore is how the rent-free period in the comparable transaction is to be treated or adjusted, so as to arrive at a rent for the new tenancy.
- One option is to amortise the full rent-free period over the entire lease term, because the rent-free period is an incentive for the tenant to take the lease. So, in the example above, £900,000 total headline rent will be paid over 10 years, meaning the adjusted rent is £90,000 per annum. That £90,000 is then used as the starting point to establish the rent for the subject premises.
- However, for retail premises, part of the rent-free period is arguably attributable to the time it will take the tenant to fit the premises out, during which period it will not be able to trade. This could lead to questions over whether (say) only nine months of the rent-free period is the “true incentive”, and that therefore the first three months of the rent-free period should be disregarded. In the example above, that would mean that rent-free period would be treated as only nine months, resulting in an adjusted rent of £92,500.
Kirsty Black is a real estate partner and co-head of Shoosmiths’ corporate occupier group and Ben Faulkner is a barrister at Wilberforce Chambers
