Understanding rent reviews and ratchet clauses in commercial leases is essential for tenants and landlords engaged in property negotiations. In a diverse and rapidly evolving commercial property market like New Zealand, staying up-to-date with the latest rent review mechanisms can be a daunting task. This blog aims to provide an analysis of rent reviews and ratchet clauses in New Zealand commercial leases and assist tenants and landlords in making well-informed decisions.

Types of Rent Review 

There are various types of rent reviews in the New Zealand commercial property market with the most common being market rent reviews, Consumer Price Index (CPI) rent reviews and fixed rent reviews. 

Market rent reviews are designed to align the rent with the prevailing market rents for comparable properties in the area. This process typically involves engaging a valuer who provides an independent assessment of the current market rent, considering factors such as the location, condition, and specific amenities offered by the property. A market rent review can be particularly helpful if you have a gross lease given the market value of the property will affect some of the operating expenses you must cover as landlord, such as insurance and rates.

CPI rent reviews mean that the rent is aligned to the Consumer Price Index (CPI), a measure of inflation set by Statistics New Zealand. Essentially, this type of rent review helps prevent inflation decreasing the real value of the rental over time.

A CPI rent review usually includes a set formula for calculating the rent so there is reduced likelihood of a dispute or large fluctuations in the rental figure (e.g. CPI plus 2%). However, the rent adjustment cannot take into account that the value of a landlord's property might be increasing faster than the rate of inflation.

On the other hand, a ratchet clause refers to a specific type of rent review provision in a commercial lease that stipulates that the rent cannot decrease below a certain amount during the lease term. In other words, it sets a 'floor' or minimum threshold for the rent, ensuring that the landlord receives a guaranteed minimum income from the property. A 'hard ratchet' occurs when the lease specifies that rent will not drop below the rental figure following the last review (e.g. rent will not drop below market rent review on renewal). For the landlord this is beneficial for their investment whereas for a tenant, this will mean that rent will only go one way regardless (and that's up!).

The Challenges of Rent Reviews in the New Zealand Commercial Property Market

Rent reviews have become increasingly challenging in New Zealand due to the dynamically evolving commercial property landscape. Economic fluctuations, local and global trends, and unforeseen circumstances, such as the global pandemic, accentuate the need for a robust rent review process that accounts for the potential risks and fluctuations in commercial property values. As a result, both tenants and landlords must understand the potential challenges to transact effectively within the market, ensuring that their commercial lease agreements remain fair, competitive, and legally compliant. Among the key challenges faced by parties involved in rent reviews include the following:

1. Accurately assessing the market rent: Determining a property's unbiased and market-reflective value may prove challenging, given the many factors contributing to the overall market value. Reliable valuation heavily relies on an expert's judgement, considering each case's unique circumstances and nuances. Moreover, fluctuations in the property market often create discrepancies between the actual market rent and the fixed rent amount in a lease. Consequently, the risk of disagreement between the parties involved often looms over the negotiation process.

2. Increasing frequency of disputes: Disagreements during rent reviews can be time-consuming and costly for both parties. In recent years, New Zealand has seen an uptick in rent review disputes landing in court. Complicated clauses and ambiguous wording can exacerbate disagreements and create discord in an otherwise transparent process.

Understanding the Market Rent Review Process

The market rent review is one of the most common types of rent review mechanisms used in New Zealand. As previously mentioned, market rent reviews entail reassessing the current lease's rental rates based on the prevailing market rents for comparable properties in a specific area. While theoretically sound, market rent reviews can rapidly become contentious due to the variable nature of the real estate market and diverse interpretations surrounding the term 'market rent.'

To establish a fair and unbiased market rent, landlords and tenants must engage a professionally qualified valuer familiar with local market trends, an unbiased verifier, and a mediator or arbitrator if necessary. Both parties must act proactively in initiating and participating in the rent review process, minimising delays and conflicts. By communicating openly and maintaining a mutual understanding of the rent review mechanism, tenants and landlords can achieve fair and mutually beneficial outcomes from the market rent review process.

Fixed Rent Reviews: An Alternative Route

Fixed rent reviews have gained popularity as an alternative to the market rent review. This mechanism involves a predetermined series of rental adjustments throughout the lease term. The rent increases occur at regular intervals (e.g. 2% fixed increases every second anniversary of the commencement date) , offering the tenant peace of mind and financial predictability while providing the landlord with a steady and predefined rate of rental income growth. 

The Rise and Fall of the Ratchet Clause

Initially hailed as a means of providing a guaranteed minimum income for landlords, ratchet clauses have since fallen out of favour in the New Zealand commercial property market. This mechanism’s primary controversy stems from its limitation on the tenant's ability to negotiate for lower rents, even if market conditions would dictate a corresponding reduction in rental value.

Recent reforms, including the Property Law Act 2007 and the 2012 Auckland District Law Society Deed of Lease, have significantly affected the use of ratchet clauses. There is a growing preference towards prohibiting ratchet clauses in commercial leases, with an increased focus on fair rent valuations that accurately reflect market conditions.

Conclusion

Navigating the world of commercial lease rent reviews in New Zealand can be a complex and intricate process. With a clearly drafted lease and a proper understanding of the rent review mechanisms, landlords and tenants alike can confidently approach commercial lease negotiations and achieve mutually beneficial results. Open communication, expert assistance, and proactive engagement are the hallmarks of navigating rent reviews. Ultimately, fairness and adaptability stand at the forefront of navigating the ever-changing landscape of New Zealand's commercial property market.

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