Implementing annual rent reviews is critical for ensuring your commercial asset is generating the highest possible return year-on-year.
Despite market fluctuations, it is well accepted that rents are on an overall long-term upward trend. Thus it is reasonable for a landlord to receive increases each year so rent keeps pace with market.
Commercial property rent reviews can be broken down into two critical stages:
Stage 1 – Negotiation:
As there is no fixed method for reviewing commercial property rents, rent reviews are negotiated with the tenant during lease negotiations.
Achieving a well balanced rent review structure during lease negotiations helps safeguard against rental income lagging behind market rates as the lease carries over from year-to-year.
Taking care not to increase rents too aggressively, as enforcing extraordinarily high rent reviews year-on-year can have the unintended result of driving your tenant out of your property in search of better value. Obviously this is not ideal as sourcing and securing tenants comes at a cost.
Stage 2 – Implementation:
Putting a process in place to methodically and accurately implement rent reviews ensures your returns are not eroded over time by rent reviews falling through the cracks after you’ve done all the hard work negotiating profitable reviews.
Rent Review Methods
The most common rent review methods for commercial real estate in WA are;
Consumer Price Index.
- FIXED REVIEWS
The most predictable and straightforward rent review method of the three outlined here.
Fixed reviews negotiated at the time of entering the lease provide for rent to be increased by a fixed percentage, say 4% for example.
Often used between terms, market reviews aim to bring the lease in line with current market rates.
How do review methods stack up when compared against each other?
CPI vs Fixed Percentage Reviews
To demonstrate why CPI reviews have fallen out of favour as a review method in recent times, using the scenario below of a 5 year lease commencing at $50k, the graph below compares CPI reviews (the blue line) vs fixed 4% reviews (the red line), clearly illustrating that the landlord would be accepting a significant shortfall in rent over the term of the lease when using the CPI method, compared to fixed reviews.
We have averaged the CPI figures as published by the ABS between Sept quarter 2013 – March quarter 2016 for the calculations in the below graphs.
Starting rent: $50,000
Lease Term: 5 years
Review method: CPI vs Fixed 4 %
To understand the true impact we need to recall that each rent review compounds upon the previous rent reviews, so a small disparity in increases each year, results in a large suboptimal return after 5 years. Now don’t let the graph above fool you into thinking the landlord is only out of pocket $4,265, by looking only at the difference between year 5 rents alone.
The table below demonstrates that the total loss over a 5 year period is actually a whopping $10,354.
It should be becoming fairly obvious why landlords prefer fixed reviews. Not only are they predictable, allowing the landlord to accurately forecast their future income, they are more likely to result in an overall better long-term return.
A Term Deposit Account Is Not The Only Investment That Compounds
Ever missed a rent review and were not too concerned because the impact seemed fairly insignificant? Just like a term deposit account, rent reviews compound each year. The effect of one missed review can accumulate to be a staggering sum over the period of the lease.
The graph below demonstrates the impact a single missed rent review has on a five year lease compared with no missed review.
Lease term: 5 years
Starting rent: $50,000
Rent Reviews: Fixed 4%
1 x missed rent review (brown line)
This landlord is $8,493 out of pocket after a single missed rent review. Imagine the resulting damage of missing multiple rent reviews!
It gets even scarier when the method of rent review changes. Let’s look at the resulting damage of switching out the fixed 4% reviews, and replacing them with CPI rent reviews instead.
CPI reviews (blue line) vs CPI reviews with 1 x missed review (red line)
Now to drill this point home, let’s look at one final comparison – the total difference in gross rent collected between… the suboptimal (at least in recent years) CPI review method, with a single missed review in year 1 vs fixed 4% reviews consistently implemented over the life of the lease.
Review method: CPI (red line)
Missed review year 1
Review method: Fixed 4% (blue line)
No missed reviews
The purpose of the above graph is to demonstrate…
- the power of having a long-term view during lease negotiation and obtaining the strongest review method and
- the importance of diligently implementing reviews, either yourself, or on your behalf by a dependable property manager.
The combined effect of accepting CPI reviews, and missing a single review is devastating to your gross rental collections over the term of the lease.
The clear takeaway here is to aim to obtain fixed percentage rent reviews and never allow a rent review to go unchecked.
What is a ratchet clause?
Ratchet clauses provide that your rent can go up, but not down during a market rent review.
If market rates have fallen during the term of the lease and a market review is due, a ratchet clause will ensure the landlord does not experience a sudden decrease in rental income.
Ratchet clauses are common in commercial & industrial lease agreements in WA, but are prohibited in retail leases under the Retail Tenancy (retail shops) Agreement Act 1985.
How do I ensure my rent reviews are implemented?
If your property is managed by an agency, they should be notifying you in writing each time your rent has been reviewed.
That said, failure to implement rent reviews is one of the biggest reasons people leave other property management agencies and make the switch to Perth Commercial Property. Many firms just don’t make the time or commitment to putting stringent procedures in place to ensure rent is reviewed for their landlords every time with 100% certainty.
We get it right by utilising property management software, purpose built for commercial real estate and with well proven systems and procedures that have been developed and time tested over years.
If you self-manage your property, then it’s critical you put in place a reliable method of reminding yourself of rent reviews. The annual nature of reviews actually makes them harder to remember. Whatever way you choose, you need to find a methodical approach that works for you, whether that’s calendar reminders or post it notes on your fridge.
It might help to sit down at the beginning of the year, pull out all of your leases, identify when each review is due and mark each review on a calendar that’s visible to you.
Alternatively, if you are a landlord and need some help you can contact us and we will be happy to offer some assistance by offering reminders when your reviews are due.
Rent reviews should not be dismissed as a trivial detail during lease negotiations. As a landlord it is your right to obtain the highest return possible from your investment. With a commercial property, that means securing favorable rent reviews and ensuring they are implemented as scheduled in the lease.