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 – Rent Review 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.
Awareness should be given to increasing rents too aggressively. Enforcing extraordinarily high rent reviews upon your tenant 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 periods of vacancy, and sourcing and securing new tenants does come at a cost.
Stage 2 – Rent Review Implementation:
Putting a reliable 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 lease terms, where a tenant has an option to extend… that is, an opportunity to commit to a further term within the lease, 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 with CPI vs fixed 4% annual reviews.
Starting rent: $50,000
Lease Term: 5 years
Review method: CPI vs Fixed 4 %
At the time when the above scenario was calculated, it appeared this Landlord would have been out of pocket by $4,265, but that is misleading.
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 if you are looking only at the difference between year 5 rents alone.
A graph would show us that the total loss over a 5-year period is actually a whopping $10,354.
It should be becoming fairly obvious why landlords often prefer fixed rent reviews. Not only are they predictable, allowing the landlord to accurately forecast future income, but they also potentially 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 numbers below demonstrate 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
This landlord would be $8,493 out of pocket after a single missed rent review over the lifetime of the lease. Imagine the resulting damage of missing multiple rent reviews
The purpose of the above example 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 clear takeaway here is to give due consideration to your annual rent review method when negotiating the terms of your lease, and most importantly never allow a rent review to slip through the cracks without being implemented.
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 commit 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 that is purpose-built for commercial real estate firms, 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. 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, though we don’t advocate these methods!
Alternatively, if you are a landlord who needs some help, you can contact us and we will be happy to schedule some time to discuss your unique situation further.
Rent reviews should not be dismissed as 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 favourable rent reviews and ensuring they are implemented as scheduled in the lease.