News Flash: Government Proposed Ban on Upward only Rent Reviews

1. What is the proposal?

On 10 July, the government tabled the draft English Devolution and Community Empowerment Bill which contained provisions banning upward only rent reviews in business tenancies. The proposed bill is not intended to have retrospective effect, so will only apply to new tenancies entered into after the bill becomes law. The bill will also allow tenants to serve trigger notices to initiate rent reviews at the review date, to prevent landlords from delaying a review in unfavourable conditions.

The proposal will apply to open market rent reviews, index linked rent reviews, turnover base rents and rents by reference to any of the above.

It is worth saying that there is similar legislation which already operates in other jurisdictions, including Ireland, where this control was introduced in 2010.

2. What is the purpose behind the bill?

The government has said that the purpose behind the ban is connected to a push to rejuvenate the high street and support those tenants who have been struggling with increased costs in difficult economic conditions. The government has also said this change will allow rents to more accurately reflect market conditions, whereas currently leases do not adjust for downward movement in market rents.

However, there are many voices within the industry who have pointed out that this may have unintended consequences for the security of pension funds and other institutional investment, which have traditionally seen UK real estate as an attractive choice relative to other jurisdictions.

Additionally, it does not address the adverse impact on such small retail and leisure occupiers of business rates and utilities costs, which have been the cause of economic pressure over recent years. Nor does it take into consideration the fact that many modern retail leases are for relatively short lease terms and this asset class is less likely than many to contain rent review provisions in the leases.

3. What will be permitted under the proposal?

Stepped rents will be permitted under the new proposal.

The proposal will also allow index linked rent reviews (albeit in a negative inflation environment this could result in rents going down).

Capped rent reviews will be permitted.

The government's explanatory notes to the draft bill suggest that there may be exceptions to allow for collars, which would be a way of circumventing the ban. We note in Ireland that collared rents are permitted, where the lease also contains a cap.

4. What steps would be needed for it to go into force?

The bill will need to pass through several readings in Parliament, with progress not expected until after the summer recess, before being subject to committee scrutiny. Following the committee stage, there will be a final reading in Parliament before the bill is scrutinised by the House of Lords. It is likely that there will be changes to the proposal as it is debated and refined.

5. How has the market reacted?

The legislation has come without prior consultation with the property industry and initial soundings from the British Property Federation (amongst others) have warned of unintended consequences and the impact on market confidence.    

6. What might be the consequences?

In the short term we anticipate that there may be negative pressure on investment into the UK commercial real estate market given this casts doubt over the secure income streams and rental growth structure which has been seen historically. There may be a short term slowdown in volume of transactions, whilst investors wait to see the impact on valuations. In Ireland the introduction of similar legislation lead to a slowdown for several years. However, in that jurisdiction it was not initially clear if the law would have retrospective effect. As the UK government has been clear this ban would be prospective only, it may be that the effects are more limited than in Ireland or indeed there is a rush by landlords to push by landlords through transactions before the law comes into force.

We may also see a dip in the loan-to-value ratios required by lenders, as borrowers are no longer able to rely on a minimum rental income. There may be a shift in the financial covenants seen within loan documents to allow more flexibility to borrowers at risk of having income impacted by downward rent reviews. There is a risk borrowers may be more likely to breach interest cover ratio requirements within loan agreements. Indeed, it is possible that, where borrowers have entered into borrowing arrangements prior to this legislation coming into force, the statutory restrictions on rent reviews could force borrowers to be in breach of repeating loan covenants they have already agreed to without knowledge of this new control.

On the tenant side this may lead to a stronger bargaining positions in relation to rent review clauses in the run up to the legislation being adopted.

In the medium term, and judging by the effects seen in the Irish market, we may see more CPI/RPI linked rent review and turnover rents, rather than traditional open market rent reviews.

In a consistent theme over recent years, it is likely that Grade A property will be least affected with market rents strong in this area, with lower quality stock which may have been historically overrented being most impacted. This may reduce landlord appetite to invest in such stock, which may have a negative impact on the very type of asset the government is seeking to bolster by the proposal.

It is unclear what the effect might be on base rents. On the one hand, the landlord side may push for higher base rents, in order to drive up the market rent comparators for future review. Conversely, landlords may opt to lower inducements given to tenants to take leases with high base rents, as there will no longer be a guaranteed passing rent on future reviews.

It is also possible we may see landlords pushing for greater flexibility to bring leases to an end, with more leases granted without security of tenure or with landlord-only break rights, in order to have an exit option following an unfavourable review.

Currently, there is also a disincentive on landlords to introduce unusual or onerous terms in leases (such as those which restrict alienation) on the basis it can have a depressing effect on open market reviews. If the market moves towards more index-linked or stepped rents then there may be more scope for landlords to include such provisions within leases, where this might have been avoided before.

Additionally, in Ireland there has been a trend toward barter transactions, where landlords give up their rights to an upward only rent review in leases granted under the previous regime in return for providing the tenant entering into variations with improved terms (i.e. to remove break rights or commit to a longer period of occupation).

There may also be some uncertainty about how to incorporate this new legislation into 1954 Act renewals and what would be seen as a permitted modernisation by the parties to deal with the effects of this ban.

7. FAQs.

(A) How would AFLs be treated?

The legislation is not intended to have retrospective effect. The draft legislation states it will not affect leases granted pursuant to a contract (including an AFL) entered into before the legislation comes into effect. This would also extend to options for lease.

(B) How would renewal leases be treated?

Under the draft legislation, it seems likely that renewal leases (including 1954 Act renewals) will be treated as a new lease and the prohibition on upward only rent reviews will apply.

(C) Options to renew

Any landlord put options requiring the tenant to take a lease at a set rent which would defeat the principle of the ban would not be permitted. This only applies to put options entered into after the bill becomes law.

We expect that renewal pursuant to a call option agreement which is granted prior to the legislation coming into force would fall into the same category as agreement for lease, where the parties have already contracted on specific terms which are upheld.

(D) Are there any issues with underleases?

The proposal may also raise concerns in relation to underleases, where traditionally underlease rents have been expected to match the head lease rents to prevent there being a gap in the rents received by the primary tenant and the rents paid to its landlord. With the possibility of underlease rents being reviewed in a downward direction, this leaves tenants open to financial risk that their undertenant's rent may not match what is to be paid up the chain. This may also lead to additional scrutiny of the timing of underlease rent reviews.

(E) Reversionary leases and surrender and re-grants

Similarly to renewal leases, under the draft legislation, it seems likely that reversionary leases and a surrender and re-grant will be treated as a new lease and the prohibition on upward only rent reviews will apply. The may lead to a difference in the rent review provisions in such leases from the original lease, whose terms would often remain unchanged in current practice.

(F) Will leases continue to include upward only drafting (even if of no effect) in case of a future reversal of this legislation?

In Ireland it was common practice for leases to continue to include "upward only" drafting for some time after the legislation came into force. However, after a bedding-in period, the market moved forward and it is no longer usual to include these clauses. It will remain to be seen what the approach is in the United Kingdom.

(G) What might be the impact on rent review frequency?

We may see landlords pushing for more frequent reviews as a way of hedging against an unfavourable review. Certainly, elsewhere in Europe it is common to have rent reviews at a higher frequency than the standard five year intervals seen in the United Kingdom. On the other hand, we may see landlord's pushing to enter into leases with longer periods of stepped rent increases to avoid the uncertainty of a rent review.

(H) How will it affect clean energy infrastructure leases, such as solar, wind and BESS?

As these leases fall within the definition of a business tenancy under the bill, it seems likely that the impact of the prohibition will apply to this asset class. Most clean energy infrastructure leases include base rents reviewed to CPI/RPI, along with a turnover rent/profit share mechanism and as such unless the legislation carves out business tenancies of this nature, the same impact will apply potentially leading to a shift in the commercial terms and approach of landlords in this space.