COVID-19 | COVID-19 and rent reviews: rent reductions in a recession?

Economic impact of COVID-19

On 11 March 2020, the World Health Organisation formally declared the outbreak of COVID-19 as a global pandemic.  To varying degrees around the globe, countries have enforced travel bans and closures of non-essential public gatherings.

Unsurprisingly, the declaration of the pandemic prompted global panic, with grave political and economic ramifications.  Small to medium businesses (often occupying premises under retail or commercial leases) are likely to have already been impacted by the significant downturn in consumer spending.

If you are a landlord

If you are a retail or commercial landlord, you are likely to have already received requests from tenants to reduce their rent, so they may cope with this downturn.

Unfortunately the economic downturn is likely to last beyond the immediate aftermath, with a ‘Coronavirus Recession’ looming.  As the outlook darkens, we look ahead to ascertain if some tenants may be entitled to smaller rental increases or perhaps even rent reductions, depending on the rent review provisions in their leases.

We are of course talking about rental reviews by:

• Consumer Price Index (CPI); or

CPI review

Firstly, let’s jump back to basics.  CPI examines the price level of consumer goods and services.  It measures the change in prices that consumers pay for those goods and services over time.  Ultimately, CPI is used as a calculator for inflation.  The CPI is published quarterly by each Australian capital city.

CPI rent review is directly connected to the increase or decrease of the CPI and will be applied according to a (likely) complex formula in the lease.

As an example, a CPI formula (Example CPI Formula) may calculate the new rent (A) as an amount equal to the current rent (B) multiplied by the CPI for the relevant capital city for the quarter immediately preceding the review (C), divided by the CPI for the relevant capital city for the quarter immediately preceding the previous rent review (D).  The Example CPI Formula equation would be as follows:

In the recent past, our growing economy has seen a continuous (albeit low) increase in the general price level.  Therefore in the above calculation for Example CPI Formula, items ‘C’ and ‘D’ are always positive (as opposed to negative) figures.  Therefore rent increases in accordance with the mathematical calculation.

Recession and the CPI

The onset of a recession occurs when consumers curtail spending.  With officials across the world telling people to stay inside due to COVID-19, the economic toll is likely to worsen, with people forced to cut their expenditure.  Less spending means lowered demand and reduction in the rate of inflation.

If the expected recession occurs, then CPI would increase at a much smaller rate or it may even fall, causing ‘negative inflation’.  Therefore, depending on the CPI numbers on the date for rent review, a tenant’s rent will increase only marginally or otherwise it may reduce.

If a published quarterly CPI review shows a decline, landlords must pay attention as this may mean a reduction in rent for their tenants, depending on the drafting of the CPI clause.

Market review

Market reviews are generally conducted at the exercise of an option for a further term.  These reviews determine that the rent should keep pace with the market and sometimes require independent determination by a third party valuer.

Rent determined by a market review can decrease as a result in the fall in market.  Given the current expected trajectory of the economy, it is likely that these independent reviews will result in lowered rental rates.

Ratchet rent provisions?

Some landlords include ‘ratchet clauses’ in leases.  These clauses provide that rent after a review cannot be less than the rent payable prior to the review.  These provisions are prohibited from retail leases due to the retail leasing legislation across Australia.  However such a provision is not prohibited in commercial leases.

Landlords may also employ ‘collar and cap’ provisions in conjunction with both market and CPI reviews.  These prevent the rent from falling below a permitted level or increasing above another predetermined level.

Takeaways

If you would like to discuss the implications of any rent review provisions in your lease, please do not hesitate to get in contact with us.

For details of all our COVID-19 tips and updates, visit the Gadens COVID-19 Hub.

Authored by:

Andrew Kennedy, Partner
Jeremy Bouton, Lawyer