Rating Manual section 4: valuation methods - Part 1: practice note 1 - 2010 rental adjustment - Guidance

1. Introduction

1.1 This Practice Note deals with the rental adjustment stage of the Revaluation process - it does not cover either of the subsequent stages of rental analysis and scheme creation. Any toning of rental evidence to the AVD should be carried out at the scheme creation stage.

1.2 The correct adjustment and analysis of rental evidence are vital to the successful preparation and defence of a rating list.

1.3 From the outset, it cannot be over-emphasised how important it is to exercise skill, care and caution in the performance of this work which, if properly done should assist in the production of accurate valuations and will save many hours of effort when the assessments which are based on it come to be scrutinised on appeal.

1.4 The theoretical background of the rating hypothesis, and the problems to be overcome in order to bring market evidence into line with it, will be explained to help the reader understand more clearly the reasons why we adjust in the way we do. The opportunity is also taken to consider the areas of dispute, which may arise in respect of the VOA’s approach to virtual rents and its application in the rating context.

1.5 The general guidance and background given here are not intended to provide specific answers to particular local problems which will be covered, as necessary, by appropriate local instructions.

1.6 It must be emphasised that many agreements between landlords and tenants are extremely complex and in some cases a completed Rent Return (FOR) may not cover all the facts relating to the rent. In such instances, as well as in cases where the FORs have not been fully completed, supplementary questionnaires should be sent. It is not uncommon for the details of lease agreements to be covered by confidentiality clauses. Such clauses are personal to the parties. Occupiers and owners are not however exonerated from having to comply with the legal requirement to complete a FOR.

1.7 Rents will vary greatly in their reliability and it is essential that all rents be carefully considered before identifying those, which will be relied upon to create the valuation schemes. As a general rule the more adjustment that is required, the less reliable the rent will be. It is important that low or high rents are not dismissed out of hand as unreliable without first having ensured that there is sufficient additional evidence to justify departure and prove the basis.

2. Objectives

2.1 The objective of rental adjustment is to convert rental evidence into a form which is compatible with the definition of Rateable Value in Schedule 6 para 2(1) of the Local Government Finance Act 1988.

2.2 The rental evidence obtained on FORs will rarely, if ever, accord with the definition of RV. This is because: -

a) Commercial properties are normally let for a fixed term of years. The rental evidence is therefore unlikely to accord with the rating hypothesis, which assumes a tenancy from year to year with a reasonable prospect of continuance. Depending on the facts of the case, an adjustment of the rent reserved under the lease may be required (*case notes 1 and 2).
b) Commercial leases contain a variety of covenants pertaining to user, repairing, insuring and servicing obligations, rent review and treatment of tenants’ improvements. To add to the complications, there may also be a hierarchy of leasehold interests subsisting in respect of the hereditament. Many such covenants are beyond the scope of, or do not accord with, the rating hypothesis. They may, however, have a direct impact on the rent passing.
c) The contractual relationship between the actual landlord and tenant may be subject to the provisions of the Landlord and Tenant Act (LTA) 1954. This may have the effect of modifying the terms of the lease and thus the rent that might otherwise have been agreed, or it might have an effect on the future relationship.
d) Whereas for rating purposes, the whole hereditament is deemed to have been provided by the hypothetical landlord, in the real world the hereditament may be held under separate leases from different landlords and/or have been substantially altered at the tenant’s expense. The alterations may or may not have been carried out as a condition of the lease and therefore the rent may relate to something different to that which existed when it was determined. LTA 1954 s34 as amended by s1 Law of Property Act (LPA) 1969. (*Case notes 3 and 4).
e) Similarly, the rating hereditament is deemed to be vacant and to let without premium, but in the real world the present occupier may have paid a premium to the previous occupier or to the landlord (*case note 5).
f) During periods when the market is depressed reverse premiums are sometimes paid to a new tenant by the landlord or the previous occupier, or other incentives given in the form of rent-free periods in excess of any ‘norm’ fitting out period or the transfer of liabilities to the landlord.
g) The rent reserved under the lease may reflect development potential. Because the hereditament must be valued in its existing state any such element reflected in the rent may need to be ignored.
h) Much rental evidence will derive from rent reviews determined by agreement or a third party having regard to the detailed provisions in the lease, which may be difficult to interpret or give, rise to litigation. These provisions are frequently very complex and may differ substantially from the definition of rateable value. In most cases the terms provide for upwards only reviews and in a declining market the rents determined might be in excess of the market value at the relevant date.

The objective of rental adjustment is to arrive at the virtual rent which is the true equivalent annual cost of the hereditament to the lessee. It comprises the rent which is being paid adjusted to include the net balance of the rental equivalent of any incentives received by the lessee and any expenditure incurred by the lessee by way of a premium or rateable alterations to the premises.

This guidance describes the adjustments that may be required in order to adjust a rent into a virtual rent in RV terms. It will become clear that a virtual rent may not necessarily equate to the rent at which the hereditament might reasonably be expected to let from year to year on the statutory terms. The responsibility for deciding the weight to be attached to each virtual rent rests, of necessity, within the Group, ultimately with the GVO personally. Each decision will call for the exercise of skill and care, grounded in experience and sound knowledge of the local property market.

Case Note 1 - Consett Iron Co Ltd v North West Durham AC (1931)

14 R+IT 9 HL

Case Note 2 - Humber Ltd v Jones (VO) and Rugby RDC (1960)

53 R+IT 293 CA

Case Note 3 - GREA Real Property Investments Ltd v Williams

EG 250/651/79

Case Note 4 - Estates Projects Ltd v London Borough of Greenwich

EG 251/851/79

Case Note 5 - LCC v Erith and West Ham AC (1893)

3. Order of adjustment

3.1 There are no set rules governing the order of adjustment other than that the adjustment for repairs should be made last. (F W Woolworth and Co Ltd v Peck (VO) 1967 LT RA 365). However, to be consistent the following order has been adopted within the RSA application, and this Practice Note provides detailed guidance for each adjustment in similar order.

(i) VAT

(ii) Rent free periods/stepped rents.

(iii) Premiums paid by and to the tenant.

(iv) Tenant’s improvements

(v) Value of any surrendered lease

(vi) Overage or other lease terms

(vii) Domestic accommodation

(viii) Business rates and other payments

(ix) Repairing/insuring liabilities

4. Value Added Tax (VAT)

Introduction

The EEC 6th Directive sought harmonisation of the VAT legislation throughout the member states on its issue in May 1977. VAT on land and buildings was introduced in the UK after a ruling given by the European Court in June 1988 that forced compliance with the 6th Directive.

Following a period of consultation the government introduced the necessary amendment to the Value Added Tax Act 1983 by means of the Finance Act 1989 which together with subsequent Statutory Instruments etc. formed the main VAT legislation, until its consolidation in the Value Added Tax Act 1994 and the Value Added Tax Regulations 1995.

4.2 VAT on rents

Although VAT is often specified within leases to be recoverable from tenants as additional rent it is considered that it does not form part of the rent payable under the hypothetical tenancy. Such an approach would be justified if VAT were to be viewed as “usual tenant’s rates and taxes” although this would require an extension of the common understanding of this phrase. As identified below the imposition of the tax is likely to be inconsistent and its impact on underlying rents insignificant in most cases. The overwhelming need for a uniform basis for rating dictates that the RV is net of VAT. All rental adjustments should therefore be made on that basis.

4.3 The Operation of VAT

To appreciate the likely effects of VAT on rent it is first necessary to have a basic understanding of the way in which the tax operates. VAT is a tax on the supply of goods and services, which may be standard-rated, zero-rated or exempt. The VAT that a business charges on the goods or services that it supplies is called output tax, and this must be passed on to Customs & Excise (C&E) by the business at the end of each accounting period. The VAT that a business pays on the goods or services that it purchases in the course of its activities is called input tax. The business will seek to recover this VAT from C&E, but the right to recover the VAT incurred on such purchases, expenses etc is dependent upon the use to which those items are put by the business, and the following provisions will apply.

If the purchases

a) are wholly used in making taxable supplies (standard or zero-rated), the input VAT is recoverable;
b) are wholly used in supplying goods and services which are exempt from VAT or in activities which do not generate taxable supplies, the input VAT is not recoverable;
c) are used in making both taxable and exempt supplies, the input VAT is only recoverable to the extent that the purchases are used in making taxable supplies.

4.4 Application of VAT to property transactions

Prior to 1/4/89 a combination of exemption and zero-rating operated to the effect that virtually all transactions in land and buildings did not attract a liability to VAT, whilst in most cases any input VAT incurred in new construction could be reclaimed.

Since that date the position can be briefly summarised as follows:

a) the sale of the freehold of a “new” commercial building or civil engineering work is standard-rated; (“new” in this context means within 3 years of the earlier of the date of a certificate of practical completion or the date the building is first fully occupied)

a) the sale of the freehold of an “old” commercial building is exempt
1. b) the grant of a lease of any length in buildings is exempt
2. c) the sale of the freehold or the grant of a lease in land is exempt
3. d) the surrender of a lease is exempt
4. e) new building and civil engineering construction work is standard-rated
5. f) new dwellings and certain property occupied by charities remain zero-rated
6. g) Certain supplies have become standard-rated as follows:

granting any right to take game or fish;
providing - in an hotel, inn, boarding house or similar establishment - sleeping accommodation or accommodation in rooms provided in conjunction with sleeping accommodation or for the purpose of a supply of catering;
providing holiday accommodation in a house, flat, caravan, houseboat or tent;
providing pitches or other facilities for caravans (other than permanent residential caravans) or tents;
granting vehicle parking facilities, except in conjunction with lettings of buildings;
granting any right to fell and remove standing timber;
granting facilities for housing or storage of an aircraft or for mooring or storage of a ship or boat;
providing facilities such as a seat, box, or other accommodation at a sports ground, theatre, concert hall or other place of entertainment;
granting facilities for playing any sport or participating in any physical recreation. A series of lets of sports facilities may be exempt in some circumstances

4.5 The election to waive exemption (option to tax)

The principle effect of these changes would have been a significant increase in the liability to irrecoverable VAT for most property owners had it not been for the introduction of “the election to waive exemption” or option to tax as it has become known.

From 1/8/89 the option to tax permits a business to convert an exempt supply into one, which is taxable at the standard rate, thereby enabling the owner to recover any input tax payable on an acquisition, construction or refurbishment. With minor exceptions the option applies to any exempt supply (sale or lease) of commercial land or buildings. There is now a strong incentive for landlords to elect to tax rents and it is to be anticipated that in future the majority of transactions will attract VAT, although the timing of its imposition may vary.

4.6 The effect of VAT on tenants

A decision by the landlord to elect to tax a building will have implications for the tenants. They will be faced with an additional percentage to pay on top of their existing rents and service charges (being usually expressed in leases as additional rent, the tax treatment of service charges will normally follow that of rent). Whether this impost will actually increase their overheads, or whether it will be purely a cash-flow cost depends upon each tenant’s VAT status.

If, because it makes entirely VATable outputs, the tenant has full recovery of VAT on its overheads (as over 90% of all VAT registered businesses do) the VAT on the rent will generally be recoverable in the same way. The cost to such a tenant will be limited to the opportunity cost of the VAT until it is recovered from C & E. Such tenants may nevertheless welcome the imposition of VAT, as a beneficial side effect may be to change any service charge from an exempt supply to a VATable supply, thus permitting the recovery of all VAT paid on the goods and services covered therein.

However, for tenants who cannot recover all or any of the VAT on their expenditure, occupation costs will rise. The types of tenants likely to be most affected include banks, building societies, insurance companies, bookmakers, charities and small companies having a turnover below the VAT registration threshold (£64,000 per annum from 1 April 2007. Such tenants are frequently referred to as VAT-averse.

If a tenant sub-lets all or part of a building or land the VAT incurred on the rent paid to its landlord will become irrecoverable unless it also elects to tax the sub-letting.

4.7 The likely effects of VAT on rents

Most occupiers of non-domestic property are VAT registered trading organisations, over 90% of who are immune to the more serious adverse effects of the tax. The effect of VAT on their rental bids will in general be slight. However, the rents offered by the minority of tenants who are VAT - averse may well be influenced by the increased overheads of up to 17.5% of that rent. Either such tenants might reduce their rental bid or agree a higher rental in exchange for a binding undertaking that the landlord will not elect to tax the rent.

The outcome of negotiations between individual landlords and tenants will reflect the relative strength or weakness of their respective bargaining positions. This may in turn depend on the supply of and demand for such properties. In a weak market it can be anticipated that the views of prospective tenants will hold greater sway than they might do when lettings are more plentiful. But it is essentially the balance of demand between VAT-averse and VAT-immune tenants which will determine whether there is any discernible effect on the rents agreed. Markets dominated by VAT-averse tenants, such as parts of the City of London, have the greatest potential for a duality of rental level but whether such a phenomenon does in fact exist remains to be seen.

Rent reviews and lease renewals will be determined in accordance with the terms of the lease and/or the Landlord and Tenant Acts. If the terms of the lease are specific as to the assumption regarding VAT the resulting rent can be approached with certainty. However, frequently they are not, and the rent passing on review in such cases will need to be treated with caution.

Valuers will need to exercise skill and judgement in deciding whether in any particular market some of the evidence is tainted by the uneven effects of VAT. It is thought unlikely to occur in practice but the possibility must not be overlooked

4.8 VAT rates and dates

Rent inclusive of VAT should be adjusted by deducting the amount attributable to VAT. As the rent figure is gross of VAT the easiest way to do this is by dividing the gross rent by one plus the VAT rate ie if the VAT rate is 17.5% dividing the rent by 1.175.

Whilst the VAT rate has been at 17.5% since 1991 it is useful to note that this has not always been the case and it could be altered. The rate to be deducted from any inclusive rent will be the rate payable at the time:

DATE	VAT RATE
pre 1/8/89	0%
1/8/89 to 31/3/91	15%
1/4/91 onwards	17.5%

5. Landlord’s incentives

5.1 Background

The collapse of some sectors of the property market in the late 1980s and early 1990s led to significant changes in market practice affecting both the lease terms and the financial aspect of new lettings.

5.2 The standard 25-year institutional lease, for so long regarded as sacrosanct by landlords, was been sacrificed in order to attract tenants. Shorter leases of 10 or 15 years were offered as well as break clauses and two-way rent reviews. On the financial side a variety of rental incentives have been conceded by landlords including low rents, stepped rents, long rent-free periods, contributions towards fitting out, reverse premiums and taking over the tenant’s previous lease or property.

5.3 These changes have made it much harder for the valuer to interpret some market transactions and determine exactly what the deal equates to in rental terms. Many such deals are structured so as to keep the headline (or contractual) rent as high as possible thereby protecting the landlord’s reversionary interest. The parties to the transaction may have particular reasons for structuring a deal in a particular way such as cash flow requirements or for taxation purposes.

6. Adjustment for financial inducements

6.1 The presence of various financial inducements has led to much debate amongst the surveying profession on how best to analyse such transactions to arrive at an underlying (or real) rental level i.e. that which would be achieved if no incentives were offered. Unfortunately no widespread consensus has been achieved and sets out below are some of the alternative approaches together with details of the VOA’s preferred approach.

6.2 Landlords argue that the incentives are a one-off payment to the tenant for taking a lease and therefore should be amortised over the length of the lease (suggesting a high initial rental level). The tenant, on the other hand, argues that the effect of the incentives should be discounted over the period to the first review because the rent is then subject to review which will normally be to an open market rental level (giving the lowest possible equated rent).

6.3 Because the appropriate discount period varies according to the circumstances it will often fall somewhere between the two extremes. Some large firms of surveyors have advocated, as a compromise, that the incentives should be discounted over 10 years (ie normally to the 2nd review). They argue that this should allow sufficient time for the open market rental value to grow to a level at or above the headline rent. They also suggest that 10 years is a reasonable period over which to write-off the cost of tenants’ fitting out works. It must be emphasised that this 10-year rule of thumb method is no more than a compromise and as such may be challenged because it does not necessarily address a particular deal or market conditions under consideration.

6.4 To discount the rent over the 10 year period will also, without further adjustment, be suspect as it will produce an underlying rent implied fixed for a 10-year period. An overage adjustment will then be required in order to equate the rent to one which is subject to a normal review pattern for that particular class of property in that location

The correct period over which to equate rental flow will ultimately be a question of judgement based on the type of incentive being granted and on local market conditions. The common theme of landlords’ incentives is that they involve a transfer of an asset (either money or moneys worth) initially from the landlord to the tenant in exchange for an enhanced rental flow in due course. It is considered correct to equate the income flows of the actual transaction with the rental flow which would normally be expected on the standard review pattern until the rental flows coincide (an exercise in discounted cash flow). This will usually be to the rent review when the market rental catches up with the headline rent, or the first tenant’s break clause whichever is the sooner. Therefore it is an essential pre-requisite to all rental adjustment for landlords incentives to estimate the projected rental growth for the short to medium term, and to identify the timing of the tenant’s break clauses, if any, and whether they involve penalties in any form.

If the prospects for rental growth are poor then the open market rental value may well not exceed the headline rent at the first review. If the rent review mechanism is on an upwards only basis then the equation period should be extended to at least the next review.

6.7 The various financial inducements and how they should be treated for adjustment purposes is detailed below in sections 7-10.

7. Rent free period

A rent-free period is an inducement, which should be adjusted for, however this does not include periods granted to enable the tenant to complete or fit out the property for their occupation. No allowance should be given for these periods as the concession is only given to allow the tenant to complete works which, in the hypothetical world, are assumed to be carried out by the landlord or the tenant within the principle of rebus. In such cases the tenant derives no benefit from the property during the fit out period, as he is not occupying it for business. Thus when dealing with rent-free periods it is essential to exclude the period attributable to the normal fit out period for the type of property concerned. Only the period in excess of this ‘norm’ should be treated as being an incentive from the landlord.

NB. RSA makes an adjustment for a rent-free period, regardless of length; it should be verified that only the landlord’s incentive period is adjusted for

7.1 The alternative analyses available are best illustrated by an example.

A new letting of an office block for a term of 20 years has been agreed with a rent-free period of 3 years in consideration of a headline rent of £1 million. The normal rent-free period for fitting out this type of property is 6 months and Rent Reviews are fixed, at 5 yearly intervals after the normal fitting out period and are on an upward only basis. There are no break clauses.

The first stage of calculating the rental equivalent is to value the existing rental flow. The headline rent is above the market rent so it is inadvisable to use an all risks yield. The yield to be used should be the equated yield appropriate to the type of property and location concerned. This can be derived from a consideration of comparable market transactions.

NB: All Years Purchase figures are based on rents paid quarterly in advance.

Over 5 years
The valuation might be:-
Headline Rent		£1,000,000
YP 2 1/2 years @ 11%	2.2293
x PV £1 in 2 1/2 yrs @ 11%	0.7704	1.7175
			£1,717,500

Then equating this to a single rent payable over the 5 years.

Div YP 5 years @ 11%	3.9467		3.9467
5 year equivalent fixed rental			£435174
NB RSA always calculates the rental equivalent to the first rent review but this may be amended if necessary
or Over 10 years
Headline Rent		£1,000,000
YP 71/2 years @ 11%	5.2697
x PV £1 in 21/2 yrs @ 11%	0.7704	4.0598
			£4,059,800
Div YP 10 years @ 11%	6.2888		6.2888
10 year equivalent fixed rental			£645560

A comparison of the equivalent rentals produced by the 5 and 10-year equations, £435174 and £645560, highlights the importance of approaching the ‘equation’ over the appropriate period.

These rental values are derived on the assumption that after the first or second rent reviews the rental value will have grown to equal or exceed the headline rent. The minimum compound rental growth implied is therefore just over 18.1% or 4.5% pa respectively. Unless rental growth is anticipated at 18.1% pa or more it will be necessary to equate the rental flows at least until the second review.

However, the rental equivalent derived (£ 645560pa) is a single rent payable for 10 years. This approach is only valid if the rental value at the review in 5 years time is expected to be no higher than the current underlying rental equivalent. A more normal arrangement assuming rising values, would be for a lower rent to be payable up to the first review with a higher rent payable thereafter. Essentially this is an overage problem and may be dealt with either by an ad hoc adjustment or by working back to a ‘day one rent’ and building in an increase at the first review in line with the expected level of rental growth at the date the lease was agreed.

If, in the example, rental growth is anticipated at say 5% pa the rental uplift at the first review will be 27.63%.

A traditional calculation would show

Value of actual rental flow (as before)			£4059800
Let x = initial rent payable Rent Receivable YP 5 years @ 11%	3.9467	£x 3.9467	£3.9467x
Reversion to YP 5 years @ 11% x PV £1 in 5 years @ 11%	3.9467 0.5935	£1.2763x 2.3424	£2.9896x
Capital Value of Proposed Rental Flow			£6.9363x
Value of Proposed = Value of Present
		6.9363		x = £4059800 x = £585298
10 year equivalent rental for the first 5 years, assuming 5% rental growth			£585298

This equivalent rental value implies annual rental growth of 5% over the first 5 years, from £585298 pa to £747005 pa at first review and slightly over 6% rental growth to the second review to reach the headline rent. If this is viewed as unacceptably high, and no more than say 5% pa rental growth is anticipated to the second review then the rental equivalent must be calculated over 15 years as follows (it is however unlikely that growth will be uniform over such long period).

Rent Passing		£1,000,000

YP 12 1/2 years @ 11%	7.0740
PV £1 in 2 ½ years @ 11%	0.7704
Capital Value of existing rental flow		5.4498	£5449800
Let x = rental value
Rent Receivable		£x
YP 5 years @ 11%	3.9467
		3.9467	£ 3.9467x

Reversion to		£1.2763x
YP 5 years @ 11%	3.9467
PV £1 in 5 years @ 11%	0.5935
		2.3424
			£2.9896x
Reversion to		£1.6289x
YP 5 years @ 11%	3.9467
PV £1 in 10 years @ 11%	0.3522
		1.3900
			£2.2642x
Capital Value of Proposed Rental Flow			9.2005x
Value of Proposed = Value of Present
		9.2005		x = £ 5449800 x = £592337
15 year equivalent rental for first 5 years, assuming 5% rental growth			£592337pa

If the transaction included a tenant’s break clause then the equivalence period cannot extend beyond that date unless the penalties, which should be reflected, suggest that it is unlikely to be operated.

7.2 Essentially the aforementioned calculations are an exercise in discounted cash flow. It may be considered unrealistic to assume uniform rental growth particularly with the longer equation periods and it may be preferable to vary the growth rate for each period or to estimate the review rents directly and use the implied compound growth rate merely as a check of the validity of that estimation.

7.3 In the above example it is possible to adjust the passing rent to show a range of equivalent rents between £435,174, taking a tenant’s ‘extreme’ position and a rent approaching the headline figure, depending on the term over which the incentive is amortised – the longer the period the closer the equivalent rent will be to the headline figure.

7.4 The most important consideration is clearly the ‘equation’ period. Support for the view that it

should be taken as the period (excepting break clauses) to the rent review at which it is anticipated the open market rental value will reach the headline level is given in the RICS Red Book.

7.5 The Red Book covers the treatment of inducements in Valuation Information Paper No.8 – The Analysis of Commercial Lease Transactions. This paper superseded RICS Guidance Note 4 with effect from 1 April 2006. The paper states at paragraph 5.6:

7.6 “The time over which the incentive should be analysed is a much debated point. It will be recognised that the landlord will usually contend for the longest time, such as the full term of the lease, and the tenant for the shortest time, such as the first review. The valuer’s decision has to be a judgment between these conflicting claims having regard to the overall effect of all the incentives, anticipated rental growth and knowledge of the market, the motivation of the parties and what, in the real world, the valuer believes might be achieved in an open market letting on the hypothetical terms. Tenants will commonly seek to minimise the anticipated rental payments, and the occupier landlord will seek to mitigate the liability. Investor landlords will commonly seek to maximise capital value.”

7.7 The ascertainment of the ‘equation’ period necessarily involves a large element of subjectivity in relation to the expectation for rental growth at the time the lease was agreed. Clearly in cases where the incentive is such that only a modest and firmly expected level of rental growth is needed for the headline rent to be reached by the first review, the adjusted rent can be given much greater weight than a rent where there is uncertainty as to whether the equation should be taken further than the first rent review.

7.8 In cases where equation beyond the first review is being considered it is recommended that rental adjustment be undertaken on a range of possible and credible equation periods, underpinned by what is considered reasonable rental growth expectation, both optimistic and pessimistic. The earlier advice provided in the Red Book Guidance Note 4 paragraph 4.7.8 is considered relevant to assist determination of this issue, it states: “It is suggested that inducements should usually be evaluated over the period until the term end, or (if earlier) the rent review or break clause, following the time when the open market rental value assessed on the given lease rent review terms, is no longer exceeded by the headline rent.”

7.9 In any event the adjusted rent or range thereof should be tested against rents on similar properties which might provide a more direct and reliable guide to value and/or inform the decision as to where within any range of adjusted rents the rent ITRV might finally settle. The level of adjustment and subjectivity, particularly assumptions as to expected rental growth, implicit in any analysis of this kind will undoubtedly affect the weight to be attached to the rent, which will be improved if supported by more direct evidence in respect of comparable properties.

8. Reverse premiums

8.1 Premiums paid to the tenant should initially be offset against expenditure on rateable fitting out/completion works undertaken at the tenant’s expense. Any balances should be considered as an inducement.

8.2 When carrying out the equivalence calculation the capital sum can be deducted directly (suitably discounted to present value if necessary) from the value of the actual rental flow.

8.3 Alternatively since a Reverse Premium is essentially a sum of money given to a tenant, which can be applied to pay the rent, they can be treated as equivalent to a rent-free period.

9. Contributions to fitting out

9.1 VOs will need to differentiate between contributions toward expenditure by the tenant on items, which will form part of the rateable hereditament, and those towards tenants non-rateable fixtures and fittings. Those covering the latter and any excess over reasonable expenditure will need to be treated as a reverse premium as outlined above.

10. Assuming liabilities

Arguably the most difficult incentive given by a Landlord to adjust in rental terms will be the taking on of a liability previously faced by a tenant. This will often be in the form of the liability to pay rent (possibly in excess of the current rental value) on a tenant’s former building. An estimate of the value of the liability transferred will be needed where better rental information is not available. The recommended approach will be to estimate the burden of rent, rate and service charge taken on both during the period in which a new tenant for the accommodation is found and the cost of any subsidy or incentive borne thereafter. Again this is likely to involve a consideration of the likely rental growth over the short to medium term. Such a liability could conceivably encompass the cost of dilapidations at the expiry of a lease. Once quantified the capital sum can be dealt with directly or related to an equivalent rent-free period.

11. Treatment of premiums

11.1 It cannot be over emphasised that premiums, especially large premiums, need to be treated with caution. They should not merely be dismissed without full consideration as they may help to provide an insight into the demand for and therefore potentially the value of, a particular property or group of properties.

11.2 The period of amortisation of a premium also requires great care. If the premium is truly capitalised profit rent then it should be amortised over the period to the first review or renewal where the basis is to open market rental value. This may result in a very high rent, which is unsupportable by other open market evidence. Part of the reason for this may be that rent reviews and lease renewals are often below true open market lettings. This is partially because the evidence used in rent reviews and lease renewals is often historic and in times of rising rents gives the tenant an advantage. It is also an indication of the imperfection of the market and the keenness of both landlords and tenants to reach an agreement. Once in possession the tenant is released from the pressure of having to secure the premises which can lead to inflated rents.

11.3 Where there is an element of key money part of the premium may need to be amortised over the period to the first review with the balance, i.e. that element which it is estimated represents key money, over the expected occupancy of the incoming tenant, which may be beyond the end of the lease.

11.4 Having adjusted the premium the result should be carefully considered in the light of all other evidence available in order to judge the extent, if any, to which the transaction helps to either create or support the level of values.

11.5 Any virtual rent that includes a significant element derived from an amortised premium must be treated with caution especially if the premium was paid shortly before or shortly after a rent review, or commencement of the lease.

12. Premiums and key money

12.1 A premium is the price paid by an actual or prospective lessee to a lessor or previous lessee, in consideration for the rent being below that which would otherwise be payable as the full rental value.

12.2 Treatment of premiums poses difficult problems of judgement because they rarely, if ever, show a consistent pattern. Traditionally premiums are regarded as being made up from any of the five elements set out below.

a) goodwill
1. b) tenant’s fixtures and fittings
2. c) stock
3. d) residual value of improvements ignored on review or renewal
4. e) capitalised profit rent/key money.

12.3 In order to correctly interpret and adjust for premiums it is important that the premium is broken down into component parts. This is because certain elements that might form part of the premium, i.e. goodwill, non-rateable fixtures and fittings and stock, form no part of the virtual rent and should be excluded from any sum to be amortised.

12.4 a) Goodwill

Goodwill forms no part of the rating hypothesis (except inherent or adherent goodwill in licensed premises, hotels, garden centres, etc) and should be left out of account. If the figure given at Question 28 of VO 6001/Question 24 of VO 6002 includes goodwill the goodwill element should be deducted from the premium paid. Question 9.2 of VO 6003 asks for details of capital sums paid by tenants and specifically asks for any element attributable to goodwill to be excluded from the figure stated; adjustment should ordinarily therefore not be required.

Where the premium has been apportioned and a figure for goodwill is stated care should be taken to ensure that the apportionment is realistic. In instances where the nature of the business conducted in the property changes e.g. from a bookshop to a clothes shop, any figure stated as being for goodwill should be treated as being for the interest and included in the premium figure to be analysed.

12.5 b) Fixtures and Fittings

Like goodwill non-rateable fixtures and fittings form no part of the rating hypothesis and should not be reflected in the rent.

Care should be taken to ensure that any value apportioned for fixtures and fittings is realistic and does not include rateable items forming part of the hereditament the value of which should remain in the premium.

In instances where the FOR shows that a sum was paid for the trade fixtures and fittings yet a change of trade indicates that they were of no value to the new tenant the figure stated should be added back to the premium figure for analysis purposes.

12.6 c) Stock

When a business is transferred the value of any stock included in the transaction may be included as part of the premium. FOR’s in the VO 6000 to 6002 series do not ask for the value of stock to be deducted from any premium paid or if included to be quantified. If it is suspected that stock is included in the premium stated the VO will need to judge whether further information is required.

Question 9.2 of VO 6003 asks for capital payments made by a tenant to the landlord or a previous tenant to exclude sums paid for the business rather than for the lease; the capital sum quoted should therefore not require adjustment under this head.

12.7 d) Residual Value of previous tenants improvements

If the previous tenant carried out improvements and assigned the lease the residual value of any improvements not to be reflected on rent review or lease renewal will not be included in the passing rent. However, if the previous tenant has sub-let the property then the value of the improvements will be reflected in the rent passing.

Part 12 of VO 6003/ Question 29 on VO 6001/Question 25 on VO 6002 asks for details of any alterations, improvements, refurbishments, initial fitting out or initial repairs carried out by a previous occupier and, where appropriate, costs. There are obvious practical difficulties in determining the value involved if details are not provided on the FOR. Nevertheless VOs still need to estimate or apportion the cost of the previous tenants works. The costs should then be amortised over the appropriate period as set out in Part 12 to arrive at an adjusted rent for the improved demise.

12.8 e) Capitalised Profit Rent/Key money

Having arrived at a premium excluding goodwill, fixtures and fittings, stock and the residual value of the previous tenant’s improvements the balance remaining represents either capitalised profit rent or key money or a combination of the two.

The treatment of key money is a difficult area and one on which the surveying profession is divided. The only area where there is some commonality of view is that premium evidence cannot be ignored but equally it cannot be relied on as being fully reliable evidence. It must, therefore, be treated with great care and skill and given appropriate weight.

Generally landlords and their agents hold the view that the whole of the premium represents capitalised profit rent and is paid because the prospective tenant thinks that the rental value is lower than that which he would have been prepared to pay if the property was available to let in the open market with vacant possession. In support of this view they argue: -

a) Premiums are a product of the unique nature of the property and its location and are paid because there is an excess of demand and very limited supply. The interaction between supply and demand which results in the payment of premiums are the same factors that ultimately determine rental values as well.
1. b) That it is quite common in prime locations to find new open market lettings at a level significantly above rents agreed on review or renewals.
2. c) That premiums are usually paid by large or national traders who are probably professionally advised and are unlikely to make ill conceived bids.

Legal support for the decapitalisation of premiums in order to assess rental values can also be found in the case in Ratners Jewellers v Lemnoll Ltd (1980) 255 EG 987. The case concerned an application for the determination of an interim rent as part of an application for a new lease where a substantial premium had been paid on assignment seven years earlier. Dillon J rejected the tenant’s agent’s view that the premium should not be taken into account because it included an element of key money. He held “the decapitalisation of a premium paid on an assignment of a leasehold term into a rental equivalent is commonplace of valuation which is normally reliable”.

Opponents of this approach, usually the tenants and their agents, argue that: -

a) The result of treating premiums as capitalised profit rent often result in excessively high figures, which cannot be justified by reference to other market evidence.
1. b) Because large premiums/key money are normally only paid in respect of prime retail premises it is a payment solely to obtain occupation and with it the ability to trade and earn a profit, and the premium therefore represents the opportunity cost of occupation.
2. c) In some circumstances companies are prepared to pay a premium but they would not always be prepared to pay an equivalent amount by way of increased rent. This can be for fiscal reasons or because a lease at less than the full rent would be easier to dispose of, albeit at a loss, if necessary.

13. Stepped rents

13.1 Where the rent reserved under a lease or agreement is subject to, or has been the subject of increases or decreases to amounts that were determined at the commencement of the lease, then it is known as a “stepped rent”. In addition, a lease which provides for a rent-free period will invariably specify the rent which will ultimately become payable and this is an extreme example of a stepped rent. For excess rent free periods see Part 7.

13.2 It should be noted that a rent free or reduced rent period solely for the purposes of fitting out should not be treated as a stepped rent.

13.3 Account must be taken of the obligation of the lessee to pay the increased or decreased rent, when due, and this is done by calculating the equivalent rent which would have remained constant throughout the period. Care must be taken to ensure that when the rent being paid at the date of the form of return is already the subject of a predetermined increase or decrease, this fact is properly identified and care should also be taken to ensure that the rent is not erroneously identified as being the rack rental value of the hereditament.

13.4 The adjustment is made firstly by calculating the present value of the stepped rents and then by taking the annual equivalent of this sum over the full period.

13.5 Any rent that is a stepped rent must be treated with caution. A worked example is set out below:

Example

The property is let on a 25 year lease at a rent of £50,000 for the 1st and 2nd years with a step to £60,000 for years 3 and 4 and a further step to £70,000 in year 5. The equivalent rent can be calculated as follows:

RENT x YP 2 years at 10%		£50,000 1.8427	£ 92135
RENT x YP 2 years at 10% x PV 2 years at 10%	1.8427 0.826	£60,000
		1.5220	£ 91326
RENT x YP 1 years at 10% x PV 4 years at 10	0.9652 0.683	£70,000
		0.6592	£ 46144
			229,605
Div YP 5 years at 10% equivalent constant rent	4.0249		£57,046

The yields to be adopted should accord with the market investment rates for both the type of interest and the category or property.

13.6 In the above example the equivalent rent of £57,046 needs to grow by 22.7% over the 5 year

period to equal the final step (or headline) rent of £70,000. If the implied growth is unrealistic

then VOs should consider it over a 10-year period in accordance with Part 7.

13.7 Low rents can be dealt with similarly. Having identified the projected rental growth or review rent and the normal rent free periods for such a transaction, the actual rental flow should be valued using an appropriate equated yield until the rental flows coincide, equating this with the value of the normal rental flow

14. Improvements

14.1 Five main types of improvements are commonly encountered:-

a) initial repairs;
1. b) extensions, alterations and improvements;
2. c) fitting out a shell or new building;
3. d) fitting out an existing building;
4. e) previous tenants’ alterations, improvements and fitting out.

14.2 a) Initial repairs

Where a tenant takes a property in a poor state of repair and agrees, as a condition of the lease, to put the premises into a reasonable state of repair the rent paid at the outset will most likely reflect the original condition of the building. Clearly putting the property into a reasonable state of repair will increase its rental value and the passing rent should therefore be adjusted to reflect the improved state. In all cases the cost of these initial repairs (see Question 12.1 of VO 6003/question 29 of VO 6001/question 25 of VO 6002) should be amortised to the first review, since the review rent will normally be based on the assumption, if not a fact, that all repairs are complete.

14.3 b) Extensions, alterations and improvements

Works carried out to extend a property must be taken into account to the extent that they increase its rental value. The cost of the works (see question 12.1 of VO 6003/question 29 of VO 6001/question 25 of VO 6002) should be amortised over the appropriate period). Care should be taken when considering internal works or improvements to ensure that only those that would enhance the value of the property are amortised.

Generally more weight can be placed on an analysis which has been based on the rent paid disregarding the improvement works and relating to the details of the unimproved building, i.e. an analysis of the rent based on the original demise. The more significant the adjustment made, the less reliable the rent becomes.

14.4 c) Fitting out a shell or new building

It is quite common for new shops or offices to be let in an incomplete state, often referred to as shell, or shell and core (see question 4.5 of VO 6003/question 21 of VO 6001/question 14 of VO 6002). The tenant will then be responsible for completing or “fitting out” the property, often to the tenant’s own specific requirements.

The initial rent, and possibly even that after review, will reflect the shell condition and not the fitted unit. Details of the cost of fitting out are requested at Question 12.1 of VO 6003, Question 29 (VO 6001) or Question 25 (VO 6002) but this figure may require adjustment prior to amortisation. Expenditure on fitting out is likely to vary considerably and care must be taken to ensure that expenditure on purely personal features, of no market value, is not included in that total cost. Likewise, if tenants’ non-rateable fixtures and fittings are included in the cost provided, the cost of these works should also be deducted.

14.5 d) Fitting out an existing building

Such matters as shop fitting and also partitioning, will, by their very nature, reflect the personal (or corporate) taste and requirements of the actual tenant. The hereditament is to be regarded as vacant and to let and the actual occupier will be one of the range of potential hypothetical tenants in competition for the premises. Improvements will be of value where for the purposes of the rating hypothesis they are deemed to form part of the hereditament provided by the landlord, although in fact they were carried out by an occupier.

It is sometimes argued that the extent to which these improvements are of value is limited to one extra bid which the actual occupier (who must be considered as one possible hypothetical tenant) would need to make in order to overcome the interest of other competing hypothetical tenants. The counter argument is that the landlord knows that the property meets the specific requirements of the actual occupier and that if the landlord did not accept the tenant’s one extra bid the tenant would have to look for an alternative unit and then incur the expense of carrying out the fitting out work. It is therefore unlikely that in the higgling of the market the landlord and tenant would merely agree a value limited to one extra bid.

It is essential that all improvements are considered on their merits and whether particular improvements are likely to have general appeal in the market or not is a matter of valuer judgement. A balanced view can only be reached after careful and critical consideration of all the available evidence.

14.6 e) Previous tenant’s alterations, improvements, and fitting out

The residual value of a previous tenant’s improvements should be treated with caution. Where the previous tenant assigned the interest, the residual value may be taken into account and the same principles apply as for the treatment of the current tenant’s improvements.

14.7 Landlord’s contributions towards fitting out

14.8 The landlord may have made a capital contribution towards the cost of the tenant’s fitting out in which case the contribution should be offset against the costs of the works. If the landlord has contributed the whole cost of the works then the rent should be treated as a fitted rent. If the landlord’s contribution exceeds the realistic cost of the rateable fitting out the balance should be treated as a reverse premium (see Section 8). Contributions towards the tenant’s fitting out may also allow the landlord to recoup either some, or all, of that sum by way of increased rent at the first and subsequent rent reviews. The most common ‘contribution’ from the landlord is to grant the tenant a rent-free period while the works are being carried out. This merely reduces the cost to the tenant of the premises while he cannot occupy them. The concession will be reflected in the rent agreed. If the rent-free period is realistic and purely to allow for the tenant’s fitting out work, then no adjustment is required. If however the period is excessive, the excess period should be treated as a landlord’s inducement (see Section 7).

15. Cost of improvements and the virtual rent

15.1 It is essential to remember that cost does not necessarily equate to value.

15.2 In Edma Jewellers (case 1) the Lands Tribunal said “On the one hand it would appear reasonable to assume that, if a tenant is prepared to pay for the benefits of occupation of the hereditament partly by way of rent and partly by way of capital expenditure, he would also be prepared to pay the same amounts calculated in annual terms”. “On the other hand, it is also possible to say that not all expenditure by the tenant necessarily improves the value of the landlord’s hereditament in the market, vacant and to let”. Furthermore, “it becomes necessary to examine closely the facts of each case, in order to appreciate the value of the expenditure to the actual tenant, and this must involve his thinking and expectations at the time when he undertakes to carry out his expenditure. It seems to me therefore that all expenditure must be looked at on its merits”.

15.3 In amortising the cost of carrying out a wide variety of improvements such as those listed in 14.1 above, it has been standard VOA practice to adopt what is commonly known throughout the profession as the virtual rent approach. Virtual rent being the true equivalent annual cost of the hereditament to the lessee and comprising the rent which is being paid adjusted for, amongst other things, the rental equivalent of improvements to the hereditament.

15.4 The Lands Tribunal case of Dorothy Perkins v Casey (VO) (1994 RA 391) held that in certain circumstances when determining the appropriate amortisation rate the application of the statutory decapitalisation rate needs consideration. The application of the statutory decapitalisation rate was governed by the wording of the Non-Domestic Rating (Miscellaneous Provisions) (No 2) Regulations 1989 and referred to ascertaining the rateable value of the hereditament by reference to the notional cost of constructing or providing it or part of it.

15.5 The Dorothy Perkins v Casey (VO) decision provides a legalistic and evidential approach which future Members of the Lands Tribunal may follow if confronted with similar issues. Such evidence should be sought as would provide a clear and unambiguous indication as to how the value of such improvements is being reflected in the open market and in rating practice.

15.6 A step-by-step process should be applied to the evidence submitted, with the next step applying only if a satisfactory answer is not to be found from the previous step.

Step 1: Is to look at rental evidence to see if it is clearly established how these improvements are quantified in the rental market.

Step 2: Is to consider rating settlements to see if they clearly establish in value terms the affect on the assessment of such improvements.

Then, if these steps fail to provide the required evidence, and only then,

Step 3: Is to have regard to the individual cost of providing those improvements, or a modern

alternative, on the hereditament so as to determine their value to a tenant.

15.7 The decision provides useful guidance on the hierarchy of evidence to be considered when seeking to quantify the value of improvements, and that regard to cost should only be made as a last resort in the absence of better more direct evidence of rental value.

15.8 Whilst the wording of the 1989 Regulations, as considered in Dorothy Perkins, is the same for 1990 and 1995 Rating Lists for both England and Wales, the wording of the Regulations was amended in respect of the 2000 Rating List for England only. Although the 2000 Welsh amending regulations did not alter the wording governing the application of the statutory decapitalisation rate, which remains as considered in the Dorothy Perkins appeal, the accompanying explanatory notes, although having no statutory force, imply an intention that a similar result should apply. However the 2005 Regulations for both England and Wales are both in accord.

15.9 For the purpose of the 2000 and subsequent rating lists the amended 1989 Regulations apply a prescribed decapitalisation rate only in respect of those hereditaments the rateable value of which is ascertained using the contractor’s basis of valuation.

15.10 Therefore where, in a rental or comparative valuation step 3 of the above approach is reached and treatment of improvements is by reference to cost the traditional virtual rent approach, as adopted prior to the Dorothy Perkins decision should be followed. The rental value of the improvements should be considered having regard to the amortised cost, using appropriate market rates and an amortisation period which has proper regard to both the likely useful life of the improvement and the terms of the lease against the background to which the improvement costs were incurred. Guidance on the appropriate amortisation period is given at part 17 of this Section.

16. The amortisation percentage to be used

16.1 The figure to be adopted in the amortisation of costs will differ. In all cases where a method can be clearly identified as the being one generally adopted by practitioners either in the rental market or in the field of rating then this basis can be applied in determining rateable value.

16.2 Where a market or established rating practice cannot be shown, and in order to reflect the value of the improvement there is a need to have regard to the costs in ascertaining the rateable value then, in cases where the wording of the Non Domestic Rating (Miscellaneous Provisions) (No 2) Regulations 1989 as amended require its application the statutory decap rate will apply. In all other cases regard should be had to the Guidance on appropriate amortisation rates as set out in section 18 below.

16.3 Whether the rent will or will not reflect the value of the improvement will depend upon the type of improvement made. It is therefore important to consider carefully the precise nature of the particular improvements involved. Where they are of a general nature, likely to be of value to a wide variety of other occupiers and traders, then the rental market is likely to have some regard to the level ascertained on a virtual rent basis.

16.4 What is, or is not, reflected in the rent passing on a particular property will, of course, be determined by the provisions contained in its lease, or in Landlord & Tenant law. When improvements are understood to be included in a rent it can generally be taken that it reflects their rental value. (Although valuers should be alert to instances where rents reflect earlier circumstances - e.g. original landlord’s improvements.) However, the value of fittings, etc installed for the sole benefit of a particular tenant are unlikely to be reflected, due to the difference between L&T and Rating law. For certain items, such as air conditioning, it will be rare to find that they have been reflected in the rent.

16.5 In most established town shopping areas VOs will possess rental evidence for fitted-out shops. In accordance with the established practice these rents would generally be expected to carry more weight than those requiring significant adjustment.

16.6 Shell rents which have been adjusted to reflect market adjustments for improvements may continue to be used for the purpose of supporting those fitted out rents. In such instances established valuation principles of using a virtual rent approach may be applied.

16.7 The evidence of both shell and fitted-out rents for one area can then be used for comparable purposes, so as to reflect the value of improvements to those shops where only shell rents exist.

16.8 In practice the adoption of the Dorothy Perkins’ stepped approach will usually result in the value of most tenants’ improvements being covered by step 1, with only miscellaneous items such as air conditioning being covered by step 3. This will, however be dependent upon the fund of local evidence that a VO will have been able to gather.

16.9 Approach to be adopted

Taking into account what has been outlined above, the following may provide a useful guide: -

(i) identify the facts about what fittings are included/excluded in a passing rent;

(ii) give particular weight to those rents which are inclusive of all rateable fitting-out work;

(iii) adopt the virtual rent approach to the notional or if known and relevant actual cost as at the rent date of all rateable items where the VO has evidence that the market similarly reflects such items in a rent, or where the prescribed rate is not mandatory in its application;

(iv) adopt as the tone the evidentially stronger approach of the alternatives.

17. Period of amortisation

17.1 In adjusting rents to take account of a tenant’s capital expenditure on improvements, the period of amortisation should be the shorter of the following periods starting from the date of the improvements to: -

(i) For Voluntary Improvements - i.e. those carried out otherwise than as a condition of the granting of the lease, the shorter of: -

a) the end of the useful life of the improvements (ie the time when the improvements cease to be of value); or
1. b) the next rent review where the value of the improvements are not specified to be disregarded. (However the improvements may then fall to be disregarded at a later date on renewal of the lease); (case 3) (s.34 LTA 1954 and s.1 LPA 1969); or
2. c) the date of the next lease renewal which is neither;

(ii) the first renewal since the improvements were carried out; nor

(iii) within 21 years of the completion of those improvements; or

a) exceptionally where it is known that a particular lease will not be renewed, the end of the current lease.

(iiii) FOR CONDITIONAL IMPROVEMENTS - ie those carried out as a condition of the

granting of the lease, the shorter of:-

a) the end of the useful life of the improvements (ie the time when the improvements cease to be of value); or
1. b) depending upon the terms of the lease, either the next rent review where such improvements are not specified to be disregarded (other than stepped rents) or the end of the lease (see question 12.2 of VO 6003/question 29 VO 6001/question 25 VO 6002 and Case 1).

More than one of these periods may apply when a series of improvements has been made at different dates. In such cases the total expenditure may be amortised over a period of time so averaged as to give a reasonable answer.

17.3 Statutory Rate

In deciding to adopt the prescribed rate in Dorothy Perkins v Casey (VO), Judge Marder felt he had no discretion to permit its application to a term of years rather than in perpetuity. As a result in circumstances, which dictate the application of the prescribed rate, and only in those circumstances, valuers should adopt a straight percentage calculation.

Case Note 1 Edma Jewellers Ltd v Moore (VO) (1975) RA 343 LT

Case Note 2 Merchant Investors Insurance Company Ltd v Sercombe (VO)(1983) 264 EG 990 LT

Case Note 3 Ponsford and Others v HMS (Aerosols) Ltd (1978) 247 EG 1171 HL.

18. Amortisation percentage

18.1 The amortisation rate should essentially be the market rate expected for such an investment.

18.2 The RSA system has been populated with default amortisation factors as follows: -

	Earlier Rating Lists	2005 Rating Lists	2010 Rating Lists
Shops	7%	8%	6%
Offices	9%	9%	7%
Warehouses	10%	10%	7.5%
Factories	10%	10%	8%
Land/ Miscellaneous	11%	11%	9%

18.3 These figures represent average national yields and do not override the duty of VO’s to examine market evidence in order to identify the appropriate percentages for each class of property. It should also be emphasised that yields are likely to vary not only between classes but also within classes depending on such factors as age, location, quality, type of tenant etc. It is important, therefore, to note these are default percentages only and VOs will need to decide what are appropriate for their localities.

18.4 Co ordination - The appropriate percentages to be adopted are likely to vary both between and within classes in any given locality and it is recommended that Group Reval Defence Managers co-ordinate the rates the VO proposes to adopt to ensure that there are no inconsistencies.

19. Surrender of former lease

19.1 If a former lease or agreement was surrendered as a condition of the present one being granted, then the annual equivalent of the value of the lease surrendered may need to be added to the rent. The addition should not be made when a rent review has taken place following commencement, and the basis of the review was to open market rental value.

19.2 The lease surrendered is of value because the occupier could have continued in occupation at less than the full rental value or could have assigned the lease and received the capitalised value of the profit rent in the form of a premium. The occupier would not therefore give up this value without some compensating allowance in the new rent. The new rent may therefore be less than the full open market rental value of the property.

19.3 To find the property’s full rental value the principle adopted is that, at the date of surrendering the old lease and agreeing the new lease the value of the tenant’s present interest under the old lease equals the value of the proposed interest under the new lease.

19.4 To find the full rental value it is first necessary to find the capital value of the profit rent under the old lease and the capital value of the profit rent under the new lease. As these capital values are equal the full rental value can be found by the equation “Present Interest = Proposed Interest”. A worked example is set out below: -

Example

The lease surrendered had a rent payable of £10,000 pa with an unexpired term of 3 years. The new lease rent payable is £20,000 with a review to open market rental value after 5 years.

Equation: -

Present Interest = Proposed Interest

F = Full Rental Value

Present Interest
Full Rental Value	£F pa
Deduct rent paid	£ 10,000
Profit Rent	F-10,000
x YP for 3 years at 10%	2. 6404
Capital value of present interest	2.6404 F- 26404 pa
Proposed Interest
Full Rental Value	£F pa
Deduct rent paid	£ 20,000
Profit Rent	F-20,000
x YP 5 years at 10%	4.0249
Capital Value of Present Interest	4.0249 F- 80498 pa
Present Interest =	Proposed Interest
2.6404 F-26404	4.0249 F-80498
1.3845F	54094
F	39,072
Full Rental Value	£39,072

20. Overage

20.1 The term “overage” means the enhancement of a rent because the period between the reviews specified in the lease is greater than normal.

20.2 A practice has grown up whereby some surveyors add 1% to the rent for each year by which the rent review pattern exceeds 5-yearly or sometimes 7-yearly intervals. The profession however, by no means universally accepts this practice, and the percentage adjustment is likely to be greater when there is high rental growth, than in more static markets.

20.3 VOs should take steps to determine the local “norm” for rent review patterns for each class of property within their local office area. Once the norm is established it can be argued that a balance has been struck in the real world between the interests of landlords and tenants and therefore changes in rent would not normally be expected at less than the norm interval.

20.4 For rating purposes rents derived from the “norm” review period (and possibly below) could be accepted without adjustment but those for longer periods may require some downward adjustment in line with local office evidence.

20.5 The majority of tenanted properties today are let on leases for a term of years between 5 and 25 years with the rent subject to reviews at periodic intervals. A 5-yearly review pattern is common but patterns of 3 to 7 years occur frequently. The modern rental evidence therefore differs in two ways from that envisaged in the hypothetical world of rating. Firstly, because they offer a term of years certain rather than one from year to year and, secondly, by being subject to a strict periodic review pattern. Agents may argue that rents paid under such leases with periodic reviews do not accord with the statutory definition of a rent from year to year and a downward adjustment is therefore required.

20.6 VOs may find support in resisting this argument from various decisions of the Lands Tribunal where, in the absence of any firm evidence to the contrary, they have shown a willingness to accept lease rents as being good evidence of value, but a general reluctance to adjust those rents on account of the security they offer. The Tribunal also appears to have been prepared to make adjustments for “overage” in circumstances where properties are subject to long review patterns out of line with the norm but have been reluctant, in the absence of direct and compelling evidence to the contrary, to make adjustments where properties are subject to normal review patterns. (Case notes 1-4).

20.7 Although in the hypothetical world of rating we are assuming a tenancy from year to year there is no precedent to suggest that the rent must be reviewed at the end of each year. On the contrary the Lands Tribunal has indicated that the rent may be varied as much on the initiative of the tenant as on that of the landlord. (Case note 5).

20.8 It would be unrealistic to have a hypothetical tenancy that continued indefinitely at a rent that could not be varied. In the real world, reasonable landlords and tenants freely negotiate terms whereby long leases are subject to periodic reviews. It would seem reasonable that periodically during the continuance of the hypothetical tenancy the hypothetical landlord and tenant would agree to revise the rent. Unless there is strong evidence to the contrary, there appears to be every reason for assuming that the rent under the hypothetical tenancy will be revised periodically in line with the review patterns determined in the real world.

20.9 There are also arguments as to why rents from year to year should not be adjusted or in fact may be higher than those fixed for a term of years. In the rating world the tenant has the benefit of the reasonable expectation of continuance but also has the ability to give notice at the end of any year. This differs from the real world where the tenant for a term of years is contractually bound to pay the full rental value, possibly on upward only rent reviews, until the end of the lease. In recent times there has been increasing pressure from tenants to insist the lease contains the option for them to break and this move lends added support to the argument.

20.10 During periods of rapid rises in rental values the theoretical argument has most weight.

However the market is cyclical rather than uniform with periods of rapid growth often being followed by stagnation, and sometimes even falls in value. It is during periods of falls in rental value that the tenant from year to year would benefit due to being able to terminate the tenancy or negotiate the rent down. In contrast the leaseholder is tied to the lease rent even if values have fallen.

20.11 Furthermore annual tenancies are not normally attractive to landlords because of the high cost of annual rent reviews, the uncertainty of income and the potential loss of value on the capital investment. Because some increase in rental value might be effected on this account the argument may also be used against agents who are seeking reductions on rents fixed for a term (usually 5 years) for reasons of “overage”.

Case note 1: BHS v Burton (VO) and Brighton CBC 1958 LT 51 RIT 665

Case note 2: Walls (VO) v National Car Parks Ltd 1978 LT RA 30

Case note 3: Cresta Silks Ltd v Peak (VO) 1958 LT 51 RIT 457

Case note 4: FW Woolworths and Co Ltd v Moore (VO) 1978 LT RA 186

Case note 5: LA Black Ltd v Burton (VO) 1958 LT 51 RIT 307

21. Domestic accommodation

21.1 If the rent includes domestic accommodation an apportionment will be required to enable the value of the non-domestic element to be determined. The value of the residential part to be deducted will depend on the local market conditions.

22. Non-domestic rates

22.1 In most leases or agreements where the rent is inclusive of non-domestic rates (NDR) the rent can be altered to reflect changes in the level of rates payable. Therefore, the amount to be deducted is the appropriate amount payable for the rate year in which the return form was completed. Where it is known that the rent has not been altered to reflect changes in rates since the relevant date, the amount to be deducted is the amount payable for the year in which the relevant date falls. If at the relevant date there was an expectation that the level of non-domestic rates would rise and therefore account for an increasing portion of the inclusive rent paid, then it might be appropriate to make a larger deduction than the actual relevant date NDR level.

22.2 Adjustment of Inclusive Rents

22.3 Where the occupier’s Uniform Business Rate demand was not subject to transitional phasing arrangements (Question 18 of VO 6001/Question 27 of VO 6002) the amount of rates payable can be calculated by multiplying the RV by the national non-domestic rate poundage payable for the year in which the FOR was completed, or the year following the relevant date depending upon whether the rent can be varied with variations in the NDR liability.

The table below shows the rate poundage adopted from 1990 to date:

Year	England	Wales
1990/91	34.8p	36.8p
1991/92	38.6p	40.8p
1992/93	40.2p	42.5p
1993/94	41.6p	44.0p
1994/95	42.3p	44.8p
1995/96	43.2p	39.0p
1996/97	44.9p	40.5p
1997/98	45.8p	41.4p
1998/99	47.4p	42.9p
1999/00	48.9p	44.3p
2000/01	41.6p	41.2p
2001/02	43.0p	42.6p
2002/03	43.7p	43.3p
2003/04	44.4p	44.0p
2004/05	45.6p	45.2p
2005/06	42.2p reduced by 0.7p for small hereditaments	42.1p
2006/07	43.3p reduced by 0.7p for small hereditaments	43.2p
2007/08	44.4p reduced by 0.3p for small hereditaments	44.8p

From 1997/98 to 2000 a “small hereditament” factor applied, reducing the multiplier by 0.9p. A small hereditament was one in Greater London with a RV of less than £15,000, or elsewhere with an RV of less than £10,000.

For 2005/06 onwards a small business multiplier reduces the multiplier by 0.7p for small hereditaments. They are those in Greater London with a RV of less than £21,500 and elsewhere with a RV of less than £15,000.

The City of London is able to set a different multiplier from the rest of England:

2003/04 44.7p

2004/05 45.9p

2005/06 42.5p

2006/07 43.7p (Small Business Rate 43.0p)

2007/08 44.8p (Small Business Rate 44.5p)

22.4 However, where the occupier’s Uniform Business Rate demand was subject to transitional phasing arrangements the calculation of the rates payable is complex. Therefore, on receipt of a FOR which states that the rent is inclusive of rates and the subject of transitional phasing arrangements, VOs should either send out supplementary questionnaires asking for details of the actual rates payable for the year in which the FOR was completed, or request the information from the relevant billing authority.

22.5 Question 10.2 of form VO 6003 asks whether the rent paid includes an element for non-domestic rates and if so the amount included. Where the rent is inclusive but no rates figure is quoted or where it is necessary to check any quoted figure, further enquiries of the ratepayer or billing authority should be made.

22.6 Transitional Relief

22.7 The combination of the 1990 revaluation being the first since 1973 and the introduction of a Uniform Business Rate would, if unadjusted, have resulted in large changes to some occupiers’ rate liabilities. To limit this impact provisions were made to phase in the changes.

22.8 Transitional phasing provisions continued for 1995 and 2000 rating lists for England and Wales. Importantly these schemes did not start afresh at each revaluation but started from the final rates demand figure at the end of the previous list rather than simply being phasing between the old and new rateable values. This meant it was possible to have phasing on phasing and a rates liability determined not by the actual rateable value but the cumulative phasing from the 1972/73-rate year liability.

22.9 Transitional arrangements for Wales ended on 1 April 2003. Transitional arrangements for England continued to apply to the 2005 rating lists and the relevant statutory provisions are contained in The Non-Domestic Rating (Chargeable Amounts) Regulations 2004 SI No 3387An important change was introduced for 2005 in that transitional relief would work itself out by the end of the 2008/9 rate year.

22.10 Qualification for Transitional Relief – the 2005 scheme

22.11 For the 2005 transitional scheme to apply, the rateable value for a hereditament has to be shown in a rating list for 31st March 2005 and 1st April 2005. In certain circumstances where this does not occur the valuation officer will certify a rateable value, examples include hereditaments formerly exempt as Crown occupations.

22.12 The transition rules are very similar to previous schemes and broadly speaking rely upon the rates paid for 31 March 2005 and the full bill for 1 April 2005. In most cases this will provide a “like for like” comparison in bills which will identify the change arising from the revaluation. However, this is not always the case because:

The value for 31 March 2005 or 1 April 2005 could be wrong and the VO may be prevented from correcting either of those values (because the list has closed or the the effective date is limited), the property could change on 1 April 2005 itself, or the property may split or merge prior to 1 April 2005 but only the 2005 list can be corrected (this will only occur from 1 April 2006).

22.13 Therefore the transition regulations provide for the VO to certify the value in these circumstances. For 2005 the rules for VO’s are very simply:

whenever, in the above circumstances a VO believes the list is wrong but is prevented from making a correction for 31 March or 1 April 2005 (either because the list has closed or the effective date is limited), then the appropriate value is to be certified. This is the case irrespective of whether the value is to be increased or reduced or whether the VO is actually amending the list, and neither the ratepayer nor the VO may choose whether to issue a certificate.

22.14 Occasions requiring certification under the NDR Chargeable Amounts (England) Regulations 2004 are shown in the table:

Regulation	Applies to	Date certified for:	Based on circumstances as at:	Certificate	Revised Certificate
Reg 5	Hereditament in central list	1/4/2005	1/4/2005	N/A	N/A
Reg 6	Hereditament in central list	31/3/2005	31/3/2005	N/A	N/A
Reg 7	Hereditament in central list	31/3/2005	31/3/2005	N/A	N/A
Reg 11	Hereditament in central list – apportionment	RV shown for the day	N/A	N/A	N/A
Reg 12	Reg 11 hereditaments – change in value post 1/4/05	1/4/2005	1/4/2005 and chargeable day	N/A	N/A
Reg 13	MCC on 1/4/2005	1/4/2005	31/3/2005	VO7632	VO7632A
Reg 15	When RV for 1/4/2005 is inaccurate	1/4/2005	1/4/2005	VO7633	VO7633A
Reg 16	Inaccuracy in RV for 31/3/2005 & Reg 15 certificate issued	31/3/2005	31/3/2005	VO7634	VO7634A
Reg 16	Inaccuracy in RV for 31/3/2005 and no Reg 15 certificate issued	31/3/2005	31/3/2005	VO7635	VO7635A
Reg 17	Split/Merger/Recon pre 1/4/2005 not shown until 1/4/2005	31/3/2005	1/4/2005 [i.e. value of new hereditament(s)]	VO7636	VO7636A
Schedule 1	New hereditament formed wholly or mainly from one shown in 2000 list at some time	31/3/2005	Date new hereditament becomes liable to be rated	VO7966	VO7966A
Schedule 2	Split/Merger/Recon actually occurring on 1/4/2005	1/4/2005	31/3/2005 [i.e. value of old hereditament(s)]: Split 1→2+	VO7967	VO7967A
			Merger 2+ →1	VO7968	VO7968A
			Reconstitute 2+ →2+	VO7969	VO7969A

22.15 Practical Effect of Transitional Phasing

22.16 Different transitional arrangements will apply, depending on whether the rates bill increased or decreased and whether the business is classed as small or large. A small business is defined as a property with a rateable value of under £15,000 outside London and under £21,500 within London. Transitional arrangements are based on the change in the rates bill from 2004/05 to the rates bill in 2005/06. They are not dependent on the change in the rateable value itself.

22.17 The transition scheme, which was confirmed in December 2004, operates over a four year period. Every ratepayer will pay their true rates liability in the fifth year and many will pay it well before this.

22.18 Table 1 show the proposed limits by which a rates bill can increase in a single year before transitional arrangements apply:

Year	Small Business	Large Business
2005/06	5%	12.5%
2006/07	7.5%	17.5%
2007/08	10%	20%
2008/09	15%	25%
2009/10	n/a	n/a

22.19 Slightly different arrangements apply for the proposed limits by which a rates bill can decrease in a single year, shown in table 2 below:

Year	Small Business	Large Business
2005/06	30%	12.5%
2006/07	30%	12.5%
2007/08	35%	14%
2008/09	60%	25%
2009/10	n/a	n/a

22.20 The Effect on Rental Values

At previous revaluations the differing effect of transitional phasing on properties may, in some instances, have distorted rental levels. At the 2010 revaluations AVD, 1 April 2008, the English 2005 rating lists’ transitional relief scheme had only one more year to run. For the 09/10 rate year there would be no transitional relief. The clear position of RV X multiplier = rates payable will have been restored in England as it is in Wales. Whilst at earlier revaluations the distortion of rates payments due to phasing could have affected rents it is unlikely that the expectation of one more year of transitional relief will have affected rents agreed on a five year review pattern as commonly found in the market.

22.22 It is unlikely any adjustment will need to be made to rents agreed around or after the AVD though it is possible, as with earlier revaluations, that for earlier rents some adjustment may be appropriate. The earlier 2000 version of this practice note should be consulted if adjustment is considered necessary.

23. Insurance

23.1 The definition of RV places the liability to insure the hereditament on the tenant. In the same way that commercial landlords seek to protect the value of their reversion by retaining the repairing liability and recouping the expense through a service charge so they will frequently undertake to insure their property and recover the premium directly from the tenant(s). In such circumstances, the rent passing will reflect the tenant’s liability and thus no adjustment is necessary.

23.2 In the rare event that the landlord insures without directly recovering the premium, a specific deduction will need to be made in order to adjust the rent to terms of RV. Insurance premiums are a substantial item and are unlikely to bear a consistent relationship with the rental value of the property. Because the premiums vary widely according to the use, construction, age and location of the hereditaments, it is clearly not possible to give specific advice which will cover all cases that could occur, and research indicates that it would be misleading to attempt to generalise as to premium levels If the need arises to make an adjustment to rents under this heading VO’s should consider any direct evidence of insurance premiums. In the absence of actual insurance premium rates 3.5% should normally be deducted and this figure has been set as the default factor in RSA, for the 2010 Revaluation.

24. Services

24.1 Section 23 of the General Rate Act 1967 which prohibited the deduction of any amount in respect of profit on landlord’s services or the cost of repair, maintenance and insurance of premises not forming part of the hereditament was repealed and is not re-enacted in the LGFA 1988.

24.2 Where a rent is inclusive of a service charge for services provided by the landlord the rent will require adjusting to reflect the cost of the services provided (Question 10.2 of VO6003/Question 24 of VO 6001/Question 19 of VO 6002). In cases where the landlord recovers the cost of the services by way of a separate service charge it will not normally be necessary to adjust the rent.

24.3 However the level of the charge should be closely examined. In some cases the effect of an abnormally high or low charge may make the rent suspect as evidence of rateable value. It may be necessary to treat any exceptional profit made by the landlord on the service charge as in the nature of rent and add it to the rent in determining true open market value.

24.4 Equally if the service charge covers items, which are not the responsibility of the hypothetical tenant, the rent will need to be adjusted accordingly

25. Fixtures, fittings, plant and machinery

25.1 If the rent includes an amount for the use of any trade fixtures, fittings, plant and machinery, furniture or other equipment then it will be necessary to make a deduction for any non-rateable items. The annual payment in respect of fixtures, fittings, etc should be given in answer to Part 13 of VO 6003 (question 27 of VO 6001 or question 22 of VO 6002) and this figure should, unless unrealistic, be deducted from the passing rent.

25.2 Where there is a mixture of rateable and non-rateable items the amount to be deducted should be based on a reasonable apportionment of the total estimated value of the items.

25.3 It will be a matter of local judgement to determine the level at which input is provided if no figure has been provided or if the figure provided requires apportioning between rateable and non-rateable items.

26. Repairs

26.1 Because valuations are to be made to RV (which essentially assumes FRI terms), it is necessary to keep firmly in view the extent of the tenant’s obligations under the rating hypothesis. The hypothetical tenant has the liability to maintain the hereditament in such condition as it should be had it been managed by a reasonably minded owner. That owner would have full regard to the age of the building(s), its character, the locality and the class of tenant likely to occupy it, so that only an average amount of annual repair would be necessary in the future. The hypothetical tenant’s repairing obligation extends to the entire fabric of the hereditament, although this often may not comprise one entire building. A full explanation of the tenant’s liability to repair as envisaged under the definition of Rateable Value as amended by the Rating (Valuation) Act 1999 is contained in the Practice Note to Rating Manual Volume 4 Section 4, which should be read together with this Practice Note.

26.2 To establish the state of reasonable repair for the unit of assessment the Lands Tribunal has turned to Landlord and Tenant case law for guidance

26.3 The obligation under the rating hypothesis can be compared to a number of common variations found in modern commercial leases as set out at (a) to (c) below. Question 10.1 of VO 6003, (Question 14 of VO 6000, Question 18 of VO 6002) asks which party is ultimately responsible for bearing the cost of outside and inside repairs.

a) Landlord does them but recoups cost

The landlord retains the obligation to keep the main structure and exterior in repair. At the same time, the landlord will frequently reserve the right to recoup the cost from the tenant(s). This is a common arrangement where the building is let in parts or where the landlord’s investment comprises, say, a shopping centre. From the tenant’s point of view, this may not necessarily be the cheapest option, even if the landlord is using direct labour or his own subsidiary building company. No adjustment is required to the rent since the tenant bears the financial consequences of the landlord’s repairing liability and this will be reflected in the rent passing.

b) Landlord does some or all but does not charge

The landlord bears some or all of the liability for repair without directly seeking to recoup the cost. In such cases, which are now comparatively rare, the rent might be higher than if the tenant were to bear in full the direct cost of maintaining the hereditament in a state of reasonable repair.

Traditionally, surveyors have adjusted rents by 5% where the landlord has been responsible for external repairs and a further 5% if the landlord’s liability also covers internal repairs.

The Rating Support Application (RSA) has been programmed to automatically adjust rents by 5% where the landlord is liable for external repairs and by 5% if the landlord is responsible for internal repairs. These are default figures and they should only be used if they are consistent with market evidence or practice.

The percentage adjustment may well vary according to the type, age, or construction of the building and VOs need to adequately reflect instances where abnormally high repair costs are likely to be incurred (eg listed buildings subject to reflecting the availability of any assistance in the form of grants).

Therefore VO’s need to examine all local evidence in order to determine the correct adjustment for external and internal repairs borne by the landlord. In the absence of direct local evidence VO’s should consider any evidence from within the Group and co-ordination should be undertaken to ensure that VO’s proposed adjustment factors are consistent.

c) Premises in poor state of repair

When premises are in a poor state of repair, the landlord in the real world may choose either: -

(i) to put the premises in repair before offering them to let. This operation can be ignored for the purposes of rental adjustment, as the rent subsequently charged will reflect the repairs carried out by the landlord

(ii) to let the premises in their existing state on FRI terms. In this case the initial rent will not only be abated to reflect the existing condition, but also the tenant’s enforceable liability to put the property into a state of tenantable repair. Unless the parties contract otherwise, for example by letting with restricted repairing liabilities subject to an agreed schedule of condition, the physical condition at review will be on the basis that the tenant has honoured the covenant to repair, whether or not that is in fact the case.

As an alternative to reducing the initial rent, the lease or agreement more commonly may provide for a rent-free period while the tenant carries out the repairs, and recoups the cost of doing so. The treatment of rent-free periods is dealt with later in this guidance at section 5 Landlords incentives

(iii) to let the premises in their existing state on FRI terms but in addition the tenant, as a condition of the lease, undertaking to repair the premises. Normally, by the material day, the improvement will have been completed. (See also section 14 on Improvements).

Because in cases (ii) and (iii) above the tenant already bears the immediate repair burden the rent passing is likely to be fully discounted until the first review. In such cases the initial rent will reflect the poor state of repair of the property and will therefore be unreliable as evidence of the value of the property in tenantable repair; adjustments will therefore be needed. However, if the rent has been reviewed it is probable that rent will be on the basis that the property is in a reasonable state of repair commensurate with its age, character, locality and the class of tenant likely to occupy it

27. Turnover rents

27.1 Introduction & Background

A turnover rent is one where the rent payable is determined by the actual turnover achieved by the tenant. Turnover leases are most often used in relation to retail operations, including catering leases and franchises, food courts and concessions within department stores. They are by no means a new phenomenon but their use is becoming more common.

In relation to retail property turnover leases were first introduced into the UK many years ago in situations where the retailer had a captive market, such as railway stations and airports. In these unique situations there would be little if any comparable evidence upon which a landlord and tenant could agree a rent and given the monopolistic position enjoyed by the tenant the landlord would wish to receive a fair share of the profits arising therefrom.

27.2 Since the 1970’s turnover rents have been introduced into shopping centres, with Capital Shopping Centres leading the way. Whilst Capital Shopping Centres remain the main exponent of turnover based leases other developers have followed suit. The recession experienced in retailing in many parts of the UK in the late 1980’s and early 1990’s provided a spur to many landlords to accept reduced base (minimum) rents but with turnover provisions, in order to secure lettings on units which would otherwise have remained vacant. Subsequently with a growing appreciation of the operation and benefits flowing from the adoption of turnover based leases their use has increased.

27.3 More recently the growth in factory outlet retailing has seen an increase in the use of turnover-based leases by landlords, who adopt it almost exclusively within this sector of the market.

In the UK there are two principal types of turnover rent based leases. Firstly those where the rent is wholly based upon turnover, as commonly employed in respect of food courts and secondly those where the rent is based on turnover but there is a base or minimum rent. The base rent is generally determined as a percentage of open market rental value or a price per square metre. In these cases, in contrast to pure turnover rents, the landlord is guaranteed a certain minimum level of rental income.

27.4 In the following paragraphs consideration is given to the rationale behind turnover leases, the discreet advantages and disadvantages from the landlords and tenants viewpoints, when compared with the traditional institutional style lease, the typical lease terms employed and those factors which a valuer should have particular regard to when considering turnover rents in rating valuation.

28. Turnover leases – general

28.1 An investor’s aim in most cases is to secure the maximum return on their investment. In the context of a managed shopping centre environment, where the whole is in a single ownership, it has been recognised by some that the maximisation of that return is more likely if the centre is managed more as a business than a pure property investment. With this has come the recognition that it is in the landlord’s interest for individual retailers to maximise their turnover and profits, whilst not at the expense of their neighbours (also tenants of the landlord). This necessitates the landlord taking a tight control over the tenant mix, management and promotion of the centre as a whole and greater co-operation between landlord and tenant, who might otherwise be regarded as adversaries.

28.2 Rents under turnover leases are more directly related to the ability to pay of individual traders - turnovers and profit margins vary and hence the level of rent a tenant is able to pay. If rents were set in the normal way, at a more or less uniform level, particular tenants who may enhance the mix within the centre and therefore its success as a whole might be denied the opportunity to trade because of their inability to pay the ‘going-rate’. Adoption of turnover leases gives the landlord more flexibility, and a greater chance of obtaining the optimum tenant mix - a range of complementary traders - to maximise centre turnover and therefore rental income as a whole.

28.3 Management of retail centres is much easier and more effective if it is informed with the knowledge of how individual retailers are performing. Turnover leases allow landlords direct access to trading information which with today’s point of sale technology means centre managers will know more or less immediately if a part of the centre or a particular trader is performing poorly or exceptionally well. Landlord’s can then respond positively without having to wait until the retailer’s problems are such that the retailer ceases trading and a void is created which might take time to fill.

28.4 Advantages and Disadvantages of Turnover Rents

28.5 Advantages from a landlord’s point of view include :-

a) With turnover rents there is the prospect of achieving rental growth annually rather than having to wait for periodic rent reviews, in times of general inflation a turnover based lease will be a better hedge against inflation.
1. b) In new schemes pre-lets can generally be achieved more easily and the landlord is less likely to lose out on unanticipated rental growth between the date of agreement of the pre-let and the opening of the scheme, to the extent that the rental growth is reflected in increased turnover figures.
2. c) Knowledge of tenants’ turnover performance will enable the landlord to spot weak tenants or tenants who should be moved to smaller or even larger accommodation at an early stage - control of user, assignment and the facility to determine leases early where performance targets are not being met will mean the landlord is better placed and able to vary tenant mix to achieve the optimum.
3. d) Turnover information will also assist the landlord in identifying whether any particular location within the centre is weak and hence be able to take action by physically improving access/visibility to that part and/or through its marketing role more actively promote that part of the centre. Knowledge of turnover will also assist in gauging the success and effectiveness of initiatives such as promotional schemes or changes in opening hours. In each case turnover information assists greatly in the management of a development.
4. e) Refurbishment of developments is much more likely to take place when needed, as the landlord will see an immediate return on the capital invested (assuming improved trading levels) rather than having to wait until rent reviews.
5. f) Rent reviews where the base rent is geared to open market rental value are likely to be less contentious, although this will to a large extent depend upon the level of the gearing and the tenant’s perception as to when the turnover rent might bite.

28.6 Disadvantages from a landlord’s point of view include :-

a) By its very nature the turnover lease requires the landlord to carry some risk. In times of poor trading the landlord may only receive the base/minimum rent or if turnover does not live up to expectation less than open market rental value.
1. b) The increased level of management and marketing of a centre leads to additional costs, although these may be passed on to tenants via a separate service charge or marketing charge, but should if effective lead to an increase in the rent roll.
2. c) Contracting out of the Landlord and Tenant Act 1954 is generally appropriate; the process requires a court order and although these are usually a formality as both parties are required to consent, the process is nevertheless time consuming.
3. d) Funding of schemes to be let on a turnover basis is more difficult to achieve than for a centre let wholly on the basis of traditional institutional leases, as only the base rent provides guaranteed income. Valuation techniques, because of the relatively risky turnover rental element of any letting, especially in a new un-proven centre, can also lead to under-valuation of a centre when compared to a traditionally let comparable scheme.
4. e) The rental income will fluctuate year to year and this could prove disadvantageous to some landlords; the fluctuation will however be less the higher the proportion base rent is of full open market rental value, this aspect can to a certain extent therefore be influenced from the outset. However setting base rents as a high proportion of open market rental value whilst reducing the risk to the landlord is arguably not conducive to the partnership ethos required for schemes where turnover rents are employed to be successful.
5. f) Where turnover percentages are fixed, there is the potential for rental income to be affected by tenants pursuing trading policies or by following market demand which leads to lower turnover levels but at increased margins, thus retaining the tenant’s overall profitability.

28.7 The advantages from a tenant’s point of view include :-

a) The risk a tenant takes in deciding to trade in what are often untried or tested locations and/or concepts is reduced. The link between rent and turnover should ensure that the tenant will generally pay a higher rent when he can afford to and vice versa. When trading successfully a higher rent will be paid, and conversely in times when trade is down the rent payable will show a discount on full open market rental value, ie. the difference between the full open market rental value and any base rent.
1. b) cases where the base rent is fixed as a percentage of omrv, it will generally be subject to periodic review. In times when rents are rising then so too, in all probability, will retailers’ turnover, therefore over the normal rent review period the rent will track the turnover level and any increase at rent review will generally not be as high as would ordinarily be the case.
2. c) rents therefore acts as a cushion during recessionary times and also against potentially swingeing increases at rent review, rent levels should move more smoothly following levels of turnover and the tenants ability to pay, in contrast to traditional leases where periodic rent reviews often lead to substantial increases following market movements, not directly linked to what the actual occupier is able or willing to pay.
3. d) A tenant’s trading position within a centre will to an extent be protected, as it will not be in a landlord’s interest to increase the number of units let to similar traders thus increasing competition and potentially reducing turnover and rent - the landlord will seek to achieve the optimum number of suppliers of particular goods or services.
4. e) The fact that the landlord’s income will to a large extent be determined by the success of the centre is a very clear and positive incentive for the landlord to ensure that the centre is in good condition and is managed and marketed/promoted effectively.

28.8 Disadvantages from the tenants point of view include :-

a) Tenants have to disclose turnover, retail markets are highly competitive and retailers are generally loath to provide this kind of information for fear of it falling into competitors hands or in to the hands of someone who might be considering a take-over. These concerns can be eased by the inclusion of confidentiality clauses within the lease (which are the norm) and the build up of trust between retailers and landlord’s experienced in operating centres where turnover rents are employed.
1. b) are also wary that landlords might use turnover information gained in respect of one development in lease/rent negotiations in respect of shops in other centres.
2. c) The turnover percentage set at the commencement of the lease is generally fixed for the duration of the lease. The tenant is concerned with profitability, a tenant who over-estimates the profitability of the business can find itself paying a greater proportion of its turnover than it can really afford. Where profitability and turnover move together over the term of the lease then relating rent to turnover will not be disadvantageous to the tenant, assuming the turnover rent percentage is set at the outset at an affordable level. However if profitability is reduced relative to turnover then a tenant’s ‘bottom line’ will be reduced (the converse would be advantageous to the tenant but not the landlord). This could result where a tenant changes product mix in response to consumer demand or pricing in response to increased competition. Further, in times of general inflation whilst turnover may increase there is not necessarily a commensurate increase in margins/profitability.
3. d) risk can be reduced if leases are short, as the tenant can make reasonable forecasts margins in the short term. Alternatively the turnover percentage could be reviewable, although this rarely appears to be adopted in practice.
4. e) Retailers potentially have less disposable property rights; tenants generally hold inalienable rights or if they do hold a lease which is transferable there is no clearly visible profit rent. It is however not unknown for premiums to be paid on assignment of leases for units in successful centres, reflecting the wish to gain a foothold in the centre.
5. f) Where a tenant undertakes improvements to the demise, if paying an open market rent on a traditional lease the rent, in most cases, would not be increased to reflect the improved demise. However a turnover rent will be increased following improvements to the extent that turnover has increased consequent upon the improvements. It must however be borne in mind that the nature of properties where turnover rents are commonly employed; standard shop units and factory shopping outlets, mean that there is in reality limited scope for improvement to the demise, beyond normal fitting out.

28.9 Turnover Leases - Typical Terms

Inevitably turnover leases will vary, but there are a number of features common to most, which are considered below.

In all cases, where a property is held on a turnover lease it is essential that a full copy of the lease is obtained in order to fully understand the respective parties’ positions.

28.10 Lease Term

In order that the landlord has the flexibility to be able to optimise tenant mix and manage in a way that ensures a centre is trading as a whole to its maximum, the lease term will not usually be in excess of 10/15 years and is often less.

The term can however be longer where the lease is structured in a way which allows the landlord to dispossess under-performing tenants (see performance covenants), or where the base rent is highly geared to open market rental value or reviews of the turnover percentage are allowed and the landlord has complete control over alienation.

Whilst pressure in the market in the 1990’s has been for lease terms to shorten and the lease term is a more critical factor to landlords under a turnover lease, this pressure must be tempered by the fact that tenants must be allowed a sufficient time over which to amortise fitting out costs, otherwise landlords would be expected to undertake or fund this work. In factory shopping outlets where fitting out is often limited when compared with traditional high street shop units leases of 3-5 years are not uncommon.

28.11 Rent

The rent payable under a turnover lease will typically, but not always, be the greater of the base or minimum rent and the turnover rent.

28.12 Base or Minimum Rent

The base rent element, ie. that level of rent which is guaranteed will either be a given percentage of open market rental value, frequently 80% (as in the case of Capital Shopping Centres) or a price per square metre, usually consistent across a development. This element of rent will often be paid quarterly in advance, as in the case of traditional leases.

28.13 Turnover Rent

The turnover rent is based on a pre agreed percentage applied to annual turnover. The turnover adopted is generally the gross trading turnover, although deductions may be made for elements such as VAT, goods returned, goods not paid for and discounts on staff sales. The turnover figure adopted is a vital element in the calculation in any turnover rent and will be defined in detail in the lease.

28.14 The turnover rent will be payable in arrears, usually monthly but in some cases (Capital Shopping Centres) it is payable as a single lump sum. Tenants are obliged to provide turnover statements periodically in line with the timing of turnover rent payments and at the year end a balancing statement will be prepared to calculate any over or under payment. Provisions will usually be included in the lease whereby accounting disputes will be referred to arbitration.

The turnover percentage will be set at the commencement of the lease by agreement of the parties. Turnover percentages vary substantially according to the relative profitability of the trader, high volume but low margin retailers such as supermarkets will therefore have a turnover rent based on a much lower percentage than say a jewellers where although turnover itself may not be as high the profit margin will be much higher.

The table below gives an indication of the range of percentages which might be encountered in a traditional shopping centre. It must be appreciated that the turnover percentage adopted in respect of the same trade for a shopping centre will not necessarily be the same as for that trader in say a factory shopping outlet, margins and operating costs may differ substantially.

Indicative Turnover Percentages

Trade
Jeweller	10-11%
Ladies Fashions	8-10%
Men's Fashions	8-9%
Radio & Electrical	7%
Catering	7%
Shoes	8-10%
Records	9%
Sports Goods	9%
Greengrocer	6%
Butcher	4-5%
Baker	5%

28.17 Rent Review Provisions

In general leases will not include provisions for review of the turnover percentage. An exception might be when assignment of a lease is permissible, subject to the landlord’s consent (see 4.4) and there is a change in trade. In these cases it is usual for there to be a period when full open market rental value is paid, during which time turnover can be monitored, and after which a turnover percentage will be agreed between the parties, or determined by arbitration in the absence of agreement.

The base rent will however usually be reviewable. In those cases where it is set at a fixed percentage of open market rental value reviews will usually follow the pattern for the class of property in the locality. Where the base rent is set at a level not related to the rack rental level it is not uncommon for there to be provisions that the base rent be reviewed annually, on an upwards only basis, to a percentage of the previous years rent paid. In these circumstances there is the potential for the base rent to be ‘ratcheted up’ each year, depending upon the gearing of the base rent review provisions in relation to turnover and the turnover performance.

28.18 Alienation

With turnover leases it is essential for the landlord to strictly control assignment and under-letting of the demise in whole or in part, as the appropriate turnover percentage is, as outlined above, trade/tenant specific. It is not difficult to see the consequences on the rent a landlord receives for a unit in the event of a turnover lease granted to a butcher or baker being freely assignable to say a jeweller.

The landlord also needs to be in control of tenant mix to ensure the most successful blend of tenants in order to maximise the turnover of the development as a whole and leases will be drafted accordingly. For these reasons it is usual for there to be an absolute bar on dealing in whole or part of the demise. Where assignment is permitted leases will invariably require landlord’s consent, such consent not to be unreasonably withheld, but the landlord will retain the right to refuse consent should it be believed that the assignment will either reduce rent receivable or adversely affect tenant mix. In addition a buy back clause may be included, whereby a tenant wishing to assign his interest must give the landlord first refusal to buy back the lease, matching any offer made following a period of marketing.

28.19 User

Strict control of user is an essential characteristic of a turnover lease; not only to safeguard the level of rent received in respect of any individual unit but also to control tenant mix.

User clauses will often therefore be absolute (allowing no other use than that permitted) and may stipulate the brand of goods to be sold together with limits on the extent that the retail floor area may be used for the sale of specific types of goods.

Where however the base rent is geared to open market rental value and is reviewable user clauses must be drafted so as not to limit rent on review. In such cases the user clause will often be drafted so as to allow all uses within Class A1, subject to the landlord’s consent, with the proviso that the landlord can refuse consent should any change of use have a detrimental effect on rental income or tenant mix. A clause drafted in this manner will ensure that the landlord is able to control tenant mix but not be penalised at rent review by a narrowly worded user clause.

28.20 Covenants to Trade

As the rent payable to the landlord is in whole or in part related to turnover the landlord must ensure that the tenant operates a normal trading pattern in line with other retailers and does not seek to open only during limited periods when he might secure maximum profit but keep turnover and therefore rent at a lower level than might otherwise be achieved. It is usual therefore for the lease to include a clause requiring, inter alia, the tenant to keep open during ‘normal hours’, the clause should also be sufficiently flexible to allow variations for extended Christmas opening or Sunday trading.

This covenant might also cover such matters as membership of a merchants’ association, standard of window displays and the stocking of the shop.

28.21 Security of Tenure

In order that the Landlord may regain possession at the contractual end of the lease it is common practice for turnover leases to be contracted out of Part II of the Landlord and Tenant Act 1954 (the provisions relating to security of tenure for business tenancies).

28.22 Performance Clauses

Performance clauses are a common feature in turnover leases, the clause will usually specify a minimum turnover level, usually linked to the Retail Prices Index, which if not met allows the landlord to determine the lease, often at short notice. These provisions give landlords the flexibility to remove poorly performing tenants without waiting for the end of the lease or for the tenant to leave of his own volition, delay which would be potentially damaging to the performance of a centre as a whole.

28.23 Forms of Return

It is of the utmost importance that Forms of Return (Rent Returns) are carefully examined to identify if properties are let on terms where the rent is based on turnover. It is not uncommon for there to be a mix of traditional leases and turnover leases within the same development. Valuers therefore need to be wary of any development where there is such a mix to ensure that rack rents are not ‘‘grossed up’’ or indeed base rents adopted as evidence of full rental value in the mistaken belief that they are rack rents.

The Form of Return VO 6003 asks questions which should yield sufficient initial information to determine whether a property is let on a turnover lease. Part 8 asks if the rent paid, if not based on open market rental value is, amongst other options, based on a percentage of turnover or a percentage of open market rental value and if so to provide details of the basis. If the form is completed accurately then it should be self-evident whether the rent under a particular lease is in any way related to turnover. A new FOR VO6029 has been specifically designed to enable more accurate data capture of turnover rent data and it will be available from 1 April 2008.

Unfortunately the standard of completion of Forms of Return varies enormously and experience has shown that many are completed with no indication that the rent specified is a turnover/base or full open market rent. Experience and knowledge of a particular development should assist the valuer in identifying units let on a turnover basis. Analysis of a rent which is markedly above or below adjoining units might also be an indication that it has been let on a different basis to those other units.

28.24 Interpretation of Turnover Rents in Rateable Value Terms

28.25 Turnover Rents with a Base Rent geared to Open Market Rental Value

Where turnover rents are underpinned by a base rent at about the AVD which is geared to open market rental value, then the most direct and reliable route to the rateable value will usually be to gross up the geared rental paid. However, as for geared ground rents generally the lower the gearing the less weight should be attributable to the grossed up rent.

In these instances the analysed grossed up rent can be tested compared with the following, where available:-

a) rents paid for similar properties on a full open market basis (in a shopping centre where turnover rents are paid there will often be a mix of lease types either as a result of (i) the landlord’s policy (ii) some retailers will not enter into turnover leases (iii) turnover leases are inappropriate in respect of certain retailers such as travel agents or TV/Video rentals outlets where rent cannot easily be related to turnover) and/or
1. b) rents on comparable properties outside the development.

28.26 Turnover Rents where Base Rent not Geared to Open Market Rental Value close to AVD

Where base rents are not geared, regard will need to be had in the first instance to rents actually paid. Adopting as a starting point rents paid will present two fundamental problems: rent will vary from occupier to occupier, and potentially upward and downward on an annual basis.

28.27 It will be clear from the above that whilst base rents will often be set at a consistent level, rents paid when based on turnover will vary substantially, from trade to trade, when analysed as a £/sqm. Clearly the £/sqm in terms of Rateable Value to be adopted for units of a similar size, specification and location and whose occupation falls within the same mode or category should be uniform (a shop should be valued as a shop and not any particular kind of shop) and a judgement will be required to determine a level of value which is reasonably applicable to all from a wide range of rents actually paid.

28.28 It is recommended that actual rents paid, some of which may be base rents where turnover is insufficient to support a turnover rent in excess of the base, are analysed and as a first step the average of all taken. Where the average is distorted by a small number of either very low or very high rents, regard might also be had to an average rent excluding those at the range extremes. Ultimately the level of value adopted should not be based on an average rent which in actuality is paid by only a small proportion of the total number of occupiers. Rental analysis should ideally involve at least 3 years, where possible, around the AVD in order that any discernible trends might be identified.

28.29 Higher rents achieved may be criticised as being a product of the additional trade generated by a protected monopolistic or near monopolistic trading position secured by the contractual agreement between the actual landlord and tenant, effectively representing a premium over the value of the hereditament vacant and to let. This criticism has in the past been upheld by the Lands Tribunal in the context of tender rents in respect of local authority shops let on a trade specific basis (W.A. Rawlinson & Co. Ltd. v Pritchard (VO) 1959 LT 52 RIT 182 and Southend BC v Haynes (VO) 1959 LT 52 RIT 313). In these appeals however the Tribunal were able to rely on rental and assessment evidence in respect of comparable properties to arrive at a decision. In many if not the majority of developments where turnover rents (without a geared base rent) are employed, meaningful comparison will not be possible. Although the criticism is not without foundation it must not be forgotten that ‘low’ rents will also be paid by tenants who might not ordinarily be able to afford the normal ‘going rate’; these also being a product of the actual landlord’s letting policy in seeking to achieve the optimum tenant mix.

28.30 Taking an average, subject to the above caveats regarding the range, will it is suggested reconcile a range of user specific rents with what might be achieved ‘across the board’ for the properties vacant and to let on the statutory terms. Averaging rents as recommended above addresses the problem of various levels of rent being paid for similar property, but rental levels under turnover leases will also potentially vary annually and may go down as well as up; what is paid one year will not necessarily be paid in the next.

28.31 The potential for rents under turnover leases to vary annually might be argued to mirror what could happen under the rating hypothesis; a year to year tenancy, with reasonable prospect of continuance, which may be terminated on its anniversary by either party giving 6 months notice, and with it the opportunity to review the rent either upward or downward, this contention however should be resisted.

During the continuance of the hypothetical tenancy it is reasonable for the landlord and tenant to revise the rent at intervals which reflects and balances the wishes of both; providing each with a degree of certainty to future income/liability and the landlord with the comfort of a future review as protection against inflation. For these reasons market rental evidence agreed on terms where the rent is reviewed following the normal rent review pattern (reflecting the balance struck between the parties in reality) is generally to be preferred. It is therefore suggested that rateable value be assessed on the assumption that rent reviews would follow the pattern common to similar properties in the locality let on traditional leases.

The average rent paid in the year prior to the AVD should be taken as a starting point and based upon recent trading performance a view taken as to what the expectation of future levels would be. Expectation informed by pre AVD trading might reasonably be tested against immediately post AVD turnover information. The RV level adopted must take account of the fact that future actual rents payable are potentially cushioned by the turnover provisions, with rent being allowed to fall if turnover falls, subject to any base rent limits. In setting a rental level on RV terms which is envisaged would be fixed for a period in line with the prevailing normal rent review pattern, the tenant therefore carries some risk when compared with actuality, past performance being no guarantee of the future. It is to be expected that there is a variation between rents agreed in the two circumstances to reflect these divergent risks. If it is expected that the pre AVD level of turnover and therefore rent will be maintained/increased modestly then this level should be adopted without adjustment. If however it is anticipated that pre AVD levels will not be maintained, a discount should be considered. The level of discount to be judged against the expectation for future movements but tempered by the fact that the latest base rent level will act as a floor. (As outlined above it is not uncommon for the base rent itself to be reviewable, on an upwards only basis, typically to 80% of the previous year’s rent).

Where the expectation based on the pre AVD turnover and rental information is that performance will increase markedly, then consideration should be given to adopting a figure higher than the average rent paid at AVD. This approach should only be adopted where there is an established turnover record showing consistent increases and a firm expectation that such improving performance will continue. Performance clauses in effect set a level of turnover, which the parties expect, will be achieved and therefore the rent the tenant expects to pay. In addition to a consideration of base and actual rents paid these might also be considered, especially in the case of new developments where there is little turnover information.

29. Reliability of rent

The reliability of the rent as an indication of the rack rental value of the hereditament will depend on a number of factors. The most common are set out in the succeeding paragraphs. Essential rents, unless rental evidence for a particular class is very scarce, will be drawn from the most reliable category.

29.1 Rents on new lettings

These should generally be regarded as being the most reliable category. They may, however, require adjustment if, for example, an excess rent-free period or other landlords incentive has been allowed. (See Part 10.) Consideration needs to be given as to how the rent was fixed. In the past, a rent agreed by private treaty was regarded as being the most reliable and tender rents were treated with caution. In recent times tendering has become more common, and large companies tendering for accommodation in a good location are unlikely to make ill-considered bids. It is possible, however, that a small retailer might make a reckless bid when tendering for a unit in a suburban parade of shops which is subject to a strict user-limitation. (Case Note 1.) A similar approach to that outlined in Part 9, Key Money, may assist to determine the reliability of tender rents.

29.2 Anchor Tenants

Frequently, in a newly developed centre, some rents may be set at what appears to be an artificially low level in order to attract key or anchor tenants. Such tenants, as a class, are in a strong bargaining position before the shopping centre has become established, but it is arguable that because such preferential rents had been agreed before the adjoining, probably smaller, shops were let, they may not reflect their true value as part of the completed development. The position may well be different at rent review. However, if the evidence shows that several large space-users have agreed rents at levels broadly forming a distinguishable pattern, it would be difficult to escape the conclusion that the level is appropriate to those large shops as a separate class. If a rent is to be disregarded it will be necessary to have better rental evidence to displace it. (Case notes 2 and 3.)

29.3 Lease Renewals

If the lease has been renewed, then the provisions of the LTA 1954 may apply and it will be necessary to find out whether the rent was agreed by negotiation between the parties, or fixed by the courts in accordance with s.34 of the Act in default of agreement. A rent fixed by the court may be unreliable if, for example, only one side has put forward a figure for consideration.

a) Interim Rents

An interim rent is the rent, which may be agreed, or determined by the court, to be payable after the contractual term has ended, but whilst the tenancy is continued by statute, until it is terminated, whether or not a new tenancy is granted on termination (Section 24 Pt II L&T Act 1954).

For rating purposes interim rents are considered suspect due to the fact they may not have been freely negotiated on the open market. The Regulatory Reform (Business Tenancies) (England and Wales) Order 2003 modernised the workings of Part 2 of the Landlord and Tenant Act 1954. The detailed changes to the working of the 1954 Act took effect from 1 June 2004, as do accompanying changes to the statutory notices and changes to the Civil Procedure Rules

Changes to the interim rent process are summarised as follows:

i) Both landlords and tenants can now apply to court for a determination of an interim rent (prior to the changes only the landlord could do so). This means that landlords are no longer guaranteed to receive the existing contractual rent in respect of a lease renewal, as tenants are likely to apply to court for an interim rent in falling rental markets.

ii) In addition, an interim rent is now payable from the earliest termination date that could have been specified in a section 25 notice or a section 26 request (section 24B of the 1954 Act). As a result, the scope for the tactical serving of such notices or requests has been reduced significantly, since parties can no longer delay the start date for the payment of interim rent by giving 12 months’ notice to determine the tenancy after the lease expiry date.

iii) The amount of interim rent will be fairer to both parties. Usually, it will be the rent for the new tenancy (i.e. open market rent), backdated, but subject to adjustment if market conditions change significantly over the period interim rent is payable. Similarly, there may be an adjustment if the new occupational terms are significantly different from the old ones. In some cases, the old method of determining interim rent will continue to apply e.g if the landlord opposes renewal

b) Consideration of interim rent and market rent

Prior to the changes it was held the amount of the interim rent must “have regard to” the rent payable under, and the terms of the current tenancy, and be determined, on the assumption that the tenancy is an annual tenancy, as at the date at which the interim rent starts to run. This very often resulted in the interim rent being less than the new Section 34 market rent payable under the new tenancy when granted. There was a discount, or “cushion”, as it was more usually described. Under the 2004 Reforms, this has changed, and prima facie (but not invariably) the Section 34 market rent payable initially under the new tenancy will be the interim rent as well. In most cases, the ‘cushion’ will no longer exist.

The new criteria for determination are however complex and an open market rent will not always result. The interim rent will usually be the same as the renewal rent, open market rent, if 3 conditions are satisfied,

The tenant was in occupation of the entire premises at the date of notice
The landlord did not oppose renewal
A new tenancy of the entire demise is granted

The exceptions to the above are:

i) If the terms of the new tenancy are so different from the old tenancy that it would make a substantial difference to the market rent. In this case the interim rent will be a reasonable rent for the tenant to pay while the old tenancy continues. Where a sub tenancy of part exists regard will be had to the level of rent payable for that part

ii) The interim rent payable under the new tenancy differs substantially from the market rent at the date when interim rent is payable. In this case the interim rent will be determined in accordance with market conditions at the time that interim rent became payable.

iii) Both (i) and (ii) above apply. In this case the interim rent will be that which it is reasonable to pay

If neither the 3 conditions are satisfied, nor the exceptions applicable, then the old approach to interim rents is adopted except that regard will be given to the rent payable under any sub tenancy of part of the property comprised in the tenancy. This will result in the rent being calculated by a formula, which produces a discounted market rent.

Interim rents should therefore still be treated with caution. Full facts of how it was determined will be required to judge its reliability for rating purposes.

29.4 Review Rents

If the rent has been fixed on review, a number of points have to be considered in gauging its reliability.

a) Rent review basis

For the review rent to be of most use as evidence for our purpose, the review clause should specify that the review is to “open market value” or “rack rental value” assuming vacant possession, and a normal review frequency. In recent years there has been a great deal of Landlord and Tenant litigation on the meaning of various common phrases within rent review clauses, and bad drafting can often lead to unexpected results. (Case Note 4).

If the review rent is merely a stepped rent (ie to a figure which was agreed at the commencement of the lease), then clearly it will not necessarily represent the rack rental value at the review date. Similarly, if the review clause contains a special formula for calculating the rent, the result must be treated with circumspection. Occasionally, leases provide for the review rent to be indexed - for example, in accordance with the RPI. This will invalidate the review rent as a measure of market value.

If the review is upwards only and the rent has not been increased following the review, it should be borne in mind that the rent passing could be in excess of open market value.

b) Agreed or arbitration

The weight to be attached to a rent fixed by agreement will be greater than if the parties resorted to an independent expert or to arbitration. In making their awards, independent experts are entitled to bring their own knowledge of values to bear, whereas arbitrators cannot stray outside the confines of the evidence presented.

c) Restricted-user clause

If there is a restricted-user clause the rent may be distorted on account of it. (Case Note 5).

29.5 Geared Ground Rents

A ground rent is a rent paid for vacant land. Traditionally ground rents reflected the value of the land only and were subject to very infrequent review.

Modern ground leases normally incorporate periodic rent reviews (5 yearly reviews are common) and often the basis of review is an agreed proportion of the rack rental value of the completed property or development.

Therefore ground rents should not be ignored as they may well provide useful evidence. However geared ground rents which represent only a small percentage of the open market rental value should be treated with caution as there is less of an incentive for the parties to agree a true open market rent.

29.6 Sale and Leasebacks

A sale and leaseback is an arrangement whereby a freeholder, or in some instances a leaseholder, sells their interest in a property for an agreed sum and takes a lease back on the whole or part of the property from the purchaser. Agents often argue that the rents resulting from sale and leaseback transactions are unreliable because they are the product of a financial arrangement and reflect the cost of borrowing rather than an open market rental value. In the case of some initial rents this may be true. It is also not uncommon for the initial rent to be higher than the open market rental value in order to increase the value of the freehold interest sold. Some leaseback rents are based on open market rental values and whether or not this is so will vary from case to case.

In the case of John Lewis and Co Ltd v Goodwin (VO) and Westminster CC 1988 LT RA 1 the Lands Tribunal, in the absence of any direct evidence of department store rents, considered in detail a leaseback rent on Debenhams in Oxford Street. The member held “… that the Debenhams leaseback rent ….. cannot be accepted as dependable evidence of market rental value. Market rental value is by common consent geared primarily to profitability whereas a leaseback transaction is essentially a funding operation in the context of which the initial rent is geared not so much to profitability as to the relative strengths of the property market at the time the transaction is arranged.”

The situation may well be different where the leaseback rent has been subject to a review. It is quite common for the rent review clause to specify that the rent should be an open market rent. Some review clauses however may continue to gear the rent to the initial funding arrangement.

It is therefore essential that VOs carefully consider any sale and leaseback transaction and, if possible, obtain a copy of the lease in order to establish the true nature of the arrangement and the weight, if any, to be attached to the rent.

29.7 Connected Parties

If the landlord and tenant are connected parties, (see question 2.2 of VO 6003, or question 6 of VO 6000 and VO 6002) there must inevitably be severe doubt as to whether the rent is reliable. It should therefore be regarded as suspect, but nevertheless adjusted and analysed, until there is positive evidence to demonstrate its unreliability.

30. Charitable Relief

Under the Local Government Act 1988, the amount of rates payable by charities is usually reduced. The effect is that charities pay only one-fifth of the rates that would otherwise be due. For occupied property, two qualifications must be met:

The ratepayer must be a charity or trustees for a charity; and
The hereditament must be wholly or mainly used for charitable purposes (whether of that charity or of that and other charities).

In addition to the relief for charities described above, billing authorities have the power to grant further relief, up to 100%, to this category.

Where an occupier enjoys the benefit of charitable relief, it may affect its ability to pay rent and allow it to outbid other potential occupiers. Where the analysis of a rent on a property occupied by a charity is out of line with the rents on other similar properties, this may be the reason.

31. Reliability Indicator

The Complexity Indicator in RSA is based on responses to questions in the rent return form and is automatically set by RSA. As it is not based on subjective opinion, this is a useful indicator as to whether significant adjustments may be required.

Complexity Indicator

0 = None

1 = Repairs and / or Insurance not Tenant’s responsibility

2 = Rent free period

3 = Living accommodation included in rent

4 = Stepped rent

5 = Premium paid / received

6 = Car parking included in rent

7 = Expenditure on improvements

8 = Rates, water charges and services included in rent

9 = Other factors affecting rent e.g. break clause or restricted user

32. Relevant date of rent

The relevant date is usually the start of the period during which the adjusted rent takes effect. This will be the date of commencement or assignment of the lease, or the date of review. It will coincide with the date on which the occupier started paying the rent, except where the rent is paid in arrear or there is a rent-free period. However, it is quite common for some buildings to be pre-let and the date the rent was agreed (see question 3.3 of VO 6003, question 19 VO 6001/question 12 VO 6002) may well be some time before the commencement of the lease. In such circumstances the relevant date should be taken as the date that the rent was agreed, unless it is believed that rental movements in the period to the commencement of the lease have been anticipated.

Where the rent cannot be reduced on review and a review has passed and the rent has not been increased the relevant date can only reliably be taken as the date when the amount of rent originally took effect.

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Part 1: practice note 1 - 2010 rental adjustment

1. Introduction

2. Objectives

3. Order of adjustment

4. Value Added Tax (VAT)

Introduction

4.2 VAT on rents

4.3 The Operation of VAT

4.4 Application of VAT to property transactions

4.5 The election to waive exemption (option to tax)

4.6 The effect of VAT on tenants

4.7 The likely effects of VAT on rents

4.8 VAT rates and dates

5. Landlord’s incentives

5.1 Background

6. Adjustment for financial inducements

7. Rent free period

7.1 The alternative analyses available are best illustrated by an example.

8. Reverse premiums

9. Contributions to fitting out

10. Assuming liabilities

11. Treatment of premiums

12. Premiums and key money

12.4 a) Goodwill

12.5 b) Fixtures and Fittings

12.6 c) Stock

12.7 d) Residual Value of previous tenants improvements

12.8 e) Capitalised Profit Rent/Key money

13. Stepped rents

14. Improvements

15. Cost of improvements and the virtual rent

16. The amortisation percentage to be used

17. Period of amortisation

18. Amortisation percentage

19. Surrender of former lease

Example

20. Overage

21. Domestic accommodation

22. Non-domestic rates

22.2 Adjustment of Inclusive Rents

22.20 The Effect on Rental Values

23. Insurance

24. Services

25. Fixtures, fittings, plant and machinery

26. Repairs

27. Turnover rents

28. Turnover leases – general

28.4 Advantages and Disadvantages of Turnover Rents

28.9 Turnover Leases - Typical Terms

28.10 Lease Term

28.11 Rent

28.12 Base or Minimum Rent

28.13 Turnover Rent

28.17 Rent Review Provisions

28.18 Alienation

28.19 User

28.20 Covenants to Trade

28.21 Security of Tenure

28.22 Performance Clauses

28.23 Forms of Return

28.24 Interpretation of Turnover Rents in Rateable Value Terms

28.25 Turnover Rents with a Base Rent geared to Open Market Rental Value

28.26 Turnover Rents where Base Rent not Geared to Open Market Rental Value close to AVD

29. Reliability of rent

29.1 Rents on new lettings

29.2 Anchor Tenants

29.3 Lease Renewals

29.4 Review Rents

29.5 Geared Ground Rents

29.6 Sale and Leasebacks

29.7 Connected Parties

30. Charitable Relief

31. Reliability Indicator

32. Relevant date of rent

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