Most motels in New Zealand operate by way of leasing. One of the main reasons for this, could be that the return from the real estate investment (land & buildings) is considerably lower than that earned by the operator of the business. The capital requirements to own a freehold going concern reduce the number of potential buyers and even where such is offered, it is often split and sold as the business and real estate investment separately.
Advice on rent reviews is often sought, by both landlords and lessees. It seems that this subject is fraught with myths, misinformation and general lack of knowledge around the process. Comments in this article relate to the writer’s observations in regard to most motel leases and generally long-term commercial leases for accommodation properties. There will always be variables.
Timing. Rent reviews are normally two yearly. The right to review the rent is not a right to increase the rent. The lease should define a fairly robust process to be followed, intended to protect the interests of both parties.
The landlord/lessor would firstly issue a notice specifying the rental amount that they deem to be appropriate as from the review date, the “Lessor’s Notice”. (The review dates are specified in the lease.) The motelier/lessee must respond to the lessor’s notice within the prescribed period. If the lessee does not agree with the rental figure set, it is very important to respond, otherwise the lessee may be deemed to have accepted the new figure. The Lessee’s Notice in response, should state the rental they believe to be fair, or if they believe the rental should either stay as it is or possibly even drop if the lease has a “soft” ratchet clause. (More on ratchet clauses later.)
The review process is usually able to be commenced no sooner than three months prior to the next review date, although that can vary. If the rent review date passes without such notice, it does not usually prevent the lessor from serving the notice at a later date. The lessor can often give notice to review the rent for the applicable review date right up until the date of the following review. Some leases stipulate that if a new rental figure is then determined, it can be backdated to the earlier review date, even if the review process is carried out considerably later. Other leases state that if the review is carried out more than three months after the review date, then any increase determined can only be backdated to the date of the lessor’s notice.
So, if your landlord agrees that there is no justification for a review (increase) it is important to get this in writing. If the land & buildings change hands prior to the next rent review and there has been no such written record, it has been known for the new landlord to instigate the rent review after that review date has passed.
Negotiation. Leases often state that the lessee must pay the rent stipulated in the lessor’s notice until the outcome is determined, usually provided that the lessor’s notice is supported by a registered valuer’s report. For this and other reasons, it pays to keep the process moving to an early conclusion if possible.
If disputing the rent, a valuer may need to be appointed by the lessee. Some leases provide that if the one party does not appoint a valuer within a certain time, the single valuer appointed by the lessor (or the lessee as the case may be) will become the sole valuer whose decision will be binding. If two valuers are appointed and cannot reach agreement, then arbitration may follow. This can be a protracted and costly process and if feasible, is best avoided. (Costs of the arbitration may be apportioned to the parties by the valuers at the conclusion of the process.)
Ideally the first strategy in these situations would be to try to find the path of least resistance. In other words, having a meeting to discuss the rental and see if some common ground can be found. If successful, the agreement should be recorded in writing. A variation to the lease can be registered to record the new rental, however this may not always be necessary provided it is otherwise clearly documented.
Selling. As reviews usually come around every two years, it may well coincide with the lease going on the market. A purchaser is not likely to want to enter straight into a rent review and so it pays to anticipate this if selling. The other thing to keep in mind is that the rent review time may be a good opportunity to seek (if necessary) a lease extension. Often lessees are approaching lessors, seeking a lease extension when trying to sell, without any real bargaining chips in hand. Obtaining a rent increase is quite valuable to a landlord, not only because it increases their income but also the value of their land & buildings quite significantly. At a yield of say 6% on commercial real estate, every dollar of rent equates to over $16 of capital value. For this reason, if conceding to a rental increase it would be a good idea to try for a lease extension on favourable terms in return for putting the review to rest.
There are of course many different types of lease, however it is very uncommon to see one which actually stipulates that the rental is to be relative to turnover. There is “customary” approach to apply rental as a percentage of turnover. This figure may be quoted as anything between 28% and 33% of accommodation revenue. (This variation alone would seem to make this an unreliable method.) It does nevertheless seem to be the simplest approach and is often adopted, sometimes even by valuers.
It is hard to ignore the financial performance of the motel when assessing the rent and in many cases, the review is based around turnover. (No problem if everyone is happy with that.) There are good reasons though why the turnover approach may not be appropriate. If the lessee is a particularly good operator and produces an above average financial performance, they should not be penalised by having to pay more rent. Conversely, if the lessee is a poor operator, then this should not disadvantage the landlord as to the rental return they could expect relative to comparable properties. Most review clauses essentially state what the valuers are to take into account and what they are to ignore in their assessment. In plain terms, they are to disregard the performance of the lessee
So, what should determine market rental? Rentals paid by comparable properties is the main basis of assessment in the commercial market. Office or retail space for example is normally let on an annual per square metre basis (plus operating expenses). There is generally ample evidence as to what the market is paying per metre for a particular type of property, based on location, quality etc.
The approach to motel rentals is usually based around rent per unit, rather than per metre. Comparing one motel to others though, may not be so straightforward. There are many variables, not least the unit mix and configuration, and also location, quality, amenities etc. (This is why it is easier to default to the turnover argument.) Nonetheless, a knowledgeable arbitrator/valuer may reject any argument based on turnover and seek comparative market rental evidence. The valuer’s challenge is to find comparable evidence and make adjustments according to the location, quality and configuration of the subject property.
New Leases. An exception to the above is when the rental is being set for a new lease. Commonly in that case the seller of the lease is also the lessor for the immediate future. In other words, they have an incentive to negotiate a fair, even attractive rental in order to sell the lease. Rental therefore could be based on turnover and the lease taken to the market, which suggests that supply and demand will determine what rent a new lessee is prepared to agree to in that negotiation.
Economic Approach. A good approach to setting rental for a new lease is often termed the “economic” approach. This is based around the old rule of thumb of 33% being apportioned to each of rent, running costs and profit. (A guideline, but seldom the reality these days, particularly with OTA (Online Travel Agents) commissions eroding profits, but that is another subject.) If the turnover were to be divided by three, then after taking out running costs, the balance in theory would be divided equally between rent and the lessee’s profit. The economic approach is to take the actual running costs from the revenue and divide equally what is left, i.e. rent and profit, to assess the fair market rental. Some valuers use this method with existing leases.
Ratchet clauses. Most, but not all leases contain some type of ratchet clause. Many simply state that regardless of anything else determined by the review process, the rent cannot be less than what is currently being paid. (Known as a hard or full ratchet clause.) In recent years the move has been towards “soft” ratchet clauses, which may allow the rent to reduce if the market conditions can be proven to justify that. There different types of soft ratchet clauses. Some can be very soft, where the rental can drop back to the original figure at the start of the lease, which could be detrimental from a landlord’s point of view once the lease has been in place for a number of years. A fair approach seems what is termed the “averaging” clause. This states that if the new market rental is determined to be lower than the current rental, then the rent can drop back to the average of what the new rental should be and what has been paid up until now. This effectively splits the difference between lessor and lessee and in theory, shares any downside due to prevailing market conditions. (This would normally be qualified by stating that under any circumstances the rent cannot be less than the rental at the commencement of the lease.)
A Twist. Conventionally a “hard” ratchet clause could only be seen as negative for a lessee. However there have been situations where in a market with rapidly rising turnovers (for example Christchurch immediately post-earthquake), a hard ratchet could be an argument used in favour of the lessee. If the rental is unable to ever come back down from a new level, then the valuers need to be very careful as to how high to set that rental when it is possible that revenues could decline and return to “normal”. On the other hand, if there is a soft ratchet it could be argued on the lessor’s behalf that a higher rental is justified in the current environment, given that it does have the ability to reduce in future.
Seek Professional Advice. It must be stressed that the contents of this article are not to be construed as technical and/or legal advice. One should always seek professional legal advice in matters around property and particularly commercially complex areas such as this. We are happy to receive enquiries and offer advice where we can.
