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Market Rent Reviews and Ratchet Clauses in Commercial Leases

19 May 2020

Ratchet clauses have been a feature of leases for a very long time. They provide landlords with certainty of a minimum level of income. The value of a property is closely related to the return that a landlord derives from the market rental and the contract rental for the property. The existence of a ratchet clause accordingly adds value to a property.

What is a Ratchet Clause?

Many commercial leases include rent review clauses, which set out how the annual rent is determined. Common methods for determining annual rental include reference to market rents, CPI, or a fixed percentage.

Market-based rent reviews have historically been the most common. In the last 10 years it has, however, become more common to see other rent review methods such as fixed or percentage adjusted rent increases, or CPI adjusted rent reviews.

Many rent review clauses provide that the rent payable on review shall not be less than the rent payable at the commencement of then current lease term, or in some instances, not less than the rent payable immediately prior to the relevant review date. This requirement that the rent shall not reduce is what is called a ratchet clause.

Hard & Soft Ratchet Clauses

There are two types of ratchet clauses, namely the “hard ratchet” and the “soft ratchet”.

  • A hard ratchet will never allow the annual rent to reduce below what was previously payable.
  • A soft ratchet (also known as a commencement ratchet) will allow rental to reduce, but never to an amount which is less than the annual rent payable at commencement of the current lease term (or in some instances the previous term if the review date is also a renewal date).

The ADLS 6th Edition Lease sets the current industry standard, which is a soft ratchet for market rent reviews.

Ratchet Clauses in a Post-COVID-19 Property Market

It would be a safe bet to predict that market rentals will be impacted by the current economic environment. Some industries will be affected more than others, resulting in a shift in demand and affordability of certain types of commercial tenancies. For example, one could expect to see little change to market rents for the industrial sector in Auckland, but there will likely be vacancies in other sectors such as retail and hospitality. Consequently, market rents for these types of premises are likely to fall.

If market rents decline in the wake of COVID-19, ratchet clauses will put landlords in a strong position to negotiate market rent reviews with their tenants. Taking a strict approach may, however, be futile or impractical if a tenant has no ability to pay the rent at the pre-COVID-19 levels.

On the other hand, when a rent review is being negotiated at the time of a potential renewal of the term of the lease, the position of strength may pass to the tenant. In these circumstances, the landlord may be motivated to reduce the rent to reflect the new market level in order to retain the tenant.

The best approach will likely be for landlords and tenants to take a longer-term commercial approach and continue to work together to keep tenants’ businesses viable and landlords’ premises occupied.