• Introduction
• All recent publications
• Funds Management - Real Estate & Superannuation publications
• Funds Management - Real Estate & Superannuation services

Focus: Real Estate – September 2008

Victorian case highlights rental review risks

In brief: A recent Victorian Court of Appeal decision highlights how subtle distinctions in the wording of market rental review provisions can significantly affect the basis and outcome of market rental reviews, in particular whether a market review is on the basis of 'face rental' or 'effective rental'. Partner David McLeish (view CV), Senior Associate David Hartney and Articled Clerk Dora Banyasz report.

• 'Face rental' v 'effective rental'
• Background to the case
• The Court of Appeal decision

'Face rental' v 'effective rental'

The distinction between 'face rental' and 'effective rental' arose in the early 1990s from the practice of commercial landlords who, rather than offering lower rentals in a falling market, preferred to maintain higher rentals shown on lease documents by offering substantial incentives to tenants entering into leases. Incentives, which are often kept confidential, may be in the form of cash payments, rent-free periods, fit-out contributions, rental or make good payments under existing leases or any other benefit provided to tenants.

By maintaining 'face rentals', the capital value of buildings (calculated by reference to rental value) was preserved, albeit by sleight of hand. As a result, it became necessary to distinguish between the 'face rentals' shown on lease documents and the 'effective rental' that factors in incentives available to tenants.

Background to the case

Eureka Funds Management Limited, the landlord, and Freehills Services Pty Ltd, the tenant, are parties to a lease for commercial office premises at 101 Collins Street, Melbourne, dated 29 June 2004 for a term of 14 years from 1 July 2000. Similar lease arrangements had existed since 1991. The lease contains provisions for the market review of rental, including a review from 1 July 2003 to 'current annual market rental value' and reviews on numerous later dates to 'current annual market rental'.

Eureka had at all times sought to associate the expression current annual market rental value with the notion of 'effective rental', and the expression current annual market rental with the notion of 'face rental'. The parties agreed that the July 2003 review (that being the first review date) was properly conducted on the basis of an effective rental review.

Eureka argued that all reviews following the July 2003 review were to be conducted on the basis of a face rental review. Freehills disagreed, and argued that all reviews should be effective rental reviews.

The valuer appointed in accordance with the market rental review provision conducted the February 2004 review on an effective rental basis. The trial judge found that it was open to the valuer to conclude that the expressions current annual market rental and current annual market rental value in the market rental review provisions were synonymous and to review the rental on that basis. Eureka appealed.

The Court of Appeal decision

In Eureka Funds Management Limited & Anor v Freehills Services Pty Ltd¹, the Court of Appeal unanimously accepted the appeal, confirming that the phrases current annual market rental value and current annual market rental as used in the lease were not synonymous; they encompass two different rental review mechanisms.

The court acknowledged that the wording of rental review provisions is 'infinitely various'.² The focus must, therefore, be on interpreting the language of the lease in each particular case. In this case, the language clearly and consistently distinguished between the concepts of current annual market rental value and current annual market rental. This was the key factor in the appeal.

The court held that, in this case, 'rental' was simply the amount of rent paid as appears on the lease documents – in other words, the face rental. The 'rental value' was the face rental minus any usual distorting factors, such as incentive payments, special concessions, rent-free periods and fit-out contributions – in other words, the effective rental.

In considering the commercial context, the court held that it would not necessarily be 'uncommercial for a sitting tenant to agree to pay rent at a higher level than the rent which may be negotiated between a landlord and a new tenant.' ³

The court held that the valuer had not determined the market rental in accordance with the market rental review provisions, and ordered that the matter be remitted to the valuer to determine the current market rental of the subject premises from February 2004 on a face rental basis.

The decision demonstrates the need for clear and effective drafting of market rental review provisions, as well as the importance of clear and effective legal advice to ensure the parties' intentions are understood and accurately reflected in leases of commercial real estate.

Footnotes

1. [2008] VSCA 156.
2. Justice Cavanough at [26].
3. Justices Neave and Redlich at [14].

For further information, please contact:

• David McLeishPartner, Melbourne
  Ph: +61 3 9613 8954
  David.McLeish@aar.com.au
• Mark StubbingsPartner, Sydney
  Ph: +61 2 9230 4257
  Mark.Stubbings@aar.com.au
• Grant HigginsPartner, Brisbane
  Ph: +61 7 3334 3540
  Grant.Higgins@aar.com.au
• Rosemary MartinSpecial Counsel, Perth
  Ph: +61 8 9488 3760
  Rosemary.Martin@aar.com.au
• Nigel PapiInternational Partner, Shanghai
  Ph: +86 21 6841 2828
  Nigel.Papi@aar.com.au

Bookmark with What are these?

[Recent publications]