Legal Briefing

Rent free fitting out periods and s34 of the Landlord and Tenant Act 1954

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Real estate | 01 July 2015

On initial lettings of commercial property it is standard market practice to allow the tenant an initial fitting out allowance, generally by way of a rent 
free period. This rent free period is intended, in theory, to reflect the tenant’s time and expense incurred in fitting out the premises but is rarely calculated by reference to the actual time or cost of 
the tenant’s works. In the case of retail units it has become common market practice to offer a standard three-month rent free period.

When determining rent for the purposes of s34 of the Landlord and Tenant Act 1954 it is invariably common ground between experts that the appropriate valuation method is the comparable method of valuation. As Lewison J explained in Marklands Ltd v Virgin Retail Ltd [2003], this method works by analogy and the underlying premise is that the subject matter of the valuation would, if offered to the market, command the same value as the analogues. This method of valuation thus requires the valuer to compare ‘like with like’ and make adjustments to reflect differences between the subject property and the analogue.

When determining the rent under s34(1) how should a valuer approach rents derived from comparable transactions in which a fitting out rent-free period was given to the tenant?

Section 34(1) of the Act provides that the rent under the renewal tenancy, if not agreed, shall be:

‘… that at which, having regard to the terms of the tenancy (other than those relating to rent), the holding might reasonably be expected to be let in the open market by a willing lessor, there being disregarded – (a) any effect on rent of the fact that the tenant has or his predecessors in title have been in occupation of the holding…’

The rent to be determined under s34 is accordingly that which the holding would hypothetically be let for in the open market. Section 34 directs the court to disregard four matters, including the effect on rent of the fact that the tenant has or its predecessors in title have been in occupation of the holding: s34(1)(a).

Section 34 provides no express assumption of vacant possession but it is nevertheless established that it follows from the disregard at s34(1)(a) that the tenant is assumed to have vacated the subject premises: Harewood Hotels v Harris [1958] at 107D/E. There is also no express direction as to whether or not the premises are fitted out or offered as unfitted out premises. However, asHumber Oil Terminals Trustee v Associated British Ports [2012] at 175-176 makes clear, the subject premises are assumed to be free from tenants’ fixtures. Thus, for the purposes of s34 what the valuer must ascertain is the rent that would be agreed under a hypothetical letting of the holding in the open market between hypothetical willing parties assuming the tenant has vacated and the premises are in an unfitted out state.

The hypothetical tenancy is on the same terms as the new tenancy (‘having regard to the terms of the tenancy’) and the new tenancy takes effect from the termination of the existing tenancy (in accordance with s64). Rent is therefore generally payable from the first day of the new term and without any rent free fit out period.

When considering whether any allowance should be made for rent free periods allowed in comparable transactions, it is necessary to distinguish between ‘incentive’ rent free periods that might be available in the market, which in effect are disguised reverse premiums paid by the landlord, and ‘rent free’ fit out periods. It is generally standard valuation practice that ‘incentive’ rent free periods must be removed to find the net effective rent. What is not clear, however, is the extent to which, when seeking to obtain the net effective rent, a further adjustment should be made to take account of the fit out element of a rent free incentive. Section 34 does not specifically address this issue.

There is no express assumption in s34 that the hypothetical lessee will or will not be granted a rent free fit out. The explanation for this is presumably that rent free fitting out periods were not standard practice when the Act was drafted. Although substantial amendments have been made to the Act over the years, including in 2003, s34 was not amended to clarify the way s34(1) operates as regards fitting out and fitting out rent free periods.

The treatment of rent free fitting out periods has been extensively explored in the context of rent review. Most modern rent review clauses expressly direct that the valuation is to be carried out on the basis of vacant possession (or the same result is achieved by an express disregard of the tenant’s occupation). It follows from this assumption that the tenant is assumed to have vacated and taken all tenant’s fixtures and fittings with it so that the hypothetical tenant will be a new occupier who has to move in and fit out the unit. This is similar to the starting point under s34.

To counter this assumption of vacant possession and the hypothetical tenants’ need to fit out, review clauses generally also include a corresponding assumption (eg an express assumption that the appropriate rent free period had expired). Absent such a counter assumption, the tenant would argue that comparable evidence comprising transactions where rent free fit outs had been given should be adjusted downwards, thus depressing the rent.

The tenant, at the review date, does not actually have to fit out the premises and in the context of rent review it is not difficult to see why, from a landlord’s perspective, it could be said to be unfair that the reviewed rent should be depressed by the fiction that the incoming tenant would have an expense which the actual tenant did not have. A rent review is generally intended to mirror the actual parties’ position as closely as possible, hence the established ‘presumption of reality’, which is designed to achieve the underlying purpose of the rent review.

The position in rent review is generally 
clear and has been the subject of much litigation, but to what extent does this assist in the context of s34? Section 34 is not fulfilling the same function as a contractual rent review clause and the process of interpretation of a contract is not the same as the process of statutory interpretation. What is the statutory policy of the 1954 Act?

This issue has rarely been considered by the courts and there are only three, unreported, County Court cases:

The first of these was in 1996, Max Mara v Pearl Asurance, where the tenant argued that s34 required the Court to assume that the premises were being notionally let with vacant possession so that the premises would be in a shell condition and the new tenant would expect a rent free period to compensate. HHJ White rejected this argument, but did not give any real analysis to the problem. He essentially adopted the conventional rent review approach and found that it would be unfair to the landlord to allow a rent free fitting out period and that this was not required by s34(1)(a):

‘In my judgement the [landlords] rightly stress that if a tenant who becomes entitled to a lease renewal under the 1954 Act is to have, however the calculation is done, a notional rent free allowance as if he was again being compensated for the rental cost of fitting out when no such burden is being incurred he will receive an unwarranted windfall at the expense of the landlord… In my judgement the court should be reluctant to interpret the section in a way which involves a departure from reality with the importation of a fiction into the determination of an open market rent unless the wording unambiguously requires this… Section 34(a) read simply prevents any accretion to rent attributable to the occupation by the tenant entitled to a lease renewal and on the other side any sitting tenant concession. It does not require the court to import a fiction with all the uncertainties and distortions that would inevitably follow.’

A more reasoned approach was given by HHJ Bailey in HMV Music v Mount Eden Land (2012), who reached a different conclusion to HHJ White and held that rents derived from comparable transactions in which rent free fitting out periods had been given must be adjusted. The relevant passage from his judgment is as follows:

‘The observation that the rental effect stems from that factual situation and where it does not exist, as on renewal, should be kept out of the equation, and the further comment as to requiring the court to import a fiction may be misleading when considering the performance of the statutory exercise imposed upon the court. That is to determine a rent at which, having regard to the terms of the tenancy other than those relating to rent, the holding might reasonably be expected to be let in the open market by a willing lessor. This exercise is traditionally, indeed habitually, carried out by reference to comparables. If the comparables, as in this case, are of rents payable by tenants who have three-month rent free periods, the determination of a rent which is to be paid throughout the term by reference to those comparables must surely reflect the fact that there will be no rent free period under the new lease. The court is not there importing a fiction, it is having due regard to the nature of the comparables.’

The third, and most recent case, is Iceland Foods v Castlebrook Holdings (2013) . Mr Recorder Clayton took a similar approach to HMV but he dealt with the point very briefly.

Is it correct to say that it is unfair to the landlord if the tenant is allowed a rent free period, or does the landlord get a windfall if no allowance is made?

If the standard rent free fit out period does not have the effect of inflating the ‘net rent’, which is a matter of valuation and not law, it must follow that it would not be appropriate to make any adjustment to the comparable evidence. In this scenario, to devalue a comparable to take out a rent free fit out period would produce a rent which was lower than the market rent. To require an adjustment to be made to what is already a ‘net effective’ rent would be wrong in principle.

However, the fact that it is standard market practice for a three-month rent free incentive to be given, does not, of itself, mean that the rent free period can simply be ignored or not properly be regarded as an ‘incentive’ in the sense that it does not have the effect of inflating the level of the rent which would be agreed in the open market. One might assume, all other things being equal, that a tenant would be prepared to pay a higher rent for a lease which granted a three-month fit out period than a lease which did not.

Assuming the valuation evidence does not show that the level of rent agreed in the market is unaffected by the grant or absence of a rent free fit out period, what does s34 require?

Section 34 directs the valuer to find the open market rent of the holding where the tenant has vacated and the premises are in an unfitted out state. The terms of the new tenancy are unlikely to include a rent free fit out period and rent is therefore payable from day one of the tenancy. If a comparable property is let with a three-month fit out it follows that the terms of the comparable differ to the terms of the new tenancy.

In the real world, an incoming tenant would need to fit out the subject premises and in real world transactions, the incoming tenant is given a rent free fit out period in which to do so. However, under s34, the hypothetical willing tenant will also have to fit out the premises but the hypothetical tenant is given no rent free period in which to do so. It could thus be said that the valuer should make an adjustment to reflect the difference between the real world and the position of the hypothetical tenant, ie the comparable rent should be devalued to take account of the absence of a rent free period to the hypothetical tenant.

However, the actual tenant does not need to fit out the premises. The actual world is one in which the tenant does not have to fit out its unit. What, therefore is the sense in requiring the parties to reflect something which the actual tenant does not need? In a rent review it is assumed that the parties are concerned to mirror the reality of their actual situation and it would be inconsistent with the reality of the positon at review to allow a fit out period, given the actual tenant will simply continue in occupation without any disruption to its business. 
But is this also what Parliament intended 
in s34?

To simply say that it is unfair to make an adjustment to a comparable transaction because the actual tenant does not need to fit out the unit (as HHJ White held in Max Mara) may be said to confuse the hypothetical world with the position of the actual tenant. Section 34 requires the valuer to assume a hypothetical transaction between hypothetical willing parties. The hypothetical transaction is one which is taking place in the real world, but the parties are not the actual tenant and the actual landlord. Why then, does it matter if the actual tenant does not need to fit out the premises?

In contrast to rent review, by directing an open market rent to be fixed, the aim of s34 could be said to put the parties in exactly the same position they would be in if a new lease was being agreed in the real world (but without the landlord being able to hold the tenant to ransom as a sitting tenant). In the real world, absent the tenant’s security of tenure under the 1954 Act, at the end of the lease the landlord would have to agree new terms in the open market. If it was standard market practice to grant a three-month rent free 
fit out, the landlord would have to grant 
this. The landlord would not get a net 
effective rent from day one of the new tenancy in the real world. If the Act is 
designed to mirror the position of the open market, and not the reality of the actual parties agreeing a renewal lease, why is it unfair to the landlord if the rent it gets is the rent that would be agreed on a new letting in the open market?

The issue may by framed this way: did Parliament intend the new rent under 
s34 to be determined by reference to the actual circumstances of the actual tenant or by reference to the open market conditions, where the rent may take into account a need to fit out which the tenant does not have?

The law remains unclear on this issue and to know the answer, we will have to await a decision of the High Court or above.

By Kirk Reynolds QC and Elizabeth Fitzgerald, Falcon Chambers.

E-mail: reynolds@falcon-chambers.com; fitzgerald@falcon-chambers.com.