Rent Free Fitting Out Periods in 1954 Act Renewals

Rent Free Fitting Out Periods in 1954 Act Renewals

In a 1954 Act claim for a renewed business tenancy, the Court will (if the parties cannot agree) need to determine the rent payable by the tenant in respect of the new lease.  As part of this process the Court will, invariably, hear expert evidence and consider comparables (ideally in the form of open-market transactions of similar properties in a similar area).

As anyone who has been involved in the letting market in recent years will know, commercial landlords, on the open market, tend to offer incentives to incoming tenants: one of these is usually termed a ‘rent free period’.

Rent free periods come in two forms:

Firstly, they may be used as a means of deferring the rent payment, which has the effect of increasing the headline rent (e.g. £100,000 p/a over a 5 yr term with 12 mths rent free, is the ‘real world’ equivalent of £80,000 p/a).  There are advantages for both parties in this scenario: a tenant eases cash flow at the outset of a lease (when expenditure may be high), and a landlord can artificially increase the headline rent (which may be beneficial on any review date when the rent is reviewed on an upwards only basis).

This form of rent free periods is not troublesome for the court.  Because the court can only determine a rent payable from Day One of any renewal tenancy, when assessing any comparable with such a rent free period, the headline rent will be discounted (i.e. reduced) to take into account the artificial uplift caused by such a rent free period.

Secondly, there are rent-free periods for fitting out works (otherwise known as fitting out allowances); these are notional quid pro quos agreed between a landlord and an incoming tenant to reflect the fitting out costs that the tenant anticipates incurring before being able to occupy the premises.  These have, in recent years, proved troublesome for the courts.

Fitting Out Allowances and the 1954 Act

At its most basic, the dilemma is clear:  On the one hand, a landlord can argue – with some force – that a tenant seeking a renewal tenancy does not need, nor should it benefit from, a rent free fit out period.  The tenant will, invariably, be in occupation at the date of the renewal.  Why, then, should a sitting tenant benefit from the windfall of a fitting out allowance provided to new incoming tenants?

The tenant’s answer is traditionally twofold: Section 34(1) of the 1954 Act requires the court to assess the rent on the basis of a notional hypothetical (and new) letting.  On the open market, an incoming tenant would receive a fitting out allowance, so the matter should be no different under the Act.  This analysis is supported by the ‘disregard provision’ at s.34(1)(a), which requires a court, when determining the rent payable under a renewal tenancy, to disregard “any effect on rent of the fact that the tenant has or his predecessors in title have been in occupation of the holding”.  Applying this disregard (so the argument goes), one must ignore the current occupation of the existing tenant, including any fit out works which that tenant may have undertaken at the start of the (original) lease, and instead determine the rent as though the tenant (and its fit out works) were not present at the site.

There is no binding authority on which of these arguments is correct.  Although an early decision (Max Mara v Pearl Assurance Unrep. Central London County Court (1996)) preferred the landlord’s argument, since then all recent decisions of the County Court had favoured the Tenant’s argument: The use of rent free fit out periods on the open market should be reflected in the rent for the new lease (i.e. the headline rent should be reduced to reflect the existence of a rent-free fit out period).  Although this was the general consensus of the County Court, it is fair to say that none of these earlier cases grappled with the issues in any level of detail.

This was until 2021, when a decision of the County Court provided a detailed analysis of the competing arguments and, to the surprise of many in the industry, found for the landlord.  In HPUT Trustee No1 v Boots (Unrep 2021, Cty Ct at Central London) HHJ Dight CBE held that the rent under the new tenancy should not be reduced to reflect the notional rent free fit out period.  The Judge’s reasoning was extensive and considered the reasonableness of the situation, and the focus on reality: a sitting tenant seeking a renewal would not reasonably request a rent-free inducement when it did not need a rent-free period to undertake any fit out.

In late 2022 and early-2023, on opposite sides of the South of England, County Court Judges were grappling with the issues yet again:

In Old Street Retail v GB Healthcare (Unrep, 2022 Cty Ct Central London), HHJ Roberts disagreed with the HPUT judgment and held that the rent under the new lease should be discounted to reflect a hypothetical rent-free fit out period.

In May 2023 in Sterling House Estates v Dunelm  (Soft Furnishings) (Unrep, 2023 Cty Ct at Gloucester and Cheltenham) HHJ Blohm KC handed down judgment in a hearing which took place in December of the previous year (and, therefore, prior to the Old Street Retail v GB Healthcare judgment).  Judge Blohm KC also favoured the tenant’s argument, and departed from the decision in HPUT.

Both of these recent judgments considered the earlier case law in more detail than any earlier judgment had done.  Both cases also provided detailed reasons as to why HPUT was, in the views of those judges, incorrectly decided.  Given the timing of these two cases, neither judgment refers to the other, and both Judges independently found for the Tenant.

In these most recent cases, the Judges both refer to the clear wording in s.34(1) of the 1954 Act; in particular the provision of s.34(1)(a), which disregards “any effect on rent of the fact that the tenant or his predecessors in title have been in occupation of the holding”.  If this disregard is to apply (as it must), then the court should disregard the fact that the sitting tenant will not in fact need a period to fit out the premises.

Both cases also referenced the misnomer in thinking that deducting for a notional fit out indicates a ‘lack of reality’.  In fact, as the judgments observe, including such a deduction accords with the reality of valuing the rent based on a hypothetical letting on the open market, as any hypothetical tenant would require a fit out reduction.

Judge Blohm KC, in Sterling v Dunelm, raised a further reason: The notional letting is a letting of the demised premises which excludes tenants’ fixtures and fittings (this is the effect of New Zealand Government Property Corpn v H M & S [1982] QB 1145); as such, any assessment of the rent must assume that the existing fit-out has been removed: meaning that, in this ‘fictional reality’, an incoming tenant will require a rent-free fit out period.

Comment

It is respectfully suggested that both recent decisions of Old Street Retail v GB and Sterling v Dunelm provide the more convincing answers to this precedent-free conundrum:  In HPUT much was made of the lack of reality, but s.34 requires the court to determine the rent in a certain way: the very concept of a hypothetical transaction imports a ‘fiction’ to the process, but that is the role of the 1954 Act – it is to set a rent by that fiction.

Once one recognises that the court is not mediating between the landlord and tenant, but is undertaking a rental determination based on a fictional transaction, the other arguments relied on by landlords fall away: The existing tenant is unlikely to need a fit out period, but that is irrelevant to the hypothetical tenant.  The tenant might get a windfall from this discount, but this is no more than applying the statutory test.  Indeed, on this understanding, if the court was to assess the rent on a hypothetical transaction but then import into that hypothetical transaction the reality of the current situation, this arguably imports the largest fiction of all.

These recent cases provide a return to normality for practitioners (including valuers who, in this author’s experience, tend to discount fit out periods from the headline rents of comparables as a matter of course).  However, doubt still remains, and HPUT remains a persuasive dissenting judgment amongst a sea of County Court decisions pointing in favour of tenants.  In reality, until a disgruntled party takes the matter on appeal, we are unlikely to be entirely free from doubt.

Jamal Demachkie acted for the tenant, Dunelm (Soft Furnishings) Limited, in the above case.

The three County Court decisions referenced in this article can be accessed by clicking on these links:

• HPUT Trustee No1 v Boots (Unrep 2021, Cty Ct at Central London) HHJ Dight CBE
• Old Street Retail v GB Healthcare (Unrep, 2022 Cty Ct Central London) HHJ Roberts
• Sterling House Estates v Dunelm (Soft Furnishings) (Unrep, 2023 Cty Ct at Gloucester and Cheltenham) HHJ Blohm KC

Article by Jamal Demachkie