Fair Market Rent – Do buildings count?

City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54

This appeal concerned the proper construction and effect of provisions of a lease between the parties relating to the expression ‘Fair Market Rent’ for the purposes of a rent review.  In this decision the full Court of Appeal held that the trial judge had erred in the declarations of the principles applicable to determining the Fair Market Rent, Martin CJ stating that the ‘commercial consequences [of the trial judge’s construction]... were exceptional’.  Despite this case turning on its own facts, Martin CJ stated that while there are limits to the extent to which a court can or should bring its view of commerciality to bear upon the task of construing a contract by reference to the words used by the parties, commercial consequences as exceptional as these strongly suggest error in the process of construction.1  

Facts

Homebase Management Pty Ltd (Homebase) has held a succession of ground leases for the site at the corner of Salvado Road and Harborne Street since 1987 (Land).  The City of Subiaco (City) has granted these leases to Homebase with the understanding, characteristic of a ground lease, that any improvements carried out by Homebase would revert to the City at the expiry of the term.

Homebase, at its own cost demolished the dilapidated buildings and other structures on the Land and constructed new buildings which it has used for office, retail and showroom purposes. The cost of these improvements and buildings have been amortised over the life of the lease.

The Lease

The most recent lease relating to the Land was executed in 2003 and provided for a review of the rent pursuant to its terms every three years commencing on 1 January 2006.  The rent at each review is to be the highest of a number of alternatives, one of which, was an amount equal to the Fair Market Rent which was defined as:

‘Fair Market Rent means the rent which the Leased Premises would reasonably command at the Review Date in a free and open market taking into account all relevant factors, matters or variables used in proper land valuation practice on the basis that the Leased Premises were vacant and available to be let on the same terms as are contained in this document (includes its Term) and as if this document included a term that the Leased Premises were to be put to the same use (and could only be put to the same use) as the use to which the Leased Premises are in fact put by the Lessee at the Review Date (whether or not that is the highest and best use of the Leased Premises) and:

(a)               without taking into account the Lessee's and any sublessee's trade fixtures and fittings;

(b)               taking into account permanent structural or other improvements to the Leased Premises made at the Lessee's expense and the actual use of those improvements by the Lessee; and

(c)                ignoring any value attaching to:

         (i)                 goodwill created by the Lessee's occupation of the Leased Premises; and

         (ii)                any licence or permit in respect of the business carried on by the Lessee or any sublessee on the Leased Premises.’

This definition was varied by the parties in 2007 when they deleted the text of paragraph (b) and substituted:

'(b)              ignoring any value attaching to permanent structural or other improvements to the Leased Premises made at the Lessee's expense.’

The dispute

The City and Homebase each engaged valuers to provide advice regarding the values of Fair Market Rent as at 1 January 2012 (Review Date).  The advice provided by each valuer gave rise to a dispute as to the proper construction and effect of the relevant provisions of the lease relating to the determination of Fair Market Rent. 

At first instance

Homebase commenced proceedings for the resolution of that dispute. 

The trial judge made a number of declarations with respect to the principles applicable to the determination of Fair Market Rent. 

The trial judge held that the 2007 amendment had the effect of requiring the market rent to be reviewed by reference to a hypothetical negotiation, with respect to the rent payable for land which was entirely unimproved as at the Review Date.2  In making declarations to this effect the trial judge also declared that:

‘regard must be had to the fact that... a hypothetical willing but not anxious prospective lessee would have to incur the costs of constructing permanent structural and other improvements to the Land that are necessary to put the Land to the same use as it was put by the plaintiff at the relevant Review Date under the Lease.’3

The nature of a ground lease

Martin CJ in his judgment discussed the nature of a ground lease, being a commercial arrangement pursuant to which the tenant is given a right of possession on the basis that it will carry out improvements on the land which would enhance its use and would ultimately revert to the landlord at the expiry of the lease.4

His Honour further explained that a ground lease typically has the commercial characteristic that the rent negotiated by the parties to such leases, takes into account the extent of the parties respective rights and obligations, including the tenant’s obligation to carry out improvements that will revert to the Landlord.  Murphy JA in his judgment also discussed the nature of ground leases stating, that ordinarily the lessee of a ground lease will seek a long-term lease to allow it sufficient time to recapture the costs of its investment.5

The nature of a rent review clause

The general purpose of a rent review as explained by Murphy JA, is to enable the landlord to obtain, from time to time, the market rental which the premises would command if leased on the same terms on the open market at the review dates. The purpose behind such a clause being to reflect the changes in the value of money and real increases in the value of the property during a long tenancy term.6

His Honour further stated that nevertheless, each rent review provision must be construed according to its terms and within the context of the lease instrument.7

On Appeal

The City appealed the declarations made at first instance.  The Court of Appeal allowed the appeal with Martin CJ (Newnes JA concurring) and Murphy JA providing separate reasons.

The Court of Appeal unanimously agreed that the trial judge had erred in his construction of the lease.8

Martin CJ, (Newnes JA concurring), criticised the declarations made at first instance, citing the exceptional commercial consequences they entailed.In particular His Honour highlighted the effects that the construction of the Fair Market Rent accepted by the trial judge would have:

  • the market rent would be assessed on the assumption that any prospective hypothetical tenant would only agree to pay a rent which took account of the cost which would be incurred by that tenant constructing buildings, or other improvements on land which was entirely unimproved, but leaving out of account any value to be attributed to those buildings or improvements;

  • at each Review Date the market rent would diminish because any prospective hypothetical tenant would have to amortise the cost of the buildings and other improvements notionally to be constructed on the unimproved land over a shorter period; and

  • that there would inevitably come a point in the life of the lease at which the amortised cost of the construction of the buildings and other improvements over the remaining life of the lease would exceed the commercial value of possession of the premises, which would mean there would be no market for a lease on the terms posited by the declaration and as a result – no Fair Market Rent.

Martin CJ held with Newnes JA concurring and Murphy JA agreeing in a separate judgment that the proper construction of the lease required Fair Market Rent to be:10

  • the amount of rent that would be agreed between a willing but not anxious lessor and a willing but not anxious lessee;

  • at the Review Date;

  • for a ground lease containing the same terms and conditions as the lease between the parties for the same premises which were to be put to the same use as that to which they were put by the lessee at the Review Date, irrespective of whether or not that was the highest or best use of the land.

His Honour further stated that because of the nature of a ground lease, it necessarily follows that the rent is assessed on the basis that the willing but not anxious tenant would not be prepared to pay the landlord a rent which reflects the value of buildings or other improvements constructed at the tenant’s cost, but instead that the tenant would recover the cost of such buildings and improvements by amortising their value over the life of the lease.11

His Honour further stated that this construction was supported by the amendments made by the parties in 2007 in particular because:

  • the parties knew that the buildings and other improvements had been effected at Homebases’s expense; and

  • the buildings and other improvements were captured by the definition of ‘Leased Premises’ under the lease and therefore had to be included in the terms of the hypothetical lease negotiated between a willing but not anxious lessor and lessee.

Lavan Legal comment

This decision highlights the importance of careful drafting of rent review clauses, in particular, around what must be considered in calculating the Fair Market Rent. 

It is imperative to ensure clear drafting around rent review clauses due to the adverse commercial impact disputes in this area can have.

 


1 City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [26]

2 Homebase Management Pty Ltd v City of Subiaco [2013] WASC 419, [40] - [42]

3 Homebase Management Pty Ltd v City of Subiaco [2013] WASC 419, [29]

4 City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [6]

5 City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [48]

6 Basingstoke & Deane Borough Council v Host Group Ltd. [1988] 1 All ER 824, 828 – 829 citing British Gas Corp v Universities Superannuation Scheme Ltd [1986] 1 All ER 978, 980 - 981

7 City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [60]

8 See City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [26] (Martin CJ, Newnes JA concurring), [68] (Murphy JA)

9 City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [25]

10 City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [28] (Martin CJ, Newnes JA concurring), [53] (Murphy JA)

11 Murphy JA also alluded to this point– see City of Subiaco v Homebase Management Pty Ltd [2015] WASCA 54, [66]