Ratchet Clauses in Commercial Leases
In commercial lease agreements, rent review clauses provide for how annual rent payable is determined.
In addition to providing what the review is based on (i.e. either the Consumer Price Index (CPI) or market rent), many commercial leases provide that the rent payable on review shall not be reduced even if the current rental is assessed to be higher than its real current rental value.
Hard & Soft Ratchet Clauses
The clause in the lease which makes such provision is commonly known as a “ratchet clause”. There are two types of ratchet clauses, namely the hard ratchet and the soft ratchet. Just like the mechanical device which permits a wheel or rack to move in one direction only, a hard ratchet in a lease only allows for rent to move upwards. The soft ratchet on the other hand allows for rent to fall but not below the rental at commencement of the lease or a lease renewal date.
By far, the most common form of commercial lease in use today is the form supplied by the Auckland District Law Society Inc. (commonly known as the ADLS form), now in its 6th edition. The ratchet clause in the ADLS form is contained in clause 2.1(d) and it appears to be a soft ratchet. However, there is an inconsistency between the formula set out in clause 2.5(a) – a full ratchet, preventing a decrease of any kind and clause 2.5(d) – a soft ratchet, preventing a CPI review from being less than that payable at the commencement of the then current term (or previous term, in the case of a renewal date). This appears to be an error and may be addressed in the next edition of the ADLS form.
Landlords prefer hard ratchet clauses
If you are a landlord, a hard ratchet clause will work to your advantage. This is because we are aware that market rent value can be less than the current rental value and that CPI can be negative.
Tenants prefer soft ratchet clauses
If you are a tenant, you should try to get a soft ratchet clause inserted so that the “floor” is the rent at commencement. This leaves room for the rent to potentially decrease from year to year as long as it does not go below the rent at commencement of the lease or the lease renewal date.
Whether you are a tenant or landlord under the ADLS form or any other form, it is important to note that leases can be negotiated. If you discover a ratchet clause in the lease agreement that you are uncomfortable with, you should consider negotiating changes to suit your wishes at the time of entering into an Agreement to Lease. Most Agreements to Lease prescribe that the Deed of Lease be on the current ADLS form. Therefore, it will be too late to make changes once the Agreement to Lease has been signed.
If in doubt, consult us first. We have considerable experience in negotiating and drafting leases and would be happy to assist you in all your leasing needs.