The Return of the Rachet Clause
By Peter Scott | Property Leasing | Monday 9th June 2008The use of ratchet clauses is on the up as property markets toughen and property owners look for ways to keep rentals up.
Ratchet clauses have traditionally been used by property owners in markets where there is a possibility that property values might drop, dragging rentals down with them. There has been an ongoing argument over the ratchet clause so here is my spin on it…
In the tenant’s mind, it seems fair that ’supply and demand’ should be applied. If property values are dropping (and there are signs that this may happen), then why shouldn’t the rental drop back too? On the other hand, the property owner reasons that it still has holding costs, etc so has a Ratchet Clause inserted into the lease.
The ratchet clause works just like a ratchet spanner – if it’s moving at all, you can only turn the spanner one way. In the rent review world, this means that the rental can either stay as it is, or increase – even if property values are dropping.
Why haven’t you heard of the ratchet clause before? Because like the rest of our economy this year, the Property market has evolved too. As the market continued to rise and rise in recent years, the ratchet clause in property leases became forgotten and we virtually have a generation of businesses who have never felt the ratchet clause bite. Now with property values fluctuating, tight credit and a lot of movement over the supply and demand of vacant space, the ratchet clause is going to be an increasingly prominent component of property leases.
Parallel Directions recently worked with a client to negotiate a lease for 1200 square metres of commercial space, at an annual rental of around $400,000. The property owner wanted to have a full ratchet clause inserted into the lease, but we advised our client against this. Our negotiations produced a solution that is workable for both parties.
To ensure the tenant will be able to receive an equitable result at future rent reviews, we negotiated a modification to the ratchet clause. The parties have agreed that the rental will be able to drop back at a rent review, just not below the level that the tenant paid when it moved into the premises. We call this the ’soft’ or ‘modified’ ratchet clause solution. Both parties are reasonably happy with this result.
Anyone now going into a property lease will need to negotiate the ratchet clause carefully. The key will be negotiating soft or modified ratchet clauses that can provide a win-win for landlord and tenant; tight enough not to sting the tenant, but with enough give and take for the landlord to be secure.
Monday 9th June 2008 at 2:04 pm
In the late 80’s as an impoverished student I took to marking Property Management papers to make some cash. One student referred to this lease mechanism in his answer as a ‘rat shit’ clause. Is the re-emergence of this inequitable clause a signal of returning to the cowboy days of the late 80’s?
Monday 9th June 2008 at 6:43 pm
Peter, I always enjoy your blogs, not just because they provide a thoughtful commentary on property issues, but also because they report on something I regard as a key indicator of the state of the economy, both now and (more importantly) the near future.
Tuesday 22nd July 2008 at 11:40 am
Stu, I remember those days well. It took many years of paying over-the-top rentals before companies could escape those inequitable leases. In the last couple of days I have encountered another major landlord trying to incorporate a fully blown ratchet clause into the lease contract. Certainly our client is concerned that this lease requirement is outside of the previously friendly negotiation and believes the landlord has now shown its true character.
Such landlords play a dangerous game. If they want to play hardball by incorporating a full ratchet clause, then they better watch out for the equal and opposite reaction from tenants who want a fair and equitable lease agreement. Especially in a market when landlords are no longer king.
I don’t think we are returning to the “bad old days” of the late 80s and 90s. I believe tenants who enter into leases on the foundation of good advice will achieve a good outcome. Tenants who go to the market without that preparation actively encourage hungry landlords to provide a few surprises in their lease package.