A significant VCAT decision for rental determinations under the RLA

In the VCAT decision of Serene Hotels Pty Ltd v Epping Hotels Pty Ltd handed down last Friday, Member Farrelly at VCAT considered an application to set aside a determination of the rent at a hotel with gaming facilities and held that:

1. a specialist retail valuer is not entitled to use the profits method to determine rent, at least at a gaming venue;
2. a specialist retail valuer may have regard to future matters if they were known generally in the market at the time of the rental determination;  and
3. a supplementary report prepared by the valuer may be admissible in some circumstances.

Each of these issues is potentially significant for practitioners advising clients during a rent review under the Retail Leases Act 2003 (Vic), particularly point 1 above.

Legislation

Section 37(2) of the Retail Leases Act 2003 (Vic) governs current market rent reviews in retail premises leases in Victoria.   It states that:

(2)            The current market rent is taken to be the rent obtainable at the time of the review in a free and open market between a willing landlord and willing tenant in an arm’s length transaction having regard to these matters—

(a)   the provisions of the lease;

(b)    the rent that would reasonably be expected to be paid for the premises if they were unoccupied and offered for lease for the same, or a substantially similar, use to which the premises may be put under the lease;

(c)   the landlord’s outgoings to the extent to which the tenant is liable to contribute to those outgoings;

(d)   rent concessions and other benefits offered to prospective tenants of unoccupied retail premises—

but the current market rent is not to take into account the value of goodwill created by the tenant’s occupation or the value of the tenant’s fixtures and fittings.

Use of the profits method

The valuer in this case determined the current market rent for a hotel and gaming venue by using the profits method.

When using the profits method, the valuer:

1. looks at the EBITDAR (or earnings before interest, taxation, depreciation, amortisation and rent) for the business;
2. considers whether those earnings are sustainable or would be exceeded by an average, competent tenant;
3. determines the percentage of EBITDAR that is paid by tenants of comparable property;  and
4. applies that percentage to the figures at hand to determine the rent for the property in that case.

The profits method is generally used by valuers determining rent for hotels, licensed premises and gaming venues.

Then tenant submitted that, in breach of s 37(2) of the RLA 2003, the valuer took into account the tenant’s goodwill and its fixtures and fittings by using the profits method.  In particular, the tenant argued that it was impossible to have regard to the tenant’s turnover figures without also having regard to the value of the tenant’s gaming machines and entitlements.

The landlord argued that:

1. a tenant of a hotel benefits from a degree of locational goodwill because the tenant does not lease a bare shell.  In this case, the tenant of unoccupied premises would still have leased the Epping Hotel;
2. the market for pub leases has regard to the potential profitability of the pub, rather than other issues such as the square of floor space;
3. valuers habitually use the profits method to determine rent for hotels and gaming venues;  and
4. in line with established valuation practice, the valuer looked at the tenant’s turnover figures and concluded that those figures were sustainable by an average, competent manager of a new tenant.  By doing so, the valuer excluded any special effects of the tenant’s goodwill or its fittings and fixtures from the rental determination.

The Tribunal rejected the landlord’s arguments and concluded that:

39.   In my view, it is very clear from the statements in the valuation report that the rent determination is founded on the Applicant’s own trading figures, and that the Valuer has taken into account the value of the Applicant’s fixtures and fittings. This is borne out in particular by the Valuer’s statement in the valuation report, referred to above, that “It is pertinent to note that the future application by the Tenant of its owned Fixtures & Fittings is included in the rental assessment process … “. Section 37(2) of the Act mandates that the Valuer not take into account the value of the Applicant’s fixtures and fittings.

40.   The Respondent submits that the methodology employed by the Valuer is consistent with the evident purpose of the Act to strike a fair balance between the interests of the Landlord and the Tenant and to secure a fair and reasonable estimate of the rent that would be paid if the premises were let on the open market. The Respondent says that it is reasonable that the Valuer consider the profits which a willing lessee would make in the future assuming average competent management of the same business by a hypothetical willing lessee. The Respondent says that this “profits method” of determining market rent – where the Valuer takes account of the profits generated by the sitting tenant – is common in the hotel industry and not prohibited by s37(2) of the Act.

41.   However reasonable the Valuer’s methodology may seem, and whether or not it is a method that has in the past been commonly adopted by valuers in the hotel industry, I do not accept that s37(2) of the Act allows the methodology employed by the Valuer. I am satisfied that the Valuer has, contrary to the requirement in s37(2) of the Act, taken into account the value of the Applicant’s fixtures and fittings, and in so doing the Valuer has fundamentally misconstrued his task. As such, I find that the parties are not bound by the rent determination.

This case is significant for the valuing profession generally, and those determining rent for licenced premises in particular.  It is also significant for legal practitioners advising landlords and tenants during rent reviews because:

1. most licensed premises are governed by the RLA 2003 and most (if not all) current market rent reviews for those premises will have been conducted using the profits method.  This decision suggests that a significant number of determinations in the marketplace may be open to challenge in VCAT;  and
2. the decision now raises a difficult question for specialist retail valuers engaged to determine the current market rent for licenced premises and gaming venues who are accustomed to determining rent by the profits method – should they continue to use the profits method or rely on another method to determine the rent?

Future matters

Section 37(2) requires the specialist retail valuer to determine the rent ‘at the time of the review’.

In this case, the valuer had regard to anticipated changes to the regulation of the gaming industry that would render gaming machines more profitable.   The valuer determined that:

1. proposed changes to the regulation of the gaming industry were generally known and widely anticipated in the marketplace at the date of the review, even though they only took effect some time later;  and
2. as a result, tenants would have been willing to pay a higher rent on the expectation of increased profits during the term of the lease.

The tenant argued that the determining valuer must determine the rent ‘at the time of the review’, so could not have regard to future matters.

The landlord argued that the determining valuer found that the proposed changes to the law were widely known at the review date and would have influenced the rent that a hypothetical tenant would have been willing to pay, so was a relevant consideration.

The Tribunal held that:

53.   One can think of many hypothetical examples where knowledge of a likely or possible future event will undoubtedly have a bearing on the rent obtainable in the open market between a willing Landlord and a willing Tenant.  That the forecast future event may or may not occur is beside the point. What is relevant is the effect that market knowledge of a possible future event, as assessed by a valuer, may have on the rent obtainable in an open market.  In my view, section 37(2) does not prohibit the consideration of possible future events.

Advisors acting for landlords or tenants approaching a current market rent review should consider making submissions to the determining valuer about future events that were widely anticipated at the time of the review and that may have had an impact on the rent that a tenant would have been willing to pay for the property at the time of the review.

Supplementary report

The specialist retail valuer is also required by s 37(2) to have regard to ‘rent concessions and other benefits offered to prospective tenants of unoccupied retail premises.’

In this case, the specialist retail valuer did not consider in his primary report rent concessions or other benefits offered to prospective tenants.   In the lead-up to trial, the tenant’s solicitor wrote to the determining valuer and requested a supplementary report, which was provided in a short note from the determining valuer.  A protracted argument ensued over the extent to which (if at all) a supplementary report from a valuer may be considered by the Tribunal.

The Tribunal concluded that:

61.   In my view there is no hard and fast rule as to whether parties, who have appointed an independent specialist valuer and received his valuation report, are bound to accept supplementary reports or material from the valuer.  It depends on the circumstances in each case.

62.   There is nothing in the Act or the lease to suggest that the Valuer is limited to providing one document on one occasion.

63.   However, having regard to the means by which the supplementary letter was obtained, the date the letter was provided and its contents, I find that it would be unfairly prejudicial to the Applicant to pay any regard to it.

64.  It is clear from the terms of the supplementary letter itself that the Valuer has provided the letter in response to a specific request from the Respondent, a request which, in my view, is a blatant prompt to the Valuer to provide further information in respect of a matter which is conspicuously absent in the valuation report.

65.   Further, the Respondent’s request to the Valuer was made some 8 months after the Valuer provided the valuation report to the parties and some 5 months after the Applicant commenced this proceeding. In my view, once the Applicant commenced this proceeding challenging the valuation report, it became untenable for the Valuer to provide any supplementary report.

66.   In all the circumstances, I am satisfied that the supplementary letter should be wholly disregarded.

It is quite common for determining valuers to fail to mention in their determination an issue considered insignificant.

Valuers should ensure that they have a checklist of items that they are required to consider in s 37(2) of the RLA and in the lease and ensure that each item is discussed in their reports (even if only to give reasons as to why it is not relevant).

Practioners may find themselves advising clients about determinations where an item is conspicuously absent from the determination.  If so, they should consider writing to the determining valuer at the earliest stage to elicit a supplementary report, preferably before a dispute has started.

I am not aware of a copy of the decision having been posted on AustLii at this stage.  A copy of the reasons is available here: Serene Holdings Pty Ltd v Epping Hotel Pty Ltd.