Earnings-based valuation methodologies in the retail shop lease context

The recent Victorian Court of Appeal decision in Serene Hotels Pty Ltd v Epping Hotels Pty Ltd [2015] VSCA 228 is relevant to the application of earnings-based methodologies in market rent determinations for Western Australian retail shop leases.

In February 2014, the Victorian Civil and Administrative Tribunal (“VCAT”) held in Serene Hotels Pty Ltd v Epping Hotels Pty Ltd (Retail Tenancies) [2014] VCAT 97 that the parties to a hotel premises lease were not bound by a valuer’s rent determination, on the basis that the earnings-based methodology used by the valuer was inconsistent with the market rent criteria set out in the Retail Leases Act 2003 (Vic). The Victorian Supreme Court reversed the VCAT’s decision in Epping Hotels Pty Ltd v Serene Hotels Pty Ltd [2015] VSC 104, which reversal has now been upheld by the Court of Appeal.

Earnings-based methodologies are commonly used by valuers in market rent determinations for leases over a range of specific asset classes, including licensed premises. Leases of such premises can be “retail shop leases” for the purposes of the Commercial Tenancy (Retail Shops) Agreements Act 1985 (WA) either in their own right (as in the case of a lease of licensed premises), or by association due to the premises being situated in a “retail shopping centre”. The Court of Appeal’s decision may alleviate some concerns regarding the use of earnings-based methodologies in the context of Western Australian retail shop leases.

As is the case in Western Australia, the Victorian Retail Leases Act prescribes the criteria that must be applied in any market rent determination for a “retail premises lease”. Such criteria requires a valuer to determine rent having regard to “the rent that would be expected to be paid for the premises if they were unoccupied”, while specifically disregarding “the value of the tenant’s fixtures and fittings”. For Western Australian retail shop leases, the corresponding criteria requires a valuer to assume that the “retail shop lease were vacant”, and to disregard both “the value of … any stock, fixtures or fittings in the retail shop that are not the property of the landlord” and “any structural improvement, or alteration, of the retail shop carried out, or paid for, by the current tenant”.

The legislation in both States prevails to the extent of any inconsistency with any market rent criteria that may be specified in a lease document: for Western Australian retail shop leases, see Lend Lease Funds Management Limited and Golden Maple Pty Ltd [2012] WASAT 119 at [15].

In the VCAT proceedings, the lessee had successfully argued that a rent determination that applied an earnings-based methodology was invalid. The lessee submitted to the VCAT that a determination based on the lessee’s trade figures was in error in light of the requirement to assume that the premises were unoccupied, and that the valuer had also wrongfully taken into account the value of the lessee’s fixtures and fittings in applying the methodology. Due to the similarities in the legislation in both States, the VCAT decision had also raised doubts about the use of such methodologies in Western Australia.

In the initial appeal from the VCAT decision, the Victorian Supreme Court held that the market rent criteria prescribed by the Victorian Retail Leases Act was no impediment to the use of an earnings-based valuation methodology based on the lessee’s trading figures, and that the valuer did not impermissibly take into account the lessee’s fixtures and fittings. Further, the Court held that the requirements of the Act do not demand that a lessee’s fixtures and fittings are simply ignored. Earnings generated by a lessee’s fixtures and fittings can be recognised, so long as the value of those fixtures and fittings are not ultimately reflected in the market rent: i.e. by ensuring that the extent to which the fixtures and fittings generate earnings is “cancelled out” when making the final calculation of market rent. All of those findings have now been endorsed by the Victorian Court of Appeal.

Although it can now be said with a greater degree of confidence that the use of an earnings-based methodology in market rent determinations for retail premises leases and retail shop leases in Victoria and Western Australia does not contravene any prescribed market rent criteria, some doubts remain. Notably, none of the decisions referred to above addressed the potential interface between the use of an earnings-based methodology and the various restrictions relating to “turnover rent” provisions in such leases, which exist in both States.

From a practical perspective, a lessee under a Western Australian retail shop lease cannot be compelled to provide figures or statements relating to business turnover unless “the figures or statements are required for the purpose of determining rent either in whole or part by reference to the turnover of the business”. Accordingly, unless the relevant lease document expressly contemplates the use of an earnings-based methodology on a market rent review, or there is separate provision for payment of turnover rent, a valuer’s ability to obtain trading figures will be dependent on the lessee’s cooperation.

Further, even if the lessee has an enforceable obligation to provide trading figures, the lessee will generally have the right to “opt out” of that obligation at any time, unless the lessee gave notice to the lessor prior to entering into the lease (in the prescribed form) electing that the rent be determined in whole or part by reference to the turnover of the lessee’s business. 

A particular provision in a statute cannot be construed in isolation from its neighbours: X v Australian Prudential Regulation Authority (2007) 226 CLR 630. Arguably, under a less narrow construction of the market rent criteria – one which takes into account the legislative intent behind the turnover rent restrictions applicable to retail shop leases in Western Australia (i.e. that rent cannot be determined by reference to turnover without the consent of the lessee, as evidenced by a written election made by the lessee prior to entering into the lease) – the use of an earnings-based methodology in a market rent determination for most retail shop leases remains questionable. It would be a strange result to allow the rent payable by a lessee under a retail shop lease to be determined by reference to the lessee's trade figures upon a market rent review (against the lessee's wishes), when the imposition of turnover-based rent is otherwise conditional upon an express election having been made by the lessee.

Disclaimer: This post has been prepared as a general summary only. It is not, and is not intended to be, legal advice with respect to any particular matter. This post should not be relied on with respect to any particular matter without taking legal advice. The author disclaims liability to any person who relies on this post.