Marklands Ltd v Virgin Retail Ltd

The property comprised in the lease consists of a single large retail unit on ground floor and two upper levels. Its area is 21,233 square feet (gross internal area) or 19,435 square feet (net internal area).

The Fourth Schedule to the lease provides for an upwards only rent review. As is usual it requires the assumption of a hypothetical open market letting of the demised property with vacant possession for the residue of the term and on the terms of the actual lease (subject to immaterial variations). However, there are two unusual features of the rent review provisions. First, in the definition of “open market rental value” the lease contains the following direction:

The Schedule went on to provide for the appointment of an arbitrator in default of agreement on the reviewed rent. The arbitrator was to be an independent Chartered Surveyor experienced in the valuation of retail premises of the nature of those in the development. Within the directions in the Schedule about the conduct of the arbitration there is the second unusual feature of the rent review provisions. It is a direction that:

The parties were unable to agree the revised rent and Mr ADH Cheetham FRICS was appointed as arbitrator. The parties were represented by Chartered Surveyors, Mr Sandbach of King Sturge for the landlord and Mr McMurray of CB Hillier Parker for the tenant. They produced an agreed statement of facts for the arbitrator. The arbitrator received written submissions and counter-submissions from each of them. Mr Sandbach valued the property at £680,000 per annum and Mr McMurray valued it at £360,500 per annum. The arbitrator said in his award:

He proceeded to evaluate the various comparable transactions that the two valuers had placed before him. He concluded that the open market rental value of the property, on the basis required by the lease, was £425,000 per annum.

The landlord’s first complaint is that in evaluating the comparables the arbitrator was misled by the direction to value the property on an overall basis. The consequence of his misunderstanding of the real effect of the direction was that he refused to give any weight or proper weight to comparable transactions where the zoning method of valuation had been used to arrive at the rent.

Before assessing the substance of this complaint it is necessary to say something about the two methods of valuation: overall valuation and the zoning method.

Valuation essentially proceeds by analogy. The valuer looks for an analogue which is as close as possible to that which he has to value, and which has been the subject matter of a real transaction. He then works on the premise that if the subject matter of his valuation were to be the subject of a similar transaction, it would command the same value as the analogue. Since the analogue will never be identical to the subject matter of the valuation, the valuer will have to make adjustments to the value revealed by the analogue in order to reflect the differences between the analogue and the subject matter of his own valuation. In the case of a property valuation the analogues are usually called “comparables”. In the case of a property valuation typical adjustments will reflect differences between the comparables in location, terms of letting and so on. One obvious difference between different properties is that they will be of different sizes. As a first step towards eliminating the differences in size between a comparable and the subject matter of the valuation the valuer will not take the rent of the comparable and apply it to the subject property. Rather, he will divide the rent of the comparable by the area of the comparable to produce a rate per square foot. The area can be calculated in a variety of different ways, depending on the nature of the property. The RICS publish a Code of Measuring Practice to guide practitioners, and it is that Code that the lease refers to. This process of division is called “devaluation”. Having devalued the comparable, the valuer can then apply the rate per square foot to the subject property (if necessary making adjustments for the factors I have mentioned). He will then multiply the rate per square foot by the area of the subject property and thus arrive at a rental value. Sometimes, however, the valuer will think it appropriate to make a further adjustment for size, over and above the process of devaluation. This is because the subject property may be considerably larger than the comparable (in which case an end allowance or discount for size may be appropriate); or because a particular comparable may be so small as to produce an extremely high rent if looked at as a rate per square foot (often known as “kiosk rents”). This is essentially the “overall” method of valuation.

In the case of retail property, valuers have developed a more sophisticated technique, called the “zoning” method. This method notionally divides a shop into parallel zones (usually of 20 feet), starting at the street frontage and working backwards to the rear of the shop. The zone nearest the street is called “Zone X’; the one immediately behind it is called “Zone B” and so on. At some point, however, usually at around Zone C, the valuers stop zoning and classify the rest of the shop as “remainder”. Zone B is taken to be half the value of Zone A, Zone C as half the value of Zone B, and so on. This process is known as “halving back”. An alternative way of looking at this method of valuation is for the valuer to divide the area of Zone B (as opposed to its value) by two, the area of Zone C by four and so on. The resulting area is an area expressed “in terms of Zone X’ or ‘ITZA”. A Zone A rate per square foot can then be applied directly to the area ITZA. One of the theoretical underpinnings of this method of valuation is that a shop with a wider street frontage (and hence a bigger shop window) is more valuable than a shop of the same area but with a narrower shop front and greater depth. Even this method of valuation may require adjustments to be made over and above the process of devaluation. A common adjustment would be an increase in the Zone A rate to take account of a return frontage (that is a shop window at the side of the shop). This kind of adjustment reflects the importance that valuers give to shop windows. The property in the present case has a return frontage, but the parties have expressly provided that it is not to be taken into account. Another kind of adjustment might be made to reflect the configuration of a shop (for instance if it is not a regular rectangle).

The zoning method is almost invariably used to devalue the rents of standard high street shops and standard units in shopping centres. One of the maxims of valuation is “value as you devalue” (or vice versa), so that the rent of such a shop is almost invariably arrived at by applying a Zone A rate to its area ITZA.

However, the zoning method is not used right across the range of retail property. Department stores, for instance, are usually valued on an overall basis rather than by the zoning method. Some surveyors take the view that large shops (even though not department stores) ought to be valued on an overall basis too. Both parties referred me to the judgment of Neuberger J in Lewisham Investment Partnership Ltd v. Morgan [1997] 2 EGLR 150. The judge recorded the evidence given to him that some valuers consider that the overall method of valuation is more appropriate if the area of the shop in question is 5,000 square feet or more. There is some indication that the parties in the present case subscribed to that view, since not only did they require the valuation to proceed on the overall basis, but they specifically prohibited both the use of the zoning method and the consideration of evidence derived from comparables whose area was less than 5,000 square feet. The evidence before the arbitrator, however, indicated that shops of up to 10,000 square feet could legitimately be valued by the zoning method.

Mr Barnes QC, for the landlord, submitted that both the overall method and the zoning methods were means to the same end, namely the ascertainment of the correct open market rental value of the subject property. Consequently, when applied by a skilled valuer to a particular property, the two methods should lead to the same result. It follows, he said, that if a valuer deliberately places less weight on valuations arrived at by the zoning method, he deliberately closes his eyes to a body of relevant evidence. That, he submitted, amounted to a “serious irregularity” within the meaning of section 68 of the Arbitration Act 1996 and was also an error of law, in respect of which permission to appeal should be given under section 69.

In paragraph 53 of his award the arbitrator said that he had found open market lettings of River Island and Hennes to be of assistance. The River Island letting was one where the rent had been calculated on the zoning basis, although the parties re-analysed it on the overall basis too. The basis on which the Hennes transaction was valued is not clear on the evidence. In paragraph 54 the arbitrator said that he considered the rent review of Principles to be the only evidence in the Clayton Square shopping centre of assistance. That was a rent review which was agreed using the zoning method. These were the principal comparables on which the arbitrator relied in reaching his own figure. I do not think that the landlord’s criticism can be sustained on the facts. What the arbitrator in fact did was to prefer evidence of open market lettings (including lettings where the rent was agreed using the zoning method) to evidence of rent reviews, and the figure he reached is consistent with that approach.

The landlord submits that the flaw in the arbitrator’s approach can be demonstrated by examining his treatment of the Etam and JD Sports rent reviews. The Etam premises in question consisted of a large unit held under a single lease. However, for the purposes of the rent review the premies were required to be notionally divided into four small units; each unit was valued separately and their values then aggregated. Each notional unit was less than 5,000 square feet in area. Although the Etam premises were technically held under one lease, and hence may not have literally breached the contractual prohibition on considering evidence derived from small shops, they breached the spirit of that prohibition. The arbitrator said of this comparable in paragraph 34:

The valuation approach, to which the arbitrator referred, was surely the approach that required the assessment of the rent by the aggregation of the rent for the four constituent parts. In my judgment he was fully entitled to say that that comparable was of no help to him.

So far as JD Sports was concerned, the arbitrator said that the rent review appeared to have been agreed using the zoning method. He pointed out that the transaction post-dated the review date with which he was concerned by two years. However, I agree with Mr Barnes that paragraph 48 of the award indicates that the most cogent reason that persuaded the arbitrator to reject JD Sports as a comparable was that the rent had been agreed using the zoning method.

The other passage of which the landlord complains is paragraph 56 in which the arbitrator says:

However, the arbitrator was not saying that the nearby comparables were irrelevant. The arbitrator did not direct himself that he could not consider zoned transactions, and he in fact considered and relied on some such transactions. In my judgment the attribution of weight to different comparables was a matter of judgment for the arbitrator. I do not consider that the manner in which he exercised that judgment demonstrates either a serious irregularity or an error of law. Whether or not his stated reason for rejecting the JD Sports rent review was a good one, I do not consider that his rejection of that comparable can be described either as an irregularity or as an error of law.

In addition it seems to me that the evidence before the arbitrator shows that application of the zoning method and application of the overall method do not necessarily produce the same result. Both the River Island and the Hennes transactions were valued by the zoning method, and the Zone A rates were £235 and £197 per square foot respectively. There is a reasonable degree of proximity between these two rates. But if they are devalued on an overall basis the rates per square foot are £31.99 and £19.89 respectively. Indeed in the Lewisham case the unsuccessful claimant’s case against the independent expert who had fixed the rent of a large shop on review was that if he had applied the zoning method rather than the overall method, he would have arrived at a rent of £430,000 rather than the rent of £250,000 that he in fact assessed. Even if the arbitrator had decided, as a matter of valuation judgement, that no zoned transactions were helpful to him, he would in my view have been entitled to do so. Thus although Mr Barnes’ submission is logically attractive, it is not borne out by reality. This is no more than saying, as valuers often do, that valuation is an art, not a science.

The landlord’s second complaint is that the arbitrator ignored an argument put forward on its behalf. The arbitrator did not mention or deal with this argument in his award. Mr Barnes submits first that the arbitrator’s failure to deal with this argument amounts to a serious irregularity; and second that it amounts to an error of law. I will deal with the question of law first. The right of appeal under section 69 (1) of the Arbitration Act 1996 applies only to “a question of law arising out of an award”. This is the same language as previously appeared in section 1 (2) of the Arbitration Act 1979. In Universal Petroleum Co Ltd v. Handels und Transport GmbH [1987] 1 WLR 1187 Kerr LJ said:

If the alleged point of law is not dealt with in the award, I do not see how it can be said that the question of law arises out of the award. In my judgment the landlord does not overcome this jurisdictional hurdle. It also means that it is impossible to say that that the determination of the question “will” substantially affect the rights of the parties, as required by section 69 (3)(a). However, since this might be thought to be an over-technical view, I shall go on to consider the argument on its merits.

The question of law as formulated by Mr Barnes is:

I have put the word “could” in brackets, because the original formulation used the word “would”. To ask whether someone “would” do something does not seem to me to be a question of law, but a question of fact. But I accept that whether a person “could” do something may be a question of law. The argument, as presented by Mr Barnes, runs as follows. The arbitrator was required to envisage a hypothetical negotiation between a willing landlord and a willing tenant. In the course of that negotiation, each party would capitalise on all the negotiating advantages available to him. Each would also consider the alternatives open to him. In the case of the tenant the alternatives would include taking a lease of different property. In the case of the landlord the alternatives would include letting to a different tenant. But because of the size of the subject property, the landlord had another possible option. That was to divide the property into smaller component parts and then let the component parts separately. In considering that option the landlord would take into account the costs involved in dividing the property; the increased cost of managing three units as opposed to one, and the risk of voids etc. It is known that the landlord does not in fact choose that option, since the rent review provisions postulate a letting of the property as a whole. But Mr Barnes submitted that the landlord could threaten not to let the property as a whole to the tenant unless the tenant paid a rent approaching the return that the landlord could get from dividing up the property and letting it in its constituent parts. Whether this would have any impact on the tenant would depend on whether he perceived the threat as a potent one, and what alternatives were available to him.

Mr Barnes relied on the well-known decision of Donaldson J in FR Evans (Leeds) Ltd v. English Electric Co Ltd [1978] 1 EGLR 93 (subsequently affirmed by the Court of Appeal). The case concerned the rent review under a lease of a large factory in the North of England, called the Walton Works. The judge considered the nature of the hypothetical negotiations that would take place between the landlord and the tenant. There are, I think, two passages that bear on the present argument. First at 94L the judge said:

Second at 95F the judge said:

Mr Barnes fastened on the second of these quoted passages. Mr Dowding QC, appearing for the tenant, fastened on the first. The two passages are not easy to reconcile. The first suggests that one of the landlord’s options, namely the division of the property cannot be taken into account at all (“irrelevant”). The second suggests that the tenant is entitled to rely on his other options as part of the negotiating process. Mr Barnes submits, with considerable force, that to allow one party to the hypothetical negotiation to deploy his alternatives as bargaining counters, but to refuse to allow the other to do so, is illogical, unfair, and not what happens in the real world. However, as Mr Barnes said in the course of his reply, although the hypothetical negotiations replicate the real world, they do not replicate what he called an “unconstrained world”. In the real world, parties often do not reach agreement, since their individual aspirations are irreconcilable. But in the hypothetical world, they always reach agreement. Although each party may have alternatives, it seems to me that the only permissible alternatives are those within the framework of the hypothetical transaction. Thus the landlord can point to other tenants willing to take a lease of the property on the offered terms and the tenant can point to other properties that he would be willing to take. But it does not seem to me to be permissible for the landlord to say that he could enter into a different kind of transaction, when he is known to be willing to enter into that which the lease prescribes. In the first quoted passage Donaldson J was emphasising the importance of staying within the transactional framework laid down by the lease. The second quoted passage refers to other alternatives available to the tenant; but those alternatives do not violate the transactional framework laid down by the lease.

In my judgment this approach is supported by Northern Electric plc v. Addison [1997] 2 EGLR 111. The case concerned the renewal of a lease of an electricity sub-station. The tenant put forward a rent of £15. The landlord put forward a rent of £1,000. The difference between the two was attributable to the fact that the landlord’s valuer took into account the potential of the land to be let for more profitable uses. Potter LJ said: