Serene Hotels Pty Ltd v Epping Hotels Pty Ltd
[2015] VSCA 228
•27 August 2015
SUPREME COURT OF VICTORIA
COURT OF APPEAL
S APCI 2015 0042
| SERENE HOTELS PTY LTD (ACN 114 040 881) | Applicant/Appellant |
| v | |
| EPPING HOTELS PTY LTD (ACN 005 430 991) | Respondent |
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| JUDGES: | WEINBERG and TATE JJA and ROBSON AJA | |
| WHERE HELD: | MELBOURNE | |
| DATE OF HEARING: | 31 July 2015 | |
| DATE OF JUDGMENT: | 27 August 2015 | |
| MEDIUM NEUTRAL CITATION: | [2015] VSCA 228 | First revision: 28 August 2015, [48] |
| JUDGMENT APPEALED FROM: | [2015] VSC 104 (Croft J) | |
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RETAIL LEASES – Rent review – ‘Profits method’ for determining current market rent for hotel premises – Earnings-based approach (EBIDTAR) – Whether profits method is consistent with requirement under s 37(2) of Retail Leases Act 2003 that current market rent is not to take into account value of tenant’s fixtures and fittings.
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| APPEARANCES: | Counsel | Solicitors |
| For the Applicant/Appellant | Mr P R Best | Hall & Thompson |
| For the Respondent | Mr S Hopper | Wisewould Mahony |
WEINBERG JA:
I agree with Tate JA.
TATE JA:
Introduction and Summary
The question raised by this appeal[1] is whether the methodology adopted by a valuer for the purpose of determining the current market rent of premises leased by the appellant, Serene Hotels Pty Ltd (‘the Tenant’), from the respondent, Epping Hotels Pty Ltd (‘the Landlord’), is inconsistent with the prescription under the Retail Leases Act 2003 (‘the Act’) that the premises are to be treated as if they were ‘unoccupied’ and the value of the tenant’s fixtures and fittings is not to be taken into account.[2]
[1]While this is an application for leave to appeal I refer to it as an ‘appeal’ as I would grant the necessary leave. See [82] below.
[2]See s 37(2) of the Act. See [6] below.
In my view, the methodology adopted by the Valuer[3] is not inconsistent with the Act.
[3]See [15] below. The Valuer was appointed after the Landlord and the Tenant failed to reach agreement.
I consider that the judge of the Trial Division of this Court, from whom this appeal is brought, was correct to conclude that the Valuer’s methodology is consistent with the Act[4] and that no error of law had been demonstrated before him.
[4]Epping Hotels Pty Ltd v Serene Hotels Pty Ltd [2015] VSC 104 (‘Reasons’).
For the reasons below, I consider that the appeal should be dismissed.
The statutory scheme
The critical section of the Act for the disposition of this appeal is s 37(2) which
provides that a landlord is to treat the premises to be valued as unoccupied and to ignore the value of the tenant’s goodwill and the value of the tenant’s fixtures and fittings. Section 37 provides:
Rent reviews based on current market rent
(1)A retail premises lease that provides for a rent review to be made on the basis of the current market rent of the premises is taken to provide as set out in subsections (2) to (6).
(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.
(3) If the landlord and tenant do not agree on what the amount of that rent is to be, it is to be determined by a valuation carried out by a specialist retail valuer appointed by —
(a) agreement between the landlord and tenant; or
(b) if there is no agreement, the Small Business Commissioner —
and the landlord and tenant are to pay the costs of the valuation in equal shares.
(4)The landlord must, within 14 days after a request by the specialist retail valuer, supply the valuer with relevant information about leases for retail premises located in the same building or retail shopping centre to assist the valuer to determine the current market rent.
Penalty: 50 penalty units.
(5) In determining the amount of the rent, the specialist retail valuer must take into account the matters set out in subsection (2).
(6) The valuation must—
(a) be in writing; and
(b) contain detailed reasons for the specialist retail valuer's determination; and
(c) specify the matters to which the valuer had regard in making the determination.
(7) The specialist retail valuer—
(a) must carry out the valuation within 45 days after accepting the appointment, or within such longer period as may be agreed between the landlord and tenant, or if there is no agreement, as determined in writing by the Small Business Commissioner; and
(b) may seek to enforce under Part 10 (Dispute Resolution) an obligation of the landlord under subsection (4).
The effect of s 37(1) is that the sub-ss that follow, (2)–(6), are to be taken to be terms of a retail lease, as contractual conditions. The parties are not free to contract out of these conditions, pursuant to s 94 of the Act which relevantly provides:
(1)A provision of a retail premises lease or of an agreement (whether or not the agreement is between parties to a retail premises lease) is void to the extent that it is contrary to or inconsistent with anything in this Act (including anything that the lease is taken to include or provide because of a provision of this Act).
(2)A provision of a retail premises lease or of an agreement (whether or not the agreement is between parties to a retail premises lease) is void to the extent that it purports —
(a) to exclude the application of a provision of this Act; or
(b)to limit the right of a party to the lease to seek resolution of a retail tenancy dispute under Part 10 or otherwise to limit the application of that Part.
The objective of s 37(2) would appear to be that of ensuring that a tenant does not suffer a rent increase by reason of its own improvements. As counsel for the Tenant puts it, ‘why should a tenant have to pay more rent because of things the tenant has done?’. The Tenant argues that the objective of s 37(2) is the same as that to which s 29(b) of the Retail Shop Leases Act 1994 (Qld) is directed. Section 29(b) also prescribes that a valuer is to ignore the value of the tenant’s business and the tenant’s fixtures and fittings. It provides:
In making a determination of the current market rent, the specialist retail valuer —
(a) must determine the rent —
(i)on the basis of the rent that would be reasonably expected to be paid for the retail shop if it were unoccupied and offered for leasing for the use for which the shop may be used under the lease or a substantially similar use; and
(ii)on the basis of gross rent less lessor’s outgoings payable by the lessee under the lease; and
(iii) on an effective rent basis; and
(b)must not have regard to the value of the goodwill of the lessee’s business or the lessee’s fixtures and fittings in the retail shop; and
(c) must have regard to —
(i)submissions from the lessor and lessee about the market rent of the shop; and
(ii) the other matters prescribed by regulation.
In Vesco Nominees Pty Ltd v Stefan Hair Fashions Pty Ltd[5] Muir J identified as the purpose of s 29(b) the avoidance of unfairness that would result to the tenant if the rent were increased by reason of the tenant’s own expenditure on matters for its business. He said:
The purpose of section 29(b) in excluding ‘the lessee’s fixtures and fittings’ from consideration in the determination of market rent is to prevent perceived unfairness which could flow from the rent being increased to take into account the enhanced value of the demised premises and the benefit to the lessee resulting from the lessee’s own expenditure on items for the improvement of its business.[6]
[5](2001) Q Conv R ¶54-555 (‘Vesco’).
[6]Ibid [46].
Muir J further described s 29(b) as having a ‘remedial character’.[7]
[7]Ibid [50].
This is consistent with an express purpose of the Act, being to achieve fairness between landlords and tenants. Section 1 sets out the ‘main purpose’ of the Act; it provides:
The main purpose of this Act is to replace the scheme in the Retail Tenancies Reform Act 1998 with a new scheme to enhance —
(a)the certainty and fairness of retail leasing arrangements between landlords and tenants; and
(b) the mechanisms available to resolve disputes concerning leases of retail premises.
It is noteworthy, however, that although the Act prescribes that a valuation 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, it does not otherwise direct that any particular methodology is to be adopted nor does it prohibit any particular methodology so long as the chosen methodology is consistent with the Act.
The Valuation
The lease between the Landlord and the Tenant, dated 1 February 2007 (‘the lease’) is for an initial period of 14 years. The premises leased are a hotel, bottle shop and car park (used by patrons of the hotel) in High St, Epping. The Tenant runs its business from the premises, known as the Epping Hotel.
The commencement rental was $475,000 per annum plus GST. Rental was fixed for the first two years of the lease. Thereafter the lease requires the rental to be reviewed annually to the greater of the Consumer Price Index for Melbourne (all groups) or 2.5 per cent with an exception for a market rent review to be undertaken on the 5th, 10th, 15th, 20th, 25th and 30th anniversary of the commencement date. Clause 6.2.2. of the lease provides that if the Landlord and the Tenant are unable to agree on a market rental then ‘the amount of the then current market rental for the demised premises shall be determined by an independent specialist valuer’. Clause 6.2.3 of the lease provides that the decision of the independent specialist valuer ‘shall be final and binding’.
By the time of the fifth anniversary of the commencement date, the Landlord and the Tenant had not reached agreement on a current market rent. Mr Grieve of ‘CBRE Valuations Pty Ltd’ was appointed as an independent specialist valuer (‘the Valuer’). His appointment was confirmed around November 2012. The relevant date for the determination of the current market rental undertaken by the Valuer was 1 February 2012 (‘the determination date’). He understood that the current market rental had to be determined in accordance with the Act, especially s 37(2).
The Valuer received from the Tenant detailed trading information for the financial years 2009, 2010 and 2011.
The Valuer inspected the Epping Hotel on 18 February 2013 at which time he viewed all trading segments of the property and the external perimeter. He noted that the Epping Hotel was probably constructed in the period 1910 to 1920 and is a single level premises. The trading components of the hotel include a hotel TAB room with a service counter with four terminals, three ‘easybet’ kiosks, trackside, display boards and monitors. There is a public bar with a large bar service area containing seating for some 40 patrons and including two pool tables and several video games. There is a gaming room that is open plan with 40 gaming machines, a cashier stall and adjoining bar servery. A bistro is located centrally in the hotel premises with an approximate seating capacity for 120 patrons. An outdoor area adjoins the bistro containing a children’s play area, outdoor seating and a marquee erected to provide weather protection and seating, typically for patrons of the TAB. There is a drive-in bottle shop that provides dual lane drive-through undercover service. There are sealed access roads and car parking on two grade levels.
The 40 gaming machines are leased by the Tenant. The Tenant personally holds a gaming entitlement for each of the 40 machines. These could be sold on the open market or taken with the Tenant if it vacated the Epping Hotel. The Tenant had committed to purchasing the 40 gaming entitlements in May 2010. The Tenant also owns the various fixtures, fittings and equipment required to operate the business.
The Epping Hotel trades seven days a week. It has a licence to supply liquor
on the licensed premises on a 24-hour basis[8] with restricted trading on Good Friday and Anzac Day. For off-premises consumption it is licensed to trade between 7:00am and 11:00pm, with restricted trading on Sundays and Good Friday and Anzac Day.
[8]The licence condition is expressed as a licence to supply liquor for consumption on the licensed premises between 7:00am and 7:00am the following morning.
The Valuer noted that he had received submissions made on behalf of the Tenant to the effect that he should pay no regard to legislative changes to the Victorian gaming industry which came into effect on 16 August 2012, over six months after the review date. Those changes were anticipated to result in increased revenue streams to the operators of electronic gaming machines, including the Tenant.
The Valuer considered that it was appropriate for him to consider the legislative changes because, as at the determination date, it was known that the changes would come about albeit that they were to occur in the future. As he said in his valuation:
[T]hese changes as at the date of valuation were common knowledge in the gaming industry, indeed the Tenant had committed to purchase 40 gaming entitlements at auction in May 2010 and a 10% deposit had been paid. In my view this opinion is consistent with the definition of market rental which assumes both parties act knowledgeably and prudently. Accordingly I have determined a rental which takes into account that there is a period of 197 days from the 1st of February 2012 until the introduction of the new gaming structure on the 16th August 2012 and the effects of this new structure thereafter until the next market review which is due on the 1st of February 2017.
He then proceeded to explain his proposed use of an earnings-based methodology, EBIDTAR (earnings before interest, depreciation, taxation, amortisation and rent), for the valuation of the Epping Hotel. He said:
I refer to the long established valuation practice within the hotel industry which measures worth on the basis of net operating profit/EBIDTAR (earnings before interest, depreciation, taxation, amortisation & rent) whereby private financial arrangements are disregarded as these are not considered direct operating expenses. As a consequence Profit & Loss Statement inclusions such as interest on loans, depreciation, amortisation, leasing charges, hire purchase costs and taxation are excluded from the calculation of EBIDTAR.
He went on to explain that the EBIDTAR methodology required a valuer to disregard payments made by a tenant for capital purchases such as gaming machines and gaming entitlements. He said:
The issue in respect to the new gaming structure therefore arises in respect to the appropriate treatment of cost items incurred by the Venue Operator (in this situation the Tenant) which include:
·Professional/Consultancy advice in the lead up to the introduction of the new gaming structure;
·The cost of the gaming entitlements;
·The cost of gaming equipment;
·The costs associated with the operations of gaming which have been undertaken by the Gaming Suppliers: Tabcorp and Tattersall’s.
In my view the doctrine of EBIDTAR being the basis of value should continue to be observed and that costs and expenses incurred which relate to payments in respect of capital purchases should be disregarded in the assessment of EBIDTAR, this includes the following items:
·Payments in respect to gaming entitlements;
·Payments relating to the leasing of gaming equipment;
·Payments relating to loans advanced in respect of the new gaming structure.
The Valuer also took into account the potentially adverse effect upon the profits of the Tenant’s business of the public policy of pre-commitment (a policy not likely to take effect until after a study that might take years to complete), the removal of automatic teller machines from gaming venues and a prohibition on gaming machine advertising. He went on to state that he intended to apply an assumption of good average standard of management:
Hotel premises are, largely by the nature of their design, specialised improvements. It is my observation over many years that the industry measures value and rental on the basis of trading propensity and operational profitability, assuming good average standard of management. In my view, given this market norm, the current market rent for the Epping Hotel should be assessed on this same basis.
Therefore a significant component of this rental determination is the assessment of a reasonable trading level for the Epping Hotel.
He sought some independent verification of the trading results which was only possible in relation to gaming revenues as sourced from the website for the Victorian Commission for Gaming and Licensing Regulation (‘the VCGLR’). He looked at the actual expenditure reported by the VCGLR for each of the venues in the area where the Epping Hotel is located, the City of Whittlesea, including the Epping Hotel and multiple other hotels in the area and a bowls club. From this he calculated a figure for the turnover of a gaming machine at each venue based on an average player payback ratio of 90.5 per cent for the years 2010/11 and 2011/12.
The Valuer generated a five year trading forecast for the Epping Hotel based on the actual trading information provided; comments and information provided with the submissions made to him; comments provided by the Tenant during his inspection of the premises; and his ‘knowledge of trading outcomes of venues which are considered to have some comparability to the Epping Hotel’. He calculated the gaming revenue before and after the introduction of the legislative changes which would likely generate a greater stream of gaming revenue:
The gaming revenues adopted for the period 1st February 2012 to 15th August 2012 are $38,011 per week, thereafter gaming revenues are based upon a gross turnover per EGM [electronic gaming machine] of $5,320 which is reflective of VCGLR expenditure information inclusive of a 5.0% decrease to take into account the introduction of those prescriptive gaming measures as of 1st July 2012.
In explaining the rationale of the rental determination the Valuer emphasised that the profits method was the traditional method used for assessing market rental for hotels and that the Epping Hotel had revenue and profit forecasts that were ‘reasonable’. This assessment was not challenged. On the appeal, counsel for the Landlord relies on this assessment to suggest that it would be wrong to view the Epping Hotel as generating earnings reflecting an enhanced level of profitability due to the personal goodwill of a tenant (for example, the type of earnings that might be attributable to the proprietor of a hotel being a celebrity footballer) or to enhanced fixtures and fittings beyond the market norm (for example, futuristic electronic gaming machines beyond the market norm). The Valuer said:
Traditionally rental for hotel premises has been assessed in the market on the basis of turnover levels and perceived EBIDTAR levels, it being a basic underlying notion that the business’s capacity to pay is a major rental consideration. The trading cash flows assessed for the Epping Hotel reflect, in my view, a level of revenue and profitability forecasts which are reasonable as at the date of this determination.
He went on to refer to s 37(2) of the Act and the broad industry parameters used in calculating rental with respect to the percentage of gross sales that goes towards rent derived from different items, including bar sales, off premises sales, food sales, and so on. He said:
I refer to Section 37(2) of the Retail Leases Act which directs the Determining Valuer as follows; ‘ … 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.’ It is usual industry practice that the fixtures and fittings used in the operation of the business be held in the ownership of the Tenant and it is the Tenant’s responsibility to adequately maintain or if necessary replace such items.
It is also the market norm whereby the negotiation of a new lease agreement would also comprise the Tenant’s purchasing the Fixtures & Fittings plus the negotiation of a Rental. My review of transactional evidence suggests the following broad industry parameters have been applied in the assessment of rental:
Rental Approach
Rental Parameters
By Gross Turnover:
Bar Sales:
Off Premises Sales:
Food Sales:
Accommodation Sales:
Gaming Commissions:
Other Income:
7.0 to 9.0%
4.0 to 5.0%
7.0 to 9.0%
15.0 to 20.0%
16.0 to 18.0%
5.0 to 10.0%
By EBIDTAR:
EBIDTAR:
38.0 to 40.0%
This table indicates that, for example, if a valuer used the Gross Turnover rental approach then, based on transactional evidence, 7 per cent to 9 per cent of the gross turnover from bar sales would go towards rent, in accordance with broad industry parameters, as would 16 per cent to 18 per cent of the gross turnover from gaming commissions. On the alternative EBIDTAR rental approach the equivalent broad industry parameters would indicate that 38 per cent to 40 per cent of the EBIDTAR would go towards rent.
In alluding, opaquely, to the manner in which EBIDTAR is calculated, the Valuer made the following critical statement about a tenant’s fixtures and fittings:
It is pertinent to note that the future application by the Tenant of its owned Fixtures & Fittings is included in the rental assessment process, the market based rental ratios take this ownership into account so as to avoid double dipping.
I will call this in what follows ‘the critical statement’. The judge sought to explain the critical statement in his reasons. It was also the subject of much argument on the appeal. It is regrettable that the Valuer did not explain himself in clearer terms, spelling out with greater exactitude the methodology he had employed rather than using casual expressions such as ‘double dipping’ which are open to competing interpretations and do no more than invite argument.
The Valuer then took into account the changing legislative regime he had referred to earlier and noted that this would cause the rental ratio to change:
In a post 16th August 2012 market environment the operation of the new gaming structure will deliver a new set of trading parameters whereby (assuming constant gaming expenditures) revenues to venues will be increased due to the changed allocation and taxation regimes whilst operational expenses will increase due to the onus of gaming operations being the responsibility of the Venue Operator (not Tabcorp or Tattersall’s). Bearing this in mind it is a reasonable expectation that the rental ratio applied to gaming income will alter.
He also took into account the market uncertainties that might arise in the future, including the growth of internet-based gaming, the unknown cost of future gaming entitlements (the life-cycle being ten years), the risk of a reduction in gaming expenditure because of changes to legislation, and the policy of pre-commitment by users of electronic gaming machines, referred to above.[9] On the basis of these issues it was his opinion that in the post-16 August 2012 gaming environment, ‘the rental to EBIDTAR ratio should decrease’.
[9]See [24] above.
He was satisfied that evidence from the market for hotels confirmed the rental ratio he had identified in the table above for the pre-August 2012 period[10] and that adjustment was then necessary for the specific features of the Epping Hotel. He said:
Unlike typical rental premises, hotels are looked upon as a specific asset class. In this respect, I am satisfied that market rental evidence supports the rental ratios indicated earlier in respect of the pre 16th August 2012 period, and, it is the specific characteristics of the Epping Hotel which must be addressed herein. I have done so in the trading adopted.
In the post 16th August 2012 period I restate my view that the rental ratios need to be adjusted to take account of the changed way that gaming will be operated in hotel venues.
[10]See [28] above.
Ultimately the Valuer decided to apply a 38 per cent rental ratio to the EBIDTAR for the Epping Hotel for the period up to 15 August 2012 and a decreased rental ratio of 34 per cent to the EBIDTAR for the period from 16 August 2012 onwards:
I have determined to assess the current market rental for the Epping Hotel via the application of a 38.0% rental ratio to the EBIDTAR assessed for the trading period 1st February 2012 to 15th August 2012 and a 34.0% rental ratio to the EBIDTAR assessed for the period post 16th August 2012. My calculations which take into account the annual rental increases are detailed as follows:
Year End
31 January
EBIDTAR
Assessed
Column 1
Assessed Rental
Column 2
Adopted Rental
2013
$1,466,115
$519,252
$631,914
2014
$2,047,871
$696,276
$647,712
2015
$2,050,734
$697,249
$663,905
2016
$2,063,999
$701,760
$680,503
2017
$2,079,449
$707,013
$697,515
Total
$3,321,550
$3,321,550
The Valuer concluded that the current market rental for the Epping Hotel as at 1st February 2012 was $631,914 per annum plus GST and the current market rental inclusive of GST was $695,106 (collectively, ‘the market rental determination’).
Serene Hotels challenged the market rental determination before the Victorian Civil and Administrative Tribunal (‘the Tribunal’) on the basis that the Valuer had failed to apply the criteria as set out in s 37(2) of the Act.
The Tribunal’s reasons
The Tribunal found that the Valuer had failed to apply the criteria in s 37(2) of the Act and that he had thereby misconceived the task required of him by the terms of the lease.[11] The Tribunal held that the parties were not bound by the market rental determination.
[11]Serene Hotels Pty Ltd v Epping Hotels Pty Ltd (Retail Tenancies) [2014] VCAT 97 (‘Tribunal’s reasons’).
The Tribunal noted that there was no reference in the valuation to the protest by the Tenant that although he provided profit and loss statements for the relevant years, he had submitted to the Valuer that, in light of s 37(2) of the Act, the Valuer should be cautious in using the Tenant’s own trading figures and that he should first consider the rent and conditions of any comparable retail premises. The Tenant had submitted that the Valuer should not consider the Tenant’s trading figures because, as he said:
[S]ection 37(2)(b) [of the Act] provides that one of the matters to be taken into account is the rent that would be reasonably expected to be paid for premises if they were unoccupied … If you were to assume that premises were unoccupied, there would be no trading figures to consider.[12]
[12]Tribunal’s reasons [26].
The Tribunal seized on the critical statement and held that the Valuer had erred because he took into account the Tenant’s fixtures and fittings when he was obliged by s 37(2) not to take them into account. The Tribunal said:
In my view, it is very clear from the statements in the valuation report that the rent determination is founded on the Applicant’s [the Tenant’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.[13]
[13]Ibid [39] (emphasis as in original).
The Tribunal rejected the Landlord’s view that the methodology employed by the Valuer is consistent with the purpose of the Act to strike a fair balance between landlords and tenants or to secure a fair and reasonable estimate of the rent that would be paid if the premises were let on the open market. He held that the methodology employed was directly contrary to the Act. He said:
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 s 37(2) of the Act allows the methodology employed by the Valuer. I am satisfied that the Valuer has, contrary to the requirement in s 37(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.[14]
[14]Ibid [41].
He also found that the Valuer had erred by failing to treat the premises as if they were unoccupied. It is the Tenant who owns the fixtures and fittings and leases the gaming machines and, he held, by taking into account those matters the Valuer was not arriving at a valuation that presumed the premises were unoccupied:
It is clear that the Valuer has assumed that a hypothetical willing tenant will acquire the Applicant’s business, inclusive of the fixtures and fittings and gaming machines and gaming entitlements. While that may not be an unreasonable assumption, the Applicant submits that the assumption, taken into account by the Valuer in reaching the rent determination, is offensive to the requirement in s 37(2)(b) of the Act that the Valuer must have regard to the rent that would be reasonably expected to be paid if they [the premises] were unoccupied. The submission has merit.
The plain meaning of unoccupied premises is that the premises are not occupied by the Applicant, or any other tenant. As the Applicant owns the fixtures and fittings and leases the gaming machines the use of which is dependent on the gaming entitlements held by the Applicant, it follows that the premises unoccupied will not include the Applicant’s fixtures and fittings or the gaming machines.[15]
[15]Ibid [43]-[44] (emphasis as in original).
He rejected the view that s 37(2) identifies exhaustively and exclusively all the considerations that a valuer must take into account. He said:
By sub-section 37(2)(b), the Valuer must have regard to 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. Save that the Valuer must:
–consider the rent that might be paid for the premises unoccupied and offered for lease for the same or similar use; and
–not take into account the value of the goodwill created by the sitting tenant’s occupation or the value of the sitting tenant’s fixtures and fittings,
section 37(2)(b) does not, in my view, set a boundary on matters that the Valuer may consider.[16]
[16]Ibid [49].
He considered that the Valuer was entitled to take into account the effect of the future legislative changes because such foreshadowed changes can affect the rent obtainable in an open market. However, he considered that, insofar as the Valuer calculated the effect the legislative changes would have on the Tenant’s trading figures, this was a component of the same error of founding the market rental determination on the Tenant’s trading figures which necessarily, and wrongly, included the value of the Tenant’s fixtures and fittings.[17]
[17]The Tribunal also concluded that the Valuer had ignored a relevant consideration, namely, whether there were any rent concessions or other benefits offered to prospective tenants of unoccupied retail premises. This factor, identified in s 37(2)(d) of the Act, was not mentioned in the Valuer’s reasons. The Landlord sought to tender a subsequent letter from the Valuer, dated 18 October 2013, responding to a request from the Landlord, in which the Valuer commented that rent concessions and other benefits are not typically offered to prospective tenants of unoccupied premises. The Tribunal held that although the Act did not suggest that a valuer should be confined to one document only, he considered that it would be unfairly prejudicial to the Tenant to pay any regard to the Valuer’s subsequent letter. This matter was not in issue in the appeal.
The Landlord sought leave to appeal from the Tribunal’s order that the parties are not bound by the market rental determination, pursuant to s 148 of the Victorian Civil and Administrative Tribunal Act 1998 (‘the VCAT Act’). Leave was granted[18] and
[18]Leave was granted by Mukhtar AsJ on 20 October 2014.
the appeal[19] was heard by a judge of the Trial Division.
[19]In fact there were two appeals before the judge, an appeal by the Landlord against the orders of the Tribunal and an appeal by the Tenant against the grant of leave by Mukhtar AsJ on the ground that the issues raised were not questions of law as was required by s 148 of the VCAT Act. The judge dismissed the appeal against the orders of Mukhtar AsJ and there is no challenge to that dismissal.
The judge’s reasons
The judge allowed the appeal against the Tribunal in full.[20]
[20]Reasons [106].
He rejected the view that the Act does not allow the methodology employed by the Valuer. He held that the Valuer was permitted to adopt the profits method of calculating market rental based on the Tenant’s trading accounts. Furthermore, he held that the Valuer did not impermissibly take the Tenant’s fixtures and fittings into account.
He first addressed what was described as Question 1, namely, ‘Whether the Tribunal erred in finding that the Act does not allow the methodology employed by the Valuer’. In holding that the Tribunal did so err, the judge emphasised that the profits method, whereby the trade actually carried out on the premises is taken into account, has been considered permissible in many cases, including Cartwright v The Guardians of the Poor of the Sculcoates Union in Kingston-upon-Hull[21] where Lord Macnaghten said:
What the learned arbitrator has done is to take into consideration the amount of business which this public-house was doing. Was he wrong in that? Surely the very first thing that a tenant who was going to offer for a house of this sort would do would be to consider (roughly if he could not do it accurately) what amount of business the house commanded. It appears to me that the volume of business done in a public-house, as apparent to the man in the street — if I may use such an expression — is the very first thing that a tenant proposing to make an offer for such a house would take into consideration.[22]
[21][1900] AC 150 (‘Cartwright’).
[22]Ibid 153 (as extracted in the Reasons [31]).
To similar effect, Lord Davey said:
You have in each case to find out in the best way you can what is the rent which a tenant may reasonably be expected to give, and if the best way under the particular circumstances is to ascertain the use which a tenant might expect to be able to make of the premises, the facility afforded by the premises for the carrying on of a trade appears to me to be a primary and elementary consideration in the case. If you are to take into account the fact that the premises command a trade, you must surely ask what trade. Is it a large trade, or a small trade? And I do not know myself any better test of what trade they may be expected to command than the trade which they actually do command. It is not that you rate the profits, it is not that you rate the man’s skill and judgment or discretion in the mode of carrying on the business, but you have to ascertain what sort of a trade the hypothetical tenant, as he is called, may reasonably expect to be able to carry on on those premises as an element in determining the rent he would be willing to offer.[23]
[23]Ibid 159 (as extracted in the Reasons [31] emphasis added).
The judge noted that Cartwright had been applied in Australia.[24] He considered other authorities[25] and commentaries[26] as supportive of the methodology employed here by the Valuer, and said:
In my view, the authorities and commentaries which have been discussed provide more than an adequate basis for the view that the Valuer has, in the present circumstances, in conducting a rental valuation of hotel premises, approached his task with a methodology and reasoning process which has a firm foundation in the general law as being appropriate. Moreover, this position is, in my view, further confirmed when consideration is given to the nature of the, so-called, ‘profits method’, as has been applied and endorsed in the authorities and commentaries. [27]
[24]R v Devonport; Ex parte Ferrall [1949] Tas SR 165, 170. See also Cooper v City of Perth [1961] WAR 112, 115.
[25]Harewood Hotels Ltd v Harris [1958] 1 WLR 108; Cooper v City of Perth [1961] WAR 112; W JBarton Ltd v Long Acre Securities Ltd [1982] 1 WLR 398; Modick RC Ltd v Mahoney [1992] 1 NZLR 150; South Tyneside MBC v Wickes Building Supplies Ltd [2004] EWHC 2428 (Comm).
[26]For example, Kirk Reynolds and Guy Fetherstonhaugh, Handbook of Rent Review, vol 1 (Sweet & Maxwell, at Service 60, November 2013)
[27]Reasons [40].
The judge set out the three-step approach to a ‘profits method’ of valuation endorsed by Hill and Redman’s Law of Landlord and Tenant[28], an approach that looks first at earnings or income; secondly, deducts operational expenses; and thirdly acknowledges that what is left over is available for the payment of rent. The third category calls for an assessment of an appropriate portion of the amount available as a sum that an incoming hypothetical tenant would be willing to pay. As his Honour said:
[28]Hill and Redman’s Law of Landlord and Tenant (LexisNexis, Online Loose-leaf Service) (‘Hill and Redman’).
The nature and rationale of the ‘profits method’ is concisely stated by Hill and Redman, as follows:
The concept which underlies the profits method of valuation is easy to describe. Essentially, there are three steps in the process.
(a)An estimate is made of the income from the business. In the case of a hotel this will mean that an estimate is made of the likely income from such sources as the letting of rooms, the restaurant and bars and ancillary functions such as holding conferences or running a health club. In the case of a casino an estimate will be made of the amount which members of the club will gamble and how much will be retained by the operators.
(b)An estimate is then made of the various expenses and outgoings involved in the operation of the premises. To take again a hotel as an example there will be staff expenses, purchases of items such as food and drink, and outgoings such as fuel, rates, insurance and advertising.
(c) The difference between the income and the running costs is the net profit. This amount is available for the payment of rent. The final step is therefore to decide what proportion of the net profit should be taken as that which the willing lessee would be willing to pay as rent.[29]
[29]Reasons [40] quoting Hill and Redman [2383] (emphasis as added below).
To foreshadow what I discuss below, in my view the EBIDTAR methodology achieves the same outcome as the three-step process described by Redman and Hill and the rental ratio is ultimately the assessment of what proportion of the sum available for the payment of rent should be taken as that which the willing hypothetical incoming tenant would be wiling to pay. The rental ratio recognises that the sitting tenant will have generated the earnings it has by reason of its fixtures and fittings, amongst other things, but, where the ratio is based on an assumption of average standard management in comparable premises, and therefore average fixtures and fittings, this is not impermissibly to take the sitting tenant’s fixtures and fittings into account which is the mischief which s 37(2) is directed at avoiding.
The judge went on to endorse a further extract from Hill and Redman:
A willing lessee of premises such as a hotel would be likely to be faced with substantial initial expenditure. The rule … that all tenant’s fixtures are taken to be removed means that the incoming lessee would have to provide items such as bedroom furniture and equipment for the restaurant and common parts. When a comparables method of valuation is used, it is not usually necessary to do a calculation of initial fitting out costs since the need to fit out the premises will be a factor already taken into account in the rent agreed or determined for the comparables. The use of the profits method entails the cost of fitting out and similar work being brought into the calculations since it is a cost which will be borne by the lessee to make a profit. The usual means of paying regard to this aspect of the operation is to estimate the capital cost involved and then to rentalise it over the period of the expected life of the equipment. The annual or rentalised sum will then be an item of expenditure to be put into the notional accounts. A similar process would be necessary if a willing lessee would expect to carry out improvements to the premises.[30]
[30]Hill and Redman [2387], as quoted in the Reasons [40] (emphasis as added below).
The judge noted that the Tenant had submitted that the passages from Hill and Redman extracted above[31] indicate that it is necessary to make an express capital cost adjustment when adopting the ‘profits method’. He rejected that view. He said:
As discussed, the authorities to which reference has been made do, in my view, indicate that the Valuer’s methodology and reasoning would, as a matter of general law, be regarded as uncontroversial and in conformity with valuation law and practice with respect to hotel premises. Although the ‘profits method’ which the Valuer has applied differs in a number of respects from that described in Hill and Redman’s Law of Landlord and Tenant, the differences are merely in the technique or process applied to achieve the same outcome — which is to ensure that the value of the tenant’s fixtures and fittings is not taken into account in the calculation of current market rent.[32]
[31]See [51] and [53] above.
[32]Reasons [44] (citations omitted).
Critically, the judge concluded that s 37(2) does not demand that a sitting tenant’s fixtures and fittings are simply to be ignored. Rather, it is consistent with s 37(2) to adopt a profits method and recognise that the earnings generated by a tenant will be attributable, in part, to a tenant’s fixtures and fittings, so long as the value of the tenant’s fixtures and fittings is not reflected in the rent. This can be done by ensuring that the extent to which the tenant’s fixtures and fittings generate the earnings is ‘cancelled out’ when making the final calculation of rent. In an important passage, the judge said:
As Hillman and Redman indicate, this does not mean that the value of fixtures and fittings that may be required for the generation of profit through the conduct of the hotel business are necessarily excluded from the calculations required to estimate the current market rent. What it does mean is that the value is treated in the calculations in such a way that, as between the notional prior and future tenant, the value is in effect ‘cancelled out’ so that the future tenant is not advantaged or disadvantaged in the rental calculation as a result of the prior tenant’s expenditure and ownership of the fixtures and fittings. Clearly, in my view, this is the objective and meaning of the provisions of s 37(2) of the Act which are relevant to this proceeding.[33]
[33]Ibid [45] (emphasis added). This passage was criticized on the appeal. I discuss the criticism at [76] below.
On this approach the error of law committed by the Tribunal was to treat the mere reference by the Valuer to the tenant’s fixtures and fittings as something to which he had regard[34] as impermissibly taking into account those fixtures and fittings in contravention of s 37(2). As the judge sought to explain, s 37(2) does not prohibit a method that includes within the calculation a value for a tenant’s fixtures and fittings providing that the value of those fittings and fixtures is cancelled out in arriving at the appropriate figure representing the market rental.
[34]See [40] above.
The judge pointed to the ambiguity in the words not to ‘take into account’ in s 37(2) and their failure to identify with any exactitude the nature and extent to which the value of the tenant’s fixtures and fittings are to be ignored. However, he accepted that the words, by their ambiguity, also allowed for flexibility in the methodology adopted. He said:
[T]he words ‘take into account’ are ambiguous in the context in which they are used in s 37(2) of the Act. The ambiguity arises because these words, as used in the context of these provisions, do not specify with any clarity or particularity the nature and extent of the ‘disregard’, for rental valuation purposes, to be applied with respect to the values of fixtures and fittings. This is not a criticism of the legislation having regard to the varying approaches properly adopted by valuers in varying circumstances with respect to different types of premises. Indeed the authorities to which reference has been made illustrate the importance of this flexibility, and its acceptance and recognition at general law. Thus … these provisions, properly construed, … do allow the Valuer to assume the existence of the tenant’s fixtures and fittings for the purpose of the so-called ‘profits method’, provided that the value of those fixtures and fittings is treated in the calculations in such a way that the value is in effect ‘cancelled out’.[35]
[35]Reasons [61].
The judge was ultimately persuaded by the Landlord’s submissions. Having explained what propositions he took from Hill and Redman,[36] he said:
[36]See [53] and [55] above.
On this basis, I accept the position as put by the [Landlord]:
31. The Tribunal erred … in that:
(a)s 37(2) of the … [Act] requires the specialist retail valuer to assume the Premises is unoccupied and to disregard the value of the tenant’s fittings and fixtures;
(b)however, s 37(2) also requires the specialist retail valuer to assume there is a willing tenant bidding on the retail premises. In order to make good that assumption, the specialist retail valuer must posit certain attributes to the hypothetical tenant;
(c) in assessing the market that would bid on the lease, the specialist retail valuer concluded that the hypothetical bidder for the lease would be the operator of a hotel and gaming venue. That conclusion has not been criticised (nor could it be);
(d)the specialist retail valuer considered the sitting tenant’s earnings before interest, taxation, depreciation, amortisation and rent (EBITDAR). By using EBITDAR (and not some other figures) the specialist retail valuer excluded the acquisition costs of the sitting tenant’s gaming machines and gaming entitlements from the rental determination. It follows that the specialist retail valuer has assumed that the hypothetical tenant is leasing an empty shell and has acquired its own gaming machines and gaming entitlements;
(e)contrary to the Tribunal’s findings at para 39, the phrase ‘[i]t is pertinent to note that the future application by the Tenant of its owned Fixtures and Fittings is included in the rental assessment process …’ does not indicate that the specialist retail valuer has failed to disregard the sitting tenant’s fittings and fixtures. That phrase shows that the specialist retail valuer has assumed that the hypothetical tenant will derive its income from fittings and fixtures that it owns, not from the sitting tenant’s fittings and fixtures. This is precisely what s 37(2) requires the specialist retail valuer to do, ie to disregard the sitting tenant’s fittings and fixtures and assume that the hypothetical tenant will lease a bare shell;
(f)the Tribunal attached significance at paragraphs 43-44 of its reasons to the assumption by the valuer that the hypothetical tenant would acquire the sitting tenant’s gaming machine and entitlements. However, this is merely a convenient hypothesis that does not affect the rental determination as the acquisition costs (ie depreciation, amortisation, interest or letting costs) are excluded from the figures that the specialist retail valuer considered. This proposition can be tested by assuming that the hypothetical tenant either:
i. brings its own gaming machines to the leased premises;
ii. borrows to buy gaming machines; or
iii. leases gaming machines.
Either way, the figures considered by the specialist retail valuer would be the same, that is, the hypothetical tenant’s projected EBITDAR. It follows that the specialist retail valuer has both assumed a willing tenant and excluded the value of the tenant’s fittings and fixtures;
(g)the steps taken by the specialist retail valuer to exclude the value of the tenant’s fittings and fixtures are different to the process suggested in the extracts referred to above from … [Hill and Redman’s Law of Landlord and Tenant]. … [T]he authors suggest that up-front costs would be ‘rentalised’ over the life of the lease … . The effect of this approach is to spread the tenant’s set-up costs across the life of the lease (ie a large cost up front is defrayed over the life of the lease). The same is achieved by the specialist retail valuer in this case by projecting the hypothetical Tenant’s EBITDAR for the new term. Rather than defraying the costs across the life of the lease, they are simply taken out of the equation altogether. Either way, it is clear that the specialist retail valuer turned his mind to the exclusion of the value of the tenant’s fittings and fixtures and completed his task in accordance with the contract; and
(h)by contrast, to examine the sitting tenant’s rent as a percentage of its earnings after depreciation, interest and amortisation, and then apply that same percentage to the hypothetical tenant’s EBITDAR would inflate the rent payable in the new term and fail to disregard the value of the sitting tenant’s fittings and fixtures.
32.Accordingly, the specialist retail valuer disregarded the value of the tenant’s fittings and fixtures and properly assumed that the premises was unoccupied.[37]
[37]Reasons [46] quoting from the Plaintiff’s Outline of Submissions (24 December 2014), [31]–[32] (with emphasis as in original Outline)(citation omitted). The Submissions refer to ‘EBITDAR’ rather than ‘EBIDTAR’ transposing taxation and depreciation.
The judge’s reliance upon the Landlord’s submissions, to the extent of having adopted the Landlord’s position in precisely the terms as set out by the Landlord in its written submissions before him, is challenged on the appeal as tantamount to failing to consider the Tenant’s position. I discuss this issue below.[38]
[38]See [78]–[80] below.
Question 2 posed for his Honour was: ‘Whether the Tribunal erred in determining that the Valuer has, contrary to the requirements in s 37(2) of the Act, taken into account the value of the Defendant’s fixtures and fittings, and in so doing the Valuer has fundamentally misconstrued his task’. He held that the Tribunal had erred for the reasons he gave in response to Question 1. He said:
For the preceding reasons with respect to Question 1, Question 2 must also be answered in the affirmative. The Tribunal erred in determining that the Valuer had taken into account the value of Serene’s fixtures and fittings because the methodology adopted effectively ‘cancels out’ that value.[39]
[39]Reasons [68]. Question 3 (which was not separately in issue in the appeal) was formulated as follows: ‘Whether the Tribunal was made to understand the elements of the methodology applied by the Valuer; that is, whether it was right, without more, to seize upon the language of his report concerning the future application by the Tenant of its owned fixtures and fittings as manifestly demonstrating an approach in violation of the Act’. The judge held (at [70]) that the Tribunal ‘in finding that s 37(2) did not allow the methodology applied by the Valuer, … was not made to understand the elements of that methodology and appears to have taken certain statements in the Rental Determination out of context. In any event, as indicated in the preceding reasons, the methodology adopted and applied by the Valuer does not offend the Act’. Question 4 was: ‘Whether the Tribunal erred in deciding that it was able to disregard the Supplementary Report’. As discussed at n 17 above the judge held that the Tribunal erred in deciding that it was able to disregard the Supplementary Report.
The grounds of appeal
The Tenant challenges the judge’s determination on the basis of three grounds of appeal:
1.The learned trial judge erred in failing to find that as the EBIDTAR methodology adopted by the valuer assumed that all of the sitting tenant’s fixtures and fittings and chattels are in situ to generate income for the EBIDTAR calculation then, in order to comply with the obligations in section 37(2) of the Retail Leases Act 2003 to value the current market rent on the basis that the premises are unoccupied and without taking into account the value of the sitting tenant’s fixtures and fittings, it was necessary for the valuer in determining the current market rental to expressly adjust the EBIDTAR by debiting a sum to allow for the hypothetical in-coming tenant’s costs of acquisition of the sitting tenant’s assets determined as the value of the sitting tenant’s assets as at the rent review date or, alternatively, a rentalized sum.
2.The learned trial judge erred in finding as a general and a specific proposition that the value of the sitting tenant’s and Applicant’s fixtures and fittings and chattels was ‘cancelled out’ by application of the EBIDTAR methodology (without any express adjustment) and therefore did not contravene section 37(2) of the Retail Leases Act 2003.
3.The learned trial judge in his reasons for Judgment adopted and incorporated the Respondent’s submissions founding the ‘cancelling out’ proposition without discussion, explanation or discrimination and in doing so erred in:
(a)failing to consider and adopt the Applicant’s submission distinguishing the Respondent’s submission (as reproduced with approval in the Judgment at [46], sub-paragraph 31(f)) on the basis that the valuer in his valuation did not assume that the hypothetical in-coming tenant would bring its own assets to the premises to generate income for the EBIDTAR calculation but expressly assumed that all of the Applicant’s existing fixtures and fittings and chattels would be sold to the hypothetical in-coming tenant and therefore must be taken into account by an express adjustment to allow for the acquisition costs of the Applicant’s fixtures and fittings and chattels;
(b)failing to consider and adopt the Applicant’s submission distinguishing the Respondent’s submission (as reproduced with approval in the Judgment at [46], sub-paragraph 31(g)) on the basis that the valuer had not offset the hypothetical in-coming tenant’s acquisition costs by projecting EBIDTAR over a five year term but in fact had adopted the projection solely for the purpose of allowing for increased gaming revenue as a result of legislative changes to the gaming industry;
(c)failing to consider the Applicant’s submission distinguishing the Respondent’s submission (as reproduced with approval in the Judgment at [46], sub-paragraph 31(g)) on the basis that the valuer’s failure to account for the hypothetical in-coming tenant’s acquisition costs in the valuer’s determination did not constitute compliance with section 37(2) of the Retail Leases Act 2003 by taking the assets ‘out of the equation altogether’ but in fact founded the contravention of the section.
The first two grounds challenge the use by the Valuer of an unadjusted EBIDTAR methodology. They are necessarily inter-related and I will deal with them collectively before turning to the third ground which alleges that the judge failed to take into account certain of the Tenant’s submissions.
The Landlord also relied upon a Notice of Contention seeking to diminish the significance of any error made by the Valuer:
Any error in the specialist retail valuer’s determination identified by the applicant/appellant is an error in process and does not vitiate the determination.
Is the EBIDTAR methodology consistent with s 37(2) or does it require adjustment?[40]
[40]Grounds 1 and 2 of the grounds of appeal.
On the appeal the Tenant seeks to put its argument in a variety of ways. The Tenant submits that a valuer is required to value the rental on the basis that the incoming tenant will negotiate for a ‘bare bones’ premises (save for the landlord’s fixtures) and therefore must expressly exclude from his or her calculations the value and any benefit derived from the sitting lessee’s fixtures, fittings and chattels and also any improvements which contribute to the lessee’s personal goodwill. It submits that the EBIDTAR methodology assumes that all income-earning assets are in situ to generate the income which the valuer determines as part of the EBIDTAR calculation but, by definition, excludes from the calculation of the notional net profit (the EBIDTAR) the costs and expenses of the acquisition of the underlying capital assets. Its argument is that as a general proposition, the EBIDTAR methodology will contravene s 37(2) of the Act if:
(a) the net profit is calculated from the sitting tenant’s trading figures, as the EBIDTAR calculation will assume that the net profit is generated from the sitting tenant’s income-producing assets in situ; or
(b) if the valuer (expressly or impliedly) assumes for the purpose of the EBIDTAR calculation that the sitting tenant’s assets are in situ; and
(c) the valuer does not make a further adjustment to the EBIDTAR or does not apply a discount prior to the valuer determining what proportion (as a percentage) of EBIDTAR the hypothetical tenant would pay as the notional rent which reflects the actual value of the sitting tenant’s fixtures, fittings and chattels as at the date of the relevant rent review.
Applying these principles here, the Tenant submits that the Valuer calculated the EBIDTAR from the Tenant’s trading figures and therefore the Valuer assumed that the Tenant’s assets (particularly the gaming machines and entitlements) are in situ to generate the net profit (EBIDTAR) on which the rental valuation is based. The Valuer expressly assumed that the hypothetical incoming tenant would purchase the Tenant’s assets, including the 40 gaming entitlements and the gaming machines. The Tenant submits that the Valuer wrongly made no adjustment to the EBIDTAR calculation, nor an adjustment after the EBIDTAR had been determined, to discount the value of the Tenant’s assets (being the notional purchase cost) as at the relevant rent review date, 1 February 2012.
In challenging the ‘cancelling out’ hypothesis the Tenant further submits that if the ‘cancelling out’ proposition is based on the assumption that an incoming tenant’s acquisition costs of the sitting tenant’s assets are somehow taken into account by the EBIDTAR methodology and offset, then the proposition is erroneous as the EBIDTAR entirely ignores capital costs and expenses. The Tenant submits that here the Valuer’s detailed EBIDTAR calculations do not make any allowance for the costs of the acquisition of the Tenant’s assets. The Tenant submits that it is because the EBIDTAR calculations do not make any allowance for the costs of acquisition of the Tenant’s assets that an express adjustment ought to have been made by the Valuer.
Ultimately all the Tenant’s submissions converged on the proposition that the EBIDTAR methodology is flawed, and ought not to have been used by the Valuer without adjustment. The adjustment suggested is a one-line capital expenditure deduction from the earnings of the Epping Hotel to reflect the value of the Tenant’s fixtures and fittings in order that the value of those fixtures and fittings can be expressly excluded from the calculation before the rental ratio is applied. This form of adjustment, by means of a deduction from earnings, was employed by the valuer for the Adelaide City Council in Skycity Adelaide Pty Ltd v Valuer-General.[41] Without such an adjustment, the Tenant submits, the EBIDTAR methodology is inconsistent with s 37(2) of the Act.
[41](2009) 168 LGERA 332 (‘Skycity’).
It is significant that the Tenant does not argue that s 37(2), and its prescription that the current market rent ‘is not to take into account’ either the value of a tenant’s goodwill or the value of a tenant’s fixtures and fittings, does not mean that a valuer is prohibited from having regard to the value of a tenant’s goodwill or the value of its fixtures or fittings. Although, as mentioned above, the Tenant’s submissions are at times put in the form of arguing that a valuer must consider the demised premises to be ‘a bare bones’ premises, and that a tenant’s fixtures and fittings are to be ‘excluded’ from the calculation for market rent,[42] it is not argued that the statutory prescription under s 37(2) means that a valuer must ignore a tenant’s fixtures and fittings as though they did not exist; nor is a valuer to make no mention of a tenant’s fixtures and fittings in a valuation. The Tenant does not contend that s 37(2) creates an absolute prohibition. Rather, the Tenant submits that the prescription under s 37(2) can be satisfied where a valuer expressly makes mention of a tenant’s fixtures and fittings in a valuation and expressly provides an adjustment, by way of deduction from the earnings, that reflects the value of a tenant’s fixtures and fittings.
[42]See [64] above.
Given this approach, the Tenant must accept that the judge was correct to observe that s 37(2) fails to identify with any exactitude the nature and extent to which the value of a tenant’s fixtures and fittings are to be ignored.[43] The question then becomes: what is the nature and extent of the ‘disregard’ of a tenant’s fixtures and fittings prescribed by s 37(2)? In particular, was the judge correct to conclude that the calculation performed by the Valuer was consistent with s 37(2) because it ‘cancelled out’ the value of the Tenant’s fixtures and fittings?
[43]See [57] above.
In my view, the judge was correct to conclude that the methodology adopted by the Valuer, although it indirectly had regard to the Tenant’s fixtures and fittings by taking into account the earnings made by the Tenant, ‘cancelled out’ that regard. The ‘cancelling out’ occurred with the adoption of a rental ratio that, as the Landlord submits, ‘allows for’ a deduction of the value of the market average of fixtures and fittings. As is reflected in the third and final step in making a determination of current market rental described by Hill and Redman, from the available balance of the net earnings remaining after operational expenses it is necessary ‘to decide what proportion of the net profit should be taken as that which the willing lessee would be willing to pay as rent’.[44] That proportion is what the Valuer described as the rental ratio; this was based on market norms of what a willing lessee would be willing to pay as rent. Importantly, the rental ratio takes account of the need also for the willing lessee to acquire the fixtures and fittings of the existing tenant. As the Valuer said, ‘[i]t is also the market norm whereby the negotiation of a new lease agreement would also comprise the Tenant’s purchasing the Fixtures & Fittings plus the negotiation of a Rental’.[45] By ‘the Tenant’ in this extract the Valuer is referring to the hypothetical future tenant. The rental ratio chosen here reflects or allows for a market norm with respect to average fixtures and fittings.
[44]See [51] above.
[45]See [28] above.
In my view, the choice by the Valuer of the pre-August 2012 rental ratio of 38 per cent reflected the proportion of the Tenant’s earnings (calculated in accordance with the EBIDTAR methodology) which the willing lessee would be willing to pay as rent discounting, on a market norm basis, the notional acquisition of the Tenant’s fixtures and fittings (conceived of as average fixtures and fittings) in a manner that cancelled out the impact of those fixtures and fittings upon the Tenant’s earnings. Moreover, because the Tenant has not challenged the assumption of average good management and trading at reasonable levels, the Tenant is not in the position of having to pay more rent because of its specific fixtures and fittings (including the gaming machines and gaming entitlements); it is not in the position of having to pay more rent because of things it had done.[46] The unfairness that s 37(2) is intended to prevent is a windfall rent being paid to a landlord because of the particular qualities of the fixtures and fittings of a tenant, or personal goodwill. The methodology of the Valuer, applied to the circumstances here, avoided any such windfall.
[46]See [8] above.
Two important observations should be emphasised. One is that the rental ratio here was based on an assumption of good average standard management. As mentioned above, the Valuer made explicit his assumption that ‘a significant component of this rental determination is the assessment of a reasonable trading level for the Epping Hotel’[47] and the assumption of ‘reasonableness’ was not challenged. This assumption meant that it was permissible for the Valuer to approach the determination of the current market rental for the Epping Hotel on the basis that the Tenant’s fixtures and fittings reflected the market norm. This enabled the Valuer to rely upon transactional evidence and broad industry parameters. There was no celebrity factor, or enhanced fixtures and fittings above the market norm, that would have boosted the Tenant’s EBIDTAR beyond the market norm. Had there been such factors, in my view, to maintain consistency with s 37(2), this would have precluded reliance upon broad industry parameters and this would have driven down the proportion of the EBIDTAR that the willing lessee would be willing to pay as rent. However, there was here no evidence of matters of an exceptional kind that should have reduced the rental ratio to a percentage below the market norm.
[47]See [24] above.
The second important observation to make is that it is not often the case that other things will be equal. The Valuer quite properly recognised that there was a multitude of risks that had to be taken into account in the post-August 2012 gaming environment (including the influence of internet gaming and so on) and to reflect those matters a lower rental ratio had to be applied (34 per cent).
A valuation of current market rent is a sophisticated and multi-dimensional exercise. As mentioned at the outset, s 37(2) does not mandate any particular methodology. To be consistent with s 37(2) it is sufficient that the methodology employed ensures that any regard paid to fixtures and fittings is only regard paid to market norms providing that the assumption of average good management and reasonable trading levels is well founded and there is no celebrity factor or enhanced or high-end fixtures and fittings.
In my view, the methodology employed by the Valuer did not result in the Tenant suffering a rent increase by reason of the Tenant’s own improvements. I consider that the judge was correct to conclude that the methodology employed by the Valuer is consistent with s 37(2).
Finally, on this issue, I note that at the hearing of the appeal the passage of his Honour’s judgment set out above[48] was criticised by the Tenant on the basis that the roles of the ‘future tenant’ and ‘prior tenant’ should be reversed. In my view, the judge was correct in his references to the ‘future tenant’ and the ‘prior tenant’. The question to be addressed in this context is what is the current market rental of the demised premises which, once established, will be for the hypothetical future tenant to pay in the future. Given that the hypothetical future tenant will often be, as here, also the actual sitting tenant the question is what rent should the sitting tenant pay in the future. The purpose of s 37(2), as explained above,[49] is to ensure that the sitting tenant does not pay a higher rental in the future than it has paid in the past because of improvements it has made during the period of its previous tenancy, those improvements being reflected in the earnings. That is the nub of where the unfairness lies. However, for that unfairness to be avoided it is necessary to ensure, as the judge said, that the future tenant (in other words, the sitting tenant in the future) is not advantaged or disadvantaged in the rental calculation as a result of the prior tenant having improved the premises and enhanced the earnings obtained from the premises.
[48]See [55] above.
[49]See [8] above.
I reject grounds 1 and 2 of the grounds of appeal.
Did the judge ignore Serene’s submissions?[50]
[50]Ground 3.
The Tenant complains that the judge did not elaborate upon the ‘cancelling out’ proposition but relied upon a lengthy extract from the Landlord’s submissions.[51] It complains that, in doing so, the judge did not identify the numerous criticisms the Tenant made of the Landlord’s submissions.
[51]See [58] above.
I do not agree that the judge ignored the Tenant’s submissions. It is apparent from the broad discussion in which the judge engaged with respect to the authorities and the commentaries that he was alive to all the issues raised by the Tenant. While it is not advisable for a judge to set out in detail one party’s submissions and then to adopt the reasoning in the submissions in substitution for his or her own deliberations because this fails to demonstrate that the judge has engaged with the issues, in my view the reasons of the judge make it more than apparent that he did not do this but rather he engaged and grappled with all the issues raised. Indeed, it was only after carefully setting out his own deliberations[52] that the judge turned to the summary of points submitted by the Landlord to indicate that he accepted them. He stated that he accepted them ‘on this basis’ referring back to his own reasoning as providing the foundation upon which the Landlord’s submissions should be accepted.
[52]See [48]–[57] above.
I reject ground 3 of the grounds of appeal.
If there was an error, was it an error in process?[53]
[53]Notice of Contention.
Given the conclusions I have reached, it is unnecessary to consider the Notice of Contention. There was no error in the methodology employed by the Valuer.
Conclusion on the application for leave and on the appeal
The issues raised by this proceeding are difficult. In my view, it could not be concluded that the Tenant’s prospects of success were fanciful.[54] I consider that
leave to appeal should be granted but I would dismiss the appeal.
[54]Kennedy v Shire of Campaspe [2015] VSCA 47.
ROBSON AJA:
I have had the advantage of reading in draft the reasons for judgment of Tate JA. I agree with Her Honour’s reasons and the orders proposed. I would add the following.
The appellant (Serene) is the tenant of the Epping Hotel. The respondent (Epping Hotels) is the landlord. By a lease dated 1 February 2007, Epping Hotels leased the Epping Hotel to Serene for an initial period of 14 years.
The lease provided for rent to be adjusted on the fifth anniversary of the lease, 1 February 2012, to a sum which, if not agreed by the lessor and lessee, was to be the ‘then current market rental for the demised premises’ as determined by an independent specialist valuer.
The parties could not agree on the adjusted rental sum and agreed to the appointment of Mr Grieve of ‘CBRE Hotels’ as the independent specialist valuer.
The valuer requested information from Serene including Serene’s trading accounts for the financial years 2009, 2010 and 2011. Both parties agree that s 37 of the Retail Leases Act 2003 applied in determining the ‘then current market rental for the demised premises.’ The section is set out in the judgment of Tate JA.
In February 2013, the valuer provided to the parties his report as to his assessment and determination of the current market rental for the premises applicable from the review date of 1 February 2012.
Serene appealed the determination to VCAT contending that the valuer had failed to apply the criteria as required under s 37(2) of the Act. In particular, Serene alleged that contrary to s 37(2), in determining the market rent the valuer had taken into account the value of the tenant’s fixtures and fittings.
The Tribunal found that ’the rent determination is founded on [Serene’s] own trading figures, and that the valuer has taken into account the value of [Serene’s] fixtures and fittings.’
Epping Hotels sought leave to appeal to a judge of the trial division under s 148(1) of the VCAT Act which permitted Epping Hotels to appeal on a question of law with the leave of the trial division of this court. The application for leave to appeal was heard and granted by an associate judge. Serene thereupon appealed against the orders of the associate judge granting Epping Hotels leave to appeal.
Both the appeal by Epping Hotels against the decision of VCAT and the appeal by Serene against the order of the associate judge giving leave to appeal came on before a judge of the trial division.
The trial judge affirmed the orders of the associate judge. The trial judge allowed the appeal by Epping Hotels against the orders of VCAT.
The trial judge found that under the determination all the relevant matters as required by the Act had been addressed.
The judge found that the Tribunal erred in determining that the valuer had taken into account the value of Serene’s fixtures and fittings, because the methodology adopted by the valuer effectively ‘cancels out’ that value.
The valuer expressly noted the requirement for the value of the tenant’s fittings and fixtures to be not taken into account. The valuer suggests that he acted consistently with the Act by the use of market based rental ratios that took ownership of fixtures and fittings into account.
Serene contended that the methodology used by the valuer did not and could not comply with the Act, or, alternatively, that in order to comply, the methodology must be adjusted to expressly deduct the capital cost of the tenant’s fixtures and fittings. I disagree. In my view, the methodology used by the valuer could be, and was, applied in such a way that it complied with the requirement in the Act that the current rent is not to take into account the value of the tenant’s fixtures and fittings.
The court was informed that the methodology adopted by the valuer (described by the trial judge as the ‘profits method’) is widely used in Victoria.
The methodology seeks to calculate the earnings that the hotel business makes before expenses are deducted for interest, depreciation, taxation, amortisation and rent (the EBIDTAR method).
Clearly interest is not deducted as that is a financing cost that is at the election of the tenant. Further, depreciation and amortisation are a book entry that could distort the figures if used. Taxation is an expense levied on the owner of the business not on the business itself. Rent is paid to the owner of the freehold and is the figure to be calculated.
Thus, the earnings derived are earnings of the subject hotel that can be compared to the earnings of other hotels.
The earnings calculated can then be allocated between the owner of the business and the owner of the freehold to reflect the contribution made by each to the earnings of the hotel. By allocating a proper proportion of the earnings to the owner of the business (that includes the fixtures and fittings of the tenant), the balance left for the payment of rent will by definition not take into account the value of the tenant’s fixtures and fittings.
If the methodology is properly applied, the determination of the current market rent will not have regard to the ‘value of the tenant’s fixtures and fittings’ in the hotel. Also the current market rent will be taken to be the rent that would reasonably be expected to be paid for the hotel premises as ‘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.’
The trial judge held that s 37(2) of the Act does ‘allow the valuer to assume the existence of the tenant’s fixtures and fittings for the purpose of employing the so-called “profits method”, provided that the value of those fixtures and fittings is treated in the calculations in such a way that the value is in effect “cancelled out”.’
In my opinion, an alternate description of the methodology used by the valuer to determine the current market rent is that the methodology calculates the earnings of the hotel (using the EBIDTAR method) and then by applying an appropriate rental ratio the methodology identifies the earnings attributable to the tenant’s fixtures and fittings and excludes those from being taken into account in determining the current market rent.
By doing so, the valuer has complied with the statutory injunction that the current market rent is not to take into account the value of the tenant’s fixtures and fittings. There was no issue that the valuer had wrongly taken into account the value of the goodwill created by the tenant’s occupation.
Serene also relied on Skycity Adelaide Pty Ltd v Valuer-General.[55]Serene submits that in that case Bleby J accepted a valuation with respect to the annual rent for a casino where the EBITDAR was discounted to reflect the annual cost of owning gaming machines. Serene submits that as the valuer in this case failed to similarly discount the EBITDAR to reflect the capital costs the hypothetical incoming tenant would incur in establishing its gaming operations, the methodology fell foul of s 37(2).
[55](2009) 168 LGERA 332 (‘Skycity’).
In fact, as explained below, Bleby J did not accept the valuation as contended by Serene. The methodology was agreed between the valuers and ultimately all that Bleby J had to decide was the proportion of the EBITDAR figure that should be assigned to rent.
Skycity Adelaide Pty Ltd (Skycity) held the sole casino licence in South Australia and leased premises in the former Adelaide Railway station. Skycity was liable to pay rates to the Adelaide City Council. For the purposes of calculating the rates, it was necessary to determine the annual value of the land. The annual value was relevantly defined as follows:
annual value of land, means a value computed as three-quarters of the gross annual rental that the land might reasonably be expected to realise if leased upon condition that the landlord were liable for all rates, taxes and other imposts on the land and the insurance and other outgoings necessary to maintain the value of the land, or as five per cent of the capital value of the land, but this definition is subject to the following qualifications—
…
(c)if the value of the land is enhanced by the existence on the land of any fixtures, consisting of prescribed machinery, plant or equipment the annual value of the land must (where the annual value is computed on the basis of gross annual rental, but not otherwise) be reduced by an amount representing depreciation on that machinery, plant or equipment; …[56]
[56]Ibid 341 [31] citing the definition in s 5(1) of the Valuation of Land Act 1971 (SA).
Thus, it can be seen that the calculation of the annual value of the land was based on a rental calculated on a statutorily defined basis. It was not based on a market rental.
The parties agreed that if the annual value of the land was to be assessed on the basis of a percentage of profits of Skycity and taking into account the casino licence, the assessment was to be made in accordance with the following calculation:
(d) EBITDAR.
(e) Less $1,625,000 the cost of ownership and depreciation for gaming machines.
(f) Application of a percentage of EBITDAR for rent.
(g) Less 25 per cent the statutory adjustment.
(h) Less a further adjustment for plant and equipment allowance, which was an agreed reduction of 14 per cent.[57]
[57]Pursuant to paragraph c of the definition of annual value.
Mr Dudakov, a valuer for the Council, explained the $1,625,000 deduction as an adjustment based on a key difference between the casino and the hotels with whose trading performance it was compared:
[the valuer] noted one key difference, namely that Skycity is both an operator and owner of gaming machines, whereas in the case of hotels the operators leased the gaming machines. He therefore made an adjustment in the case of the casino for the annual cost of capital necessary to own and operate the gaming machines.[58]
[58]Skycity (2009) 168 LGERA 332, 346 [54].
The valuer’s deduction from EBITDAR in Skycity was therefore based on the exceptional features of the casino business being valued and a lack of comparable premises. There was no evidence of any exceptional features of Serene’s occupancy of the hotel that warranted such an adjustment being made. The market based analysis which was the basis of the rental ratio was based on the undisputed assumptions of Serene’s reasonable trading performance and average standard of management.
In Skycity, Bleby J was not called on to express any opinion about the validity of the explanation given by the valuer, Mr Dudakov, for the deduction of the cost of ownership and depreciation of the gaming machines.
As the trial evolved, the Skycity valuer accepted that the EBITDAR figure determined by the Council valuers should be used in the rental calculation. Ultimately, the only issue that Bleby J was required to resolve was the percentage of the EBITDAR figure that should be applied to rent.
In addressing the valuation method Bleby J referred to the common use of the EBITDAR method of assessing values of hotels including rentals for hotels. He said:
The assessment of the rental value of some types of commercial premises by reference to a percentage of the operator’s EBITDAR is by no means an unusual or unprincipled process. I accept the evidence of Mr Dudakov [a valuer retained by the council] that it is a method in common use by the operators of commercial premises themselves for assessing value of certain types of premises for a variety of purposes. This is so particularly in the hotel industry which, in this State and in Victoria, have a number of similar features, notably liquor and gaming licences and gaming, restaurant and bar facilities.
Even Mr Smithson [the valuer retained by Skycity], in his written opinion in which he assessed comparable rentals for the various components of the casino premises, when examining comparable rents of hotels, acknowledged that hotel rentals were not normally equated to a rate per square metre, due in part to the greatly differing characteristics of facilities and uses of such facilities. In that context he accepted that analysis of hotel trading figures showed that rents generally fell into a band of 30% or more of EBITDAR. This confirmed Mr Dudakov’s method as being an acceptable method for valuing the rental value of hotels. Indeed, Mr Smithson considered Mr Brogan’s [another valuer retained by the council] analogous method of valuing an STP to be acceptable.[59]
[59]Ibid 348–349, [68]–[69].
In my opinion, Skycity does not assist Serene and it throws no doubt on the correctness of the methodology adopted by the valuer in this case.
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