In our recent technology report, we looked at building agile businesses in a changing world and explored the need for tech companies to retain flexibility if entering into traditional leasing arrangements. One recurring question is whether a tenant is stuck with the terms of the lease especially when the lease will hinder the tenant company’s ability to adapt to market conditions.
Lease re-gearing - What is it?
Re-gearing a lease is the practice of re-negotiating your lease terms during the course of the lease. The practice of re-gearing can be advantageous to both Tenants and Landlords.
Examples of re-gearing include changes in the rent and rent review provisions, term extensions, variations to the alterations or dealing provisions, increasing or decreasing the demise or removing a break clause.
In essence, a compromise is reached where both the Landlord and Tenant come away with something they want. For example, “If you don’t exercise your break clause, I’ll give you a six-month rent-free period” - The Landlord gets the certainty of the Tenant’s rental income and the Tenant gets a welcome rent-free period midway through the lease term. Another example could be “I’ll pay a capital sum towards the refurbishment of the premises and in return, you accept an extended lease term” – The Landlord again gets the certainty of the Tenant’s rental income and the Tenant gets refurbished premises for a longer period.
Why do it?
Advantages for Tenants:
- Rent free periods and the return of rent deposits increases cash-flow;
- Opportunity to secure better lease terms can assist with current business needs, especially in anticipation of restructuring or a sale of the business (for instance where the Tenant secures more advantageous alterations or dealing provisions or adding additional flexibility (subletting of part of surrendering part of the premises perhaps);
- Remaining in the Premises for a longer period provides security and comfort where Tenants are happy in their existing space but looking for a reduction in rent.
Advantages for Landlords:
- Certainty of rental income for a longer period;
- Increase in the capital value of the Landlord’s asset by removing break rights and/or extending the term of the lease;
- Preserving and/or increasing the investment value of the Landlord’s asset in advance of a sale or refinance;
- Steady occupier levels mitigate empty business rates liability and costly service charges.
How is it documented?
A deed of variation is arguably the simplest way to effect a re-gear, for example to remove a break clause or amend the alterations or alienation provisions. Other options include a surrender of the existing lease and the grant of a new lease; the grant of a reversionary lease (an extension of the term) or sometimes a side letter may suffice.
Re-gearing can seem a simple bargain between Landlord and Tenant but it is important that legal advice is sought to ensure it is documented correctly. If, for example, the premises are increased or the term of the lease is extended, this will operate in law as a surrender and re-grant which could have significant implications for Tenants in respect of Stamp Duty Land Tax liability and for Landlords in respect of security of tenure rights and the release of guarantors.
Leverage - If you’re doing it, do it right!
The benefits, particularly to tenants, are dependent upon how the Tenant applies its leverage. A Tenant should always seek help from an experienced property consultant as getting the right approach will materially help its chance of cutting costs or redefining its lease. Other points to note include:
- Strategy – the Tenant must know what it wants to achieve.
- Timing – If the Tenant approaches the Landlord too early it won’t be taken seriously. If it approaches the Landlord too late the only leverage it may have will be lost with too little time to document the arrangement legally.
- Landlord’s position – How valuable is the lease to the Landlord? It is crucial for the Tenant to understand how its Landlords views risk, vacancy rates and most importantly how the specific proposal will be received. Having an effective financial argument/presentation is the cornerstone of this exercise. Providing a clear, financially based proposal usually gets the best results. Leasing is treated by Investment Landlords in a similar way to bonds by a Finance Manager. It represents the security of the return. Any lease event (i.e. a break right) that shortens or lengthens the income flow, or indeed alters its value, provides an opportunity to restructure the lease.
The concept of lease re-gearing is a useful tool and the savvy Tenant should bear it in mind, particularly where break rights are looming or the term of the lease is drawing to an end. It is however essential that lease variations are properly drafted so as to avoid adverse consequences and potential banana skins!