Given that the financial liabilities under a lease tend to be one of the biggest overheads of any business, it is important for a commercial tenant to have a working knowledge and understanding of the main terms of a lease.
Whilst most commercial tenants are very adept and experienced at negotiating the terms of a new lease, some tenants, particularly new start-up businesses, can find the process trickier (failing to understand the financial implications of various terms); therefore missing out on the opportunity to negotiate important financial terms before taking on a new lease.
Regardless of whether you are experienced or not in this field, with the frantic pace of lease negotiations in a rising market, a tenant can be pressurised by a landlord’s agent to agree heads of terms immediately. Whilst some deals are sometimes too good to miss, it is still important to take time to understand all of the terms (particular the financial implication of these) before you agree anything. For a smaller business, this is particularly important given that these terms are likely to have a major impact on your cash-flow and profits over the term of the lease.
As a lawyer working in the Kingsley Napley real estate team, I am often asked by my tenant clients to advise and assist in their negotiation of such heads of terms. There tend to be four areas, which I advise/focus on the most.
The length of the lease term needs to be sufficient for a tenant’s business needs. Whilst a start-up business may not want to be tied in to a long term, this should be equally balanced against the adverse financial consequences of relocating too early with the resulting professional costs and tax; and the negative impact an early move could have on a business’ good will, particularly if it is a new business.
A tenant should also understand the consequences of the security of tenure provisions in the Landlord and Tenant Act 1954 (“Act”). The general rule is that a business occupier with a lease within the Act will have an automatic right to renew their lease on the same or similar terms on the expiry of their lease. A landlord can only recover possession from such a tenant by using the limited grounds that are specified in the Act e.g. if the landlord wishes to redevelop the premises. In such an instance, it would be normal for the tenant to be compensated – based on a multiplier of the rateable value of the premises.
In contrast, a tenant with a lease outside of the Act is obliged to vacate the premises at the end of term and has no right to any such compensation. In such an instance, a tenant would have to negotiate new terms with a landlord, who would not be obliged to have regard to the existing terms.
More and more tenants are requesting leases with break clauses. These are particularly appealing to start-up businesses, who are less confident of future cashflow/profits; and other tenants who are confident of growth and feel that they may outgrow their current space.
In simple terms, a break clause offers a tenant an opportunity to terminate its lease early. A tenant should negotiate that there are no conditions attached to the break clause, as recent case-law has suggested that break conditions are strictly construed against the tenant. After all, a landlord still can pursue its rights against the tenant following the exercise of the tenant’s break, but crucially, if a tenant does not comply with a break condition; it can be tied to the lease and the rental liabilities for the remainder of the term.
When negotiating the form of a break, a tenantshould also consider requesting a rent free period if the theydo not exercise the break clause. A landlord may well be receptive to this request; as such an incentive would be preferable to the uncertainty and associated costs of a landlord having to re-let the premises.
A tenant should be aware that their financial liabilities under a lease extend not only to the only annual rent. It is common for a tenant to also be liable for insurance costs, business rates, VAT, service charge and utility charges.
With regard to VAT, a tenant should query whether the landlord opted to tax its interest in the premises. If so, they will be liable to pay VAT on all rents and the majority of all other financial liabilities under the lease. In such a circumstance, a tenant should consider becoming VAT registered and making an option to tax such that the tenant can recover any VAT paid.
Service charges are more commonly found in leases of part of larger buildings. Under a service charge, a tenant is liable to reimburse a proportion of the landlord’s expenditure in repairing and maintain the structure and common parts of the building. If major structural repairs are planned/undertaken, service charge contribution can soon become excessive – particularly if a tenant has taken a relatively short term lease.
With this borne in mind, a tenant should seek to limit its service charge liability by way of a suitable service charge cap. If a landlord is to agree to a cap, it will often require annual increases under the cap to reflect inflation. A tenant should also try to agree a list of exclusions for items that the landlord cannot recover as service charge. We often advise our clients that a landlord should not be entitled to charge for: any costs relating to unlet units; the capital costs of refurbishment, improvement, alteration or extension of building; or the costs of new plant and machinery in the building.
A tenant should always request a rent free period or capital contribution at the start of the term; or indeed following the tenant’s non exercise of break right (as referred to above). Various factors will affect the rental concessions that a landlord is willing to give. For example: the state of repair of the premises; how long the premises have been vacant; and the general marketability of premises. The general rule seems to be that the longer the term of the lease, the greater the incentive.
For leases greater than 3/5 years, a landlord will often require rent review at fixed dates during the term to cover inflationary pressures and changes in market conditions. Rent reviews come in many forms. The reviews can be linked to increases in inflation (by reference to the Retail Prices Index) or can be calculated by reference to the tenant’s turnover at the premises over fixed periods. However, the most common form of review tends to be a review based on open market condition under which a landlord use various hypothetical assumptions and disregards to calculate the rent.
Our advice to tenants is to request inflationary reviews, as open market property conditions (particularly in an economic micro-climate such as London) tend to run beyond inflation. A prudent tenant would also seek to protect itself from large inflationary increases by requesting a cap on the percentage increase; 5% per annum seems to be a common yardstick for such a cap.
Unless the premises are brand new, a tenant should try and resist any repair covenant which involves keeping the premises in “good and substantial repair”, as such a covenant would oblige the tenant to repair and deliver the premises back in this condition even if the premises were not a substantially worse condition on the date that the tenant first took occupation.
Our advice to tenants is to try and link its repairing obligation to a schedule of condition (a schedule of photos, showing the condition of the premises, which can be appended to the lease). That way, a tenant can be sure that it will not be obliged to repair to any better standard of condition than when it first took occupation of the premises.
Tenants’ business needs often change such that many they do not want to be tied into a lease with the resulting fixed financial liabilities. In addition, a tenant’s need for space may change over time, so they may need to underlet the whole or part of the premises at some point in the future. Unless there are special circumstances, the majority of landlords are prepared to accept a right for the tenant to assign or underlet the whole of the premises subject to a tenant first obtaining the landlord’s consent. A landlord will normally agree that its consent shall not be unreasonably withheld or delayed.
Depending on the nature, location and size of property, landlords will sometimes agree to underlet parts of a property to separate occupiers. A tenant should understand that its needs are often balanced against a landlord’s wont to control occupiers and the covenant strength of the occupiers. Both of these can affect the value of the landlord’s investment in the building. As such, it is common for landlords to impose strict requirements in alienation clauses. Examples of such include a requirement for assignees or subtenants to provide suitable accounts and/or guarantors and/or rent deposits.
In a perfect world, all tenants would have a detailed understanding of the key terms that comprise a lease. However, in reality, due to the everyday pressures of running a business, commercial tenants rarely have the time to fully deal/understand with such a topic. However, if a tenant only concentrates/understands on the 4 areas listed above, we are confident that it will soon realise and gain from the financial benefits.