With residential property investors increasingly adding commercial properties to their portfolios, Jonathan Wood outlines how commercial leases differ from assured shorthold tenancies.
Residential property investors are increasingly adding commercial properties to their portfolios. But commercial leases are a very different beast to the assured shorthold tenancies (AST) most residential property investors will be familiar with.
Jonathan Wood a property lawyer at Collyer Bristow offers a guide to key aspects of a commercial lease for investors looking to add commercial property to their portfolios.
Residential property investors will be familiar with ASTs with the term limits and the responsibilities and obligations they put on a landlord and the tenant. Commercial leases typically contain a greater number of obligations on the part of the tenant but at the same time allow the tenant more freedom.
Unlike a residential AST, a commercial lease term is not limited to a maximum term. Whilst the good old days of securing a tenant for 25 years are now rare, a typical commercial lease term is five to ten years. Rents are often paid quarterly in advance although tenants, particularly retail tenant’s, often seek to pay the rent monthly.
Full Repairing and Insuring
Ideally, a tenant of a commercial property will accept a full repairing and insuring lease, often referred to as an FRI Lease, which means they are fully responsible for decoration, repair and reimbursement of the insurance premium to the landlord. Where the tenant accepts a lease of part of a building rather than the whole, a tenant will pay a proportion of the costs of repair of the building and common parts via a service charge. It must be noted that it is not uncommon for a tenant to seek to limit their repairing liability when negotiating the heads of terms with the agents before legal documentation is prepared.
Commercial leases, unlike an AST, generally provide for the property to be returned to the landlord in full repair at the end of the term. If the tenant breaches this obligation, a landlord (if the lease permits) may issue a dilapidation claim in respect of the cost of disrepair left by the exiting tenant.
A commercial lease will usually allow the tenant to carry out internal alterations subject to landlord consent, and the landlord can request that these alterations are reinstated at the end of the term.
Where a tenant accepts a lease of whole on an FRI basis this should lead to much less day to day management for a landlord. A favourable situation for a landlord would be where they sit back and receive a commercial rent for five years under an FRI lease and at the end of the term the tenant negotiates a new lease for a further five years – that being the landlord’s only involvement during a ten year cycle.
Commercial leases typically provide five yearly rent reviews on an upwards only basis. This means that the rent cannot be decreased on the rent review date and will be typically reviewed on an open market basis. A surveyor would need to be instructed to negotiate any review on the landlord’s behalf.
Commercial tenants are usually permitted to assign or underlet the lease subject to the landlord’s prior written consent. On an assignment application, the landlord or their agents (whose costs are paid by the tenant) should review the covenant strength of the new incoming tenant, if this is not entirely satisfactory the landlord can request (if reasonable) the outgoing tenant to provide a guarantee to pay the rents and observe the covenants of the lease during the period in which the assignee is the tenant. A commercial lease often provides further provisions where the landlord can request that the new tenant provides a rent deposit and/or a guarantor if reasonable.
There are higher professional costs in securing a new commercial letting, such as solicitors’ and agents’ fees, and the landlord may even need to award a tenant a rent-free period to secure the tenancy. The legal work to complete a lease can take a number of weeks as the lease terms are negotiated and due diligence undertaken. The documentation that needs to be settled is more comprehensive. The leaseand can easily run to a 30-60 page document, not to mention ancillary documents such as a licence to alter or a rent deposit deed. Accordingly, void periods for commercial premisesmay well be longer than that of a residential property. Whilst the property is vacant the landlord will be responsible for the rates and securing and insuring a vacant property which can be expensive.
Inside or outside the Landlord and Tenant Act 1954
If the lease is inside the Landlord and Tenant Act 1954, the tenant will have a statutory right to a lease renewal at the end of the contractual term. The landlord only has limited grounds to seek possession at the end of the term, such as (amongst others) breach of covenant, persistent delay in paying rent, or if the landlord wishes to develop the property.
Obtaining possession is not a simple process for a landlord, who will have to obtain a court order and proceedings may be heavily fought if a tenant wishes to remain. The tenant may also be entitled to compensation.
If you do not wish for your tenant to have security of tenure, you can exclude the right only when granting the lease. As to whether the tenant will agree to this at the heads of terms stage is typically dependant on the type of letting or the bargaining strength of either the landlord or the tenant. The landlord is almost always in a stronger position if it can exclude sections 24 to 28 of the Landlord and Tenant Act 1954 Act in the lease.
Commercial property is a likely jump for a residential investor keen to expand their property portfolio. Taking the time to understand the complexities of a commercial lease is highly recommended before investing in a commercial property. That and finding a good commercial agent who can advise on the pros and cons of a purchase on an investment basis.