Commercial property: using break rights to negotiate better lease terms

Introduction  

Forecasts for the UK commercial property market are increasingly bleak. Vacancy rates are increasing and rents are falling, as is tenant demand for space. Landlords, keen to protect cash flow and avoid the hardship of empty rates, are offering improved terms to new tenants, including longer rent-free periods and even monthly rent payments, rather than the market-standard quarterly rent in advance.  

A tenant with the benefit of an upcoming break right may be in a strong position to negotiate a better deal with the landlord. Landlords and tenants need to be alive to certain pitfalls in adopting such a strategy.  

Tenant’s considerations

• A break right is an option and the courts will enforce an option strictly against the person seeking to exercise it (ie the tenant). Deadlines must be adhered to: if a deadline for service of a break notice is missed, even by a day, the break right is lost. If a form of notice is specified, it must be strictly followed: a tenant may be forgiven minor defects, but this should not be taken as guaranteed.
• A tenant’s right to exercise a break is often conditional. If a break right contains any of the following conditions, a landlord may be able to frustrate its operation by insisting upon strict compliance with such conditions.
  • All rents must be fully paid up to the break date: ‘rents’ include not just the principal rent but all other sums reserved as rent under the lease – eg insurance rent, service charge – and may include other debts due by the tenant to the landlord. It is fairly common for a landlord and tenant to be in dispute over the service charge, so a landlord may consider using this to frustrate the operation of a break clause.
  • There must be no subsisting breach –– of the tenant’s obligations under the lease: any breach of these – however trivial – will frustrate the tenant’s break right. For example, where a lease required a property to be painted in the last year and it had been painted just before the beginning of the last year the court held that the tenant’s obligations had not been fulfilled and the break right was thus lost.  
  • The tenant must deliver vacant possession to the landlord on the break date, free from any sub-tenancies: the tenant must ensure that any sub-tenancies are contracted out of the security of tenure provisions of the Landlord and Tenant Act 1954, so that sub-tenants have no right to remain in occupation beyond the expiry of the sub-tenancy. In addition, the tenant must ensure that, on the break date, the property is handed back to the landlord without any of the tenant’s goods, plant or equipment still at the property.

• The effect of validly serving a break notice is to bring the lease to an end on the break date. A break notice may not be unilaterally revoked. So, if the tenant changes its mind, it cannot revoke the notice without the landlord’s consent. If a tenant serves a break notice, it must have alternative accommodation ready if the notice is accepted by the landlord.
  • Even if the landlord agrees to –– revocation of the notice, the parties cannot prevent the lease from terminating. The lease is treated as terminated and a new lease granted on the break date.
  • Ordinarily, a new lease would be subject to stamp duty land tax (SDLT) but HM Revenue and Customs (the UK’s tax authority) has issued guidance that if a break notice is withdrawn by agreement between the parties before it takes effect the lease will be treated as continuing for SDLT purposes. However, if the ‘new’ lease contains an increase in the rent, or a change to the duration of the lease or the area of the property, additional SDLT may be payable.  

• Unless the break clause expressly states otherwise, any rent paid in advance for the period following the break date will not be refunded to the tenant.
• When a break clause is exercised by a tenant, any sub-leases will also come to an end on the break date (provided all sub-tenants actually vacate), so a tenant may lose its sub-tenant.
•  If a tenant wishes to use a break clause to renegotiate the terms of its lease, the tenant may wish to consider approaching the landlord well in advance of the key dates and using the threat of the break clause as a negotiating tool, rather than actually exercising the break.  

Landlord’s considerations  

If the landlord cannot frustrate the operation of the break right, apart from the commercial considerations of losing rental income and having to re-let the property, the landlord should consider a number of issues.

• If a new lease is granted (which will occur even if a break option is served and revoked), any pre-existing guarantor (under an authorised guarantee agreement or otherwise) will probably be released and the landlord may therefore need to consider the covenant strength of the tenant.
• If the previous lease was an ‘old’ (that is, granted before 1 January 1996) lease, the landlord will lose the benefit of privity of contract/privity of estate with previous tenants.
• If the previous lease was contracted out of the security of tenure provisions of the Landlord and Tenant Act 1954 so that the tenant has no right to remain in occupation after the expiry of the lease the ‘new’ lease will not be contracted out unless the landlord observes the relevant statutory process – ie notice by landlord and statutory declaration by tenant.
• The landlord needs to consider whether any terms in the lease need to be clarified. For example, if a repairing obligation is qualified so as to be in ‘no worse state’ than at the date of the lease, creating a new lease would have the effect of re-basing that standard to the date of the new lease unless the drafting is reconsidered.
• The tenant may argue that the landlord and the tenant ought to treat the break notice as never having been served. For the reasons above, a landlord ought to treat such a suggestion with extreme caution. A landlord would be better advised to insist that a new lease is prepared and, if necessary, registered at the Land Registry.