Achieving flexibility in leases
Given the current economic climate and the need to keep business costs down and financial commitments flexible it is more important than ever that business tenants achieve the best and most flexible lease terms they can get. This article focuses on some practical reminders to tenants and their professional advisers of the areas that might be relevant when seeking to maximise flexibility.
1. Heads of terms
Detailed and clear heads of terms should be agreed at the outset to ensure each party fully understands the deal being struck. Tenants should always seek advice from a surveyor familiar with the property and locality when negotiating heads of terms and to ensure that the incentive package being offered to the tenant is in line with the market norm. Once heads of terms have been provisionally agreed they should be reviewed by the tenant’s lawyer to ensure they are unambiguous and contain sufficient detail to document what has been agreed.
It is also important to keep the recommendations of the Code for Leasing Business Premises in England and Wales 2007 (the Code) at the forefront of discussions with the landlord, given that its principal objective is to achieve a fairer balance between the parties and greater flexibility in commercial lease terms. Landlords should be open about any proposed departures from the Code and provide reasons for them.
2. The premises
For ‘location, location, location’ read ‘configuration, configuration, configuration’ – a growing business is likely to have differing space requirements as it expands. Taking badly configured space may increase not only the initial fit out cost, but also the cost of re-configuring the space if the requirements of the business change. If the business contracts, the space needs to be flexible enough to cater for sub-tenants or assignees.
If reconfiguration of space is a likelihood or subletting is envisaged then the alterations provisions need to cater for this. Having to approach the landlord for consent each time alterations are proposed will be time consuming and costly. Having the ability to make certain alterations (such as minor changes to partitioning) without consent is desirable.
3. Term and break clauses
Careful thought should be given to the length of the lease term and break options. Taking a short term lease, perhaps with an option to renew (whether statutory or contractual) at the end of the lease term will mean SDLT is kept to a minimum at the outset. There’s little point in a tenant paying SDLT for a long lease term when, for example, the tenant may have every intention to exercise a break option.
In fact, the British Property Foundation’s (BPF) annual Lease Review shows that the average length of commercial property lettings has dropped from 5.9 years in 2008/2009 to just five years in 2009/2010, but where a long term is proposed, unconditional break options at regular intervals should be considered. Courts continue to interpret break conditions strictly, a stance that was emphasised in Fitzroy House Epworth Street (No. 1) v The Financial Times (2005). As a consequence tenants need to resist any conditions as they could render the break inoperable. If the landlord will not agree to unconditional breaks, the tenant should seek Code compliant breaks where the only pre-conditions are that the yearly rent is paid up to date, the tenant gives up occupation and leaves behind no continuing subleases. Such pre-conditions should not be contentious as the landlord retains the right to sue for damages for any loss it suffers for any tenant breach occurring before the break date.
The ability to dispose of the lease during the term should not be unduly restricted. Being able to assign, sublet or share possession is crucial where the tenant’s needs may change in future.
The right to assign or sublet should be subject to as few conditions as possible. On assignment, the Code recommends that the landlord should only be able to call on an AGA if reasonably required. Conditions to avoid include any period during which assignment or subletting is prohibited, any restrictions on assignment or sharing with group companies and any subjective tests regarding an incoming tenant’s ability to comply with the terms of the lease (such prohibitions are common in a retail context). A condition that a sublease rent must be the higher of passing rent and market rent must also be avoided as it could prevent subletting in a falling market.
5. Service charges
Service charges represent an extra cost on top of the yearly rent and it is important that a prospective tenant knows or has a good idea of what that charge will be. The lease should contain service charge provisions consistent with the recommendations in the RICS 2006 Code of Practice on Service Charges in Commercial Property. This code promotes transparency and makes a number of recommendations for best practice for landlords to follow when running a service charge. These include providing best estimates of service charges and other outgoings and disclosing any irregular events that may impact on the amount of future service charges. Where possible, a tenant should seek to negotiate a service charge cap to ensure there is certainty.
6. Rent and rent review
Whilst upwards only reviews are less common throughout Europe (the Republic of Ireland abolished upward only rent reviews for all new leases entered into after 28 February 2010, unless the lease was granted pursuant to an earlier contractual agreement), UK landlords routinely continue to insist on their inclusion in long term leases. However, there are other options. An all inclusive rent provides certainty and, in the absence of a service charge cap, ensures that the tenant avoids fluctuations in service charge and other costs. Other alternatives include negotiating a stepped rent, (in a retail context) seeking to link the rent to a percentage of the tenant’s turnover, upwards / downwards reviews or reviews linked to RPI / CPI.
7. Repair, reinstatement and dilapidations
Repair costs and dilapidations liability represent another ‘hidden cost’ in addition to the yearly rent, service charge and insurance costs. An appropriate survey of the premises ought to be carried out to establish its state of repair. It is vital that the tenant has an understanding of maintenance costs during the lease term. These can vary widely depending on the type and age of the property. Tenants should avoid an obligation to keep the property in repair as that includes an obligation to put the property into repair if it is in disrepair at the start of the lease (Proudfoot v Hart (1890)). Similarly, an obligation to keep the property in good condition should be resisted as it can require works to be carried out even if there is no disrepair (Welsh v Greenwich LBC (2000)).
Where appropriate, limiting repair obligations by reference to a schedule of condition (photographic or otherwise) can help to minimise the cost of repair and dilapidations.
8. During the lease
The heads of terms stage is not the only opportunity at which a tenant can achieve flexibility. In a tenant friendly market there may be scope for re-negotiating current lease deals. Landlords will want to ensure their tenants carry on trading. A tenant could seek to improve upon the terms of its lease temporarily, for example by seeking a rent concession, an ability to pay rent monthly or pushing back or adding a break date to maintain flexibility, or on a permanent basis by re-gearing its lease on more favourable terms.
When entering into a lease, a prospective tenant must not just look at the yearly rent which will be payable, but should consider its current and future business needs and seek to calculate the true cost of taking a business lease so that it can budget accordingly. Committing to a costly lease which provides for little flexibility can have dire consequences for tenants.
A version of this article appeared in The Estates Gazette on 27 November 2010.
Reviewed in 2015