Why lease flexibility is the key to success
In this current post-Brexit, post-election climate, it is more important than ever for businesses to be able to adapt to a rapidly changing market. Lease terms that give flexibility to expand or contract business operations could be vital to a business’s chances of survival in such uncertain times. So how should a tenant go about getting the right terms, and what should they and their advisers be aware of?
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. Agreeing key terms during the course of the lease negotiation, having already incurred costs and with time pressures bearing down, might result in a tenant accepting less favourable terms than they should.
When negotiating the heads of terms, tenants should always seek advice from a qualified surveyor who is familiar with the type of property and its locality to ensure they are getting an incentive package 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.
For “location, location, location” read “configuration, configuration, configuration” as a growing business is likely to have differing space requirements as it expands. Taking badly configured premises may increase not only the initial fit-out cost but also the cost of reconfiguring the space if the requirements of the business change. If the business shrinks, the space needs to be flexible enough to cater for subtenants 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.
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 at the end of the lease term, will mean stamp duty and tax (SDLT) is kept to a minimum at the outset. There’s little point in a tenant paying SDLT for a long-lease term when it has no intention of occupying the premises until expiry.
The average lease length is now seven years, according to MSCI’s Lease Events Review 2016 (up from a low of six years in 2011), reflecting the shortage of available space, but nearly 38% of leases signed in 2016 contained a break option. This demonstrates how important (and common) these clauses now are for businesses wanting flexibility, but the courts continue to interpret break conditions strictly.
Tenants should try to ensure that there are no conditions at all but if this can’t be agreed, at the very least any reference to the break being conditional on vacant possession should be avoided; case law has shown that even the presence of a security guard can be enough to frustrate the break. The Code is once again helpful here, stating that the only pre-conditions should be that the yearly rent is paid up to date and that the tenant must give up occupation and leave behind no continuing subleases.
The tenant also needs to ensure that their ability to dispose of the lease during the term is not unduly restricted. Being able to assign, sublet or share possession is crucial where the tenant’s needs may change in the 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, allowing the tenant to walk away if it can assign the lease to another business with better covenant strength.
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 being particularly 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.
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 Service Charges in Commercial Property, which 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 that there is certainty as to how much they will have to pay each year.
Rent and rent review
While upward-only reviews are less common throughout Europe, they remain the norm in the UK. However, there are other options. Negotiating a stepped rent, linking reviews to the Retail Price Index or Consumer Price Index, sometimes coupled with a “cap and collar” (limiting how high or low the review can be) provide more certainty for a tenant. In a retail lease, the level of rent could also be linked to how well the tenant performs, with the rent payable being calculated by reference to the turnover achieved by the tenant’s business at the premises.
Repair, reinstatement and dilapidations
Repair costs and dilapidations liability represent a “hidden cost”, in addition to the usual occupational costs. Getting a professional survey of the property will establish its state of repair and also give an idea of the likely maintenance costs during the lease term.
When negotiating the repairing clause, 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. An obligation to keep the property “in repair” would require the tenant to put a dilapidated property back into repair and so should also be avoided if at all possible.
Limiting repair obligations to the state and condition of the premises at the start of the lease (for example by reference to a schedule of condition, preferably photographic) is probably the best way of minimising the cost of repair and dilapidations.
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 renegotiating current lease deals, with landlords often keen to keep a tenant in occupation rather than having an empty unit.
A tenant could seek to improve on the terms of its lease temporarily, for example by seeking a rent concession, asking to pay rent monthly or adding a break date to maintain flexibility. They could also improve their position on a permanent basis by regearing the lease on more favourable terms.
When entering into a lease, it’s not just the yearly rent which matters to a prospective tenant; consideration also needs to be given to current and future business needs to calculate the true cost of taking a lease. Committing to a costly lease that provides for little flexibility can have dire consequences for a business, especially in these rapidly changing times.
Top tips for lease flexibility
- Have detailed, comprehensive, heads of terms produced by a surveyor
- Use the Code for Leasing Business Premises in England and Wales 2007 as a starting point to achieve a fair lease
- Configuration is key. Can the premises be adapted easily and cost effectively?
- Seek to include a tenant break; not only will it provide flexibility but it will typically make the lease more valuable on assignment
- Ensure any tenant breaks are unconditional or, at the very least, Code-compliant
- Consider the SDLT liability; there are no refunds for tenants who don’t stay for the whole term
- Ensure there is nothing that would make the lease difficult to assign or the premises difficult to share or underlet
- It’s not only the rent that needs to be considered; a cap on the service charge will provide greater certainty for a tenant on a budget
- An upward-only review is not the only option
- If you don’t ask you won’t get; mid-term concessions might be granted by a landlord if the alternative is an empty property or tenant in administration.
This article first appeared in EG, August 2017.