The cost of leasing premises is generally one of the top three costs of any business. Commonly, it is second only to the cost of salaries. It is also one of the longest financial commitments that a business makes, requiring owners to predict how their businesses will look in five, 10, and 15 years time, which is difficult for even the most established players.
But are businesses paying enough attention to the changing market to minimise the burden of these costs?
By choosing the right landlord and lease terms, there are ways of managing the ultimate costs of leasing premises, but it is vital that tenants are considering the issues well in advance of signing up. Costly mistakes arise because tenants do not consider the implications of unquestioningly accepting the terms landlords have traditionally offered.
Length of the lease (term): gone are the days of landlords insisting upon 20 to 25 years terms. The average length of a commercial property lease has been consistently falling over the past decade or so. Ten or 15-year terms are now more the norm for office premises, often with the right for the tenant to terminate the lease at the end of years 5 and 10. For industrial premises, short term, six year leases are widely available. Predicting your future premises requirements can be difficult so shorter terms are advantageous. A tenant also pays less Stamp Duty Land Tax on a shorter-term lease. If long term continuity and security are a concern, then options to renew for further short terms can be considered without increasing the tax liability.
Conditions to terminating early (break clauses): Having negotiated a right to terminate early, it is important that you can exercise that right easily so that you have the certainty of actually bringing the lease to an end. Historically, rights to terminate early have been subject to strict compliance with any pre-conditions which have often tripped up tenants on technicalities and left them with expensive premises they no longer require. The starting position of any negotiations should be an unconditional right to terminate early, or, at the very most, the only conditions that should be accepted are those recommended by the Lease Code 2020: being that the annual rent is up to date, occupation is given up, and there are no continuing sub-leases.
Ability to pass on your liability (alienation): Even with shorter terms, and rights to terminate early, it is still possible for a business to find itself in the position of having leased space it no longer requires. In these circumstances, the ability to easily off-set or off-load that liability, without onerous restrictions, is very important. Landlords have been keen to keep a tight control over the terms of any sale or under-letting of a tenant’s lease, but both are ways a tenant can either pass on or reduce the cost of leased premises. The often lengthy and cumbersomely phrased restrictions can seem very irrelevant or legalistic when negotiating the original terms of the lease but can have real, practical, and often costly, implications for a business years down the line. Any restrictions should be reasonable, seeking to balance the landlord’s desire to protect its capital value interest in the property and the tenant’s need to effectively manage its business costs.
Certainty of leasing costs (outgoings and service charge): Rent is the most obvious leasing cost and with the advice of a good surveyor, it should be straightforward to establish if this is being set fairly. But it is the additional costs, particularly service charge and insurance rent, that can be hidden or come as a surprise. Attention should be paid to the costs that can be recovered by the landlord through the service charge and thought should be given to excluding costs which would be unfair, such as costs not recoverable from other occupiers because of commercial deals done with them or those for services you would not actually use. Service charge caps, or even inclusive rents, are becoming more common especially for the shorter leases. Insurance costs should be fair and reasonable and should represent value for money.
Fair rental increases (rent review): While the initial rent will be a known fixed amount, your landlord will want the ability to review your rent, commonly every five years. As the Lease Code 2020 states, the rules by which the rent can be changed need to be clear and understandable. The market norm is for the rent to only be capable of going up throughout the term of the lease meaning that even in the depths of a recession you can be paying the market rate for a boom period. Although there has been considerable political, and industry, debate as to whether up and down rent reviews should be compulsorily imposed on landlords, the basic premise of upwards only still seems to be holding good. However, other methods of review are becoming more widespread particularly index linked reviews. A potential advantage for a tenant is that it may be able to negotiate a maximum uplift percentage giving certainty as to its overall costs exposure going forward. There should always be an agreed independent method of resolving any disputes.
Maintenance obligations (repair covenant): unless you are taking brand new premises, it is likely that the premises will not be in perfect condition. It is also likely that unless you, or your advisors, specifically address the issue, the repairing obligations of the lease will make you responsible for returning the premises to the landlord in a better state than you received them. This can lead to some expensive works or payments to the landlord at the end of your occupation. It is far better to try to agree the condition of the property at the beginning of the lease, ideally evidenced by a photographic record, and limit your obligations accordingly. Even with new premises, thought should be given to whether it is fair that a tenant has the responsibility for rectifying any latent defects in the original construction that may require repair during the term of the lease.
Apportionment of risk (uninsured damage): most commercial leases will let the tenant off having to carry out repairs that are caused by a risk for which the landlord has insurance cover. Most such leases will also let the landlord off insuring against risks which are not easily or economically insurable in the marketplace, such as against damage caused by terrorist activity. Both positions seem fair. However, because leases will also require the tenant to repair any damage to the premises this means that if the property is damaged by a risk which the landlord is no longer obliged to carry insurance cover for, because it is too expensive, then the tenant will have to carry out the repairs. This is not really a fair position to take because the tenant only has a relatively short interest in the property whereas the landlord has the long-term capital interest. If the building is destroyed by terrorist activity it should not be the tenant that has to reinstate the premises under its repairing obligations. In the event of uninsured damage, the risk of having to repair or reinstate the premises should fairly lie with the landlord.
Potential changes to business requirements (alterations and change of use): You may need to make changes to the premises to accommodate a new office or store layout. This will necessitate physical alterations to the premises which will commonly require the landlord’s consent. Obtaining the landlord’s consent may be time consuming and costly so should only be reasonably required where you are going to do something which affects the structural integrity or capital value of the premises. For minor, non-structural internal changes there should be limited restrictions. You may also want to use the premises for a different operational part of your business or sell your lease to a business which is in a different sector to your own. You therefore need to ensure that the permitted use under the lease is sufficient for your purposes but also flexible enough to still be a marketable lease.
The right lease can help your business thrive.
A good resource for points to consider when entering into a commercial property lease, and also a potential tool for negotiations with landlords, is the 2020 Code for Leasing Business Premises. The Lease Code is a professional statement by the Royal Institute of Chartered Surveyors (RICS) which contains mandatory requirements relating to negotiations and heads of terms that must be complied with by RICS agents, RICS regulated firms, and landlords that are RICS members. The remaining provisions of the Lease Code 2020 indicate ‘good practice’ and are not mandatory. The aim of the Lease Code 2020 is to ensure that tenants have access to the information they need in lease negotiations, and also to try to create a fair balance between the landlord and tenant.
While the Lease Code 2020 is not mandatory for landlords who are not regulated by RICS, there are a growing number of landlords who are actively seeking to differentiate themselves in the marketplace by applying some or all of it and offering flexible ‘tenant-friendly’ leasing options. These landlords are sometimes offering a range of options along side the more traditional full repairing and insuring long term leases, such as monthly licences and short-term tenant friendly leases. Often choosing the right landlord is as important as choosing the right premises. Increasingly, landlords are recognising that the provision of premises is a service and that tenants need to be treated as customers. These landlords are also seeing this as a creative and effective way of filling empty properties in a difficult economic climate. With this different approach comes some great opportunities for well advised tenants and landlords.