| Landlord still king in commerdial property leases |
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| Despite an increasingly flexible commercial property lease market, tenants still need to work to get the best deal, argues Jim Murphy. |
The full repairing and insuring thirty-five year lease with five yearly full open market rent reviews has for some time been the basic model on which commercial tenants (who have no wish to be owner occupiers) have held property. While the covenants which commercial tenants must comply with under these leases (covenants to repair, decorate, pay outgoings etc.) have remained relatively standard over the years there have been significant changes in recent years in the duration of these leases with break options becoming widely accepted. In addition, recent years have seen a substantial change in the nature and extent of lease guarantees.
The End of the Thirty-five year Lease
Traditionally, leases were for a period of thirty-five years with no break option. The thirty-five year term was chosen because that was the maximum term before a 6% stamp duty charge arose on the rents under the lease. On leases for thirty-five years or less stamp duty is charged at 1% of the annual rent (although the premium can still be subject to stamp duty up to 6% over £60,000). In recent times however, there has been a shift to shorter leases. Currently, the average commercial lease would be for a term in the region of twenty to twenty-five years.
Break Options
Depending on the negotiating strength of the parties, break options may also be available, although the landlord's position is quite strong at the moment and their first instinct is to refuse to allow a break. If available, break options generally operate between ten and fifteen years, although penalties (up to one to two years rent) are often payable on the exercise of the option. A common cause of disputes in lease negotiations relates to the manner in which the break option can be exercised. A tenant will obviously seek to have an absolute right to exercise the break whereas the landlord will want to make the exercise of the break contingent upon compliance with the lease covenants (most importantly the repair covenant). However, usually a workable compromise can be found.
The Role of Value Added Tax
VAT on leases also has a role to play in determining the duration of the term and for this reason leases of property within the VAT net are typically in excess of twenty years as this route avoids the possibility of irrecoverable VAT for landlords. The statutory rights of renewal available to tenants also plays a part in determining the term. Because a business tenant has a right to claim a lease of up to thirty-five years where it has been in occupation for more than five years, landlords traditionally either offer tenants leases of less than five years which may be inadequate for the tenant's business development plans or instead offer a term in excess of twenty years which may create too great a liability for the tenant. Legislation passed in 1994 sought to address the difficulties caused by renewal rights provisions, which although intended for the benefit of tenants, had the unintended effect of causing tenants to be offered leases which were either too short or too long. The 1994 legislation gave office tenants (only) the ability to take a lease for anything up to 35 years (without the issue of renewal rights arising). If the provision operates as intended, an office tenant would have the ability to take leases of what is probably the optimum duration (ten to fifteen years). However, to date there has been no great evidence that this procedure has been availed of. There are probably two reasons for this:-
* where the premises are in the VAT net, the overriding imperative for the landlord is to avoid VAT difficulties and so in these cases the landlord will always strive to have a lease in excess of twenty years; and
* there is evidence of a nervousness on the part of the landlords as to the procedures to be followed for a valid renunciation of rights and the 1994 legislation is not entirely clear on this issue.
Guarantees
Unless the tenant is a very substantial entity, parent company or tenant, personal guarantees may be required before a lease can be entered into. At the moment one could expect the minimum financial strength required for a tenant (or failing that a guarantor) to be net pre-tax profits for the preceding years of at least three to four times the annual rent and other outgoings under the proposed lease. Because of the provisions of the Companies Act 1990 there are situations where parent companies cannot legally guarantee the leasehold obligations of subsidiaries where both companies are controlled by a director or persons connected to that director. This has led to difficulties, principally for smaller family type companies and in many cases has resulted in either the parent company having to take the lease in its own name or personal guarantees being produced.
Where guarantee difficulties prove to be insurmountable, rent deposit deeds are often put forward as an alternative. In this situation the tenant lodges a sum of money (usually in the region of one to two quarter's rent) as security against its future performance of its obligations under the lease. The downside of the rent deposit deed is that it usually amounts to a charge over the company's property (ie. the rent deposit monies) and should be registered as such in the Companies Registration Office, which is not acceptable for some companies.
Whereas traditionally the guarantee given was for the duration of the entire term of the lease, there is now more creativity in structuring guarantees. For example, it might be provided that the guarantee will be released where the tenant reaches an acceptable covenant strength (eg. three years pre-tax profits of four times rent etc. as above) or the guarantee can be limited for a period of time or can be structured as a roll over guarantee where the guarantor guarantees only a financial amount which is rolled over annually.
Rent Review
In relation to rent and rent review provisions, the dominant arrangement is the lease at a full open market rent with five yearly upwards only full open market rent reviews. Despite the strength of the letting market, rent free periods are widely available (usually for the first quarter of the lease) particularly where there is a requirement to fit-out a property.
Conclusion
Although the landlord's position in the market is currently very strong, there is evidence of flexibility in the terms available to tenants. Tenants need to take advantage of any flexibility at the outset of lease negotiations so that they can tailor lease terms to their own business requirements. Failure to do this might result in tenants taking on unsuitable long term liabilities. |
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| Article appeared in the May 1999 issue.
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