Grant of a Lease Flashcards
Who are commercial landlords?
· Private investors, whether individuals or companies, who make a business out of letting premises. For example, the company Derwent owns a portfolio of 5.5 million square feet of commercial real estate, most of which is in Central London. At the other end of the sale, an individual may just own one small shop premises and let it out.
· Institutional investors. These are financial institutions, typically, pension funds and life assurance companies who invest in property just as they would in the stock market. Compared to the stock market, property has been traditionally seen as a safe and valuable investment, offering both income (through rent) and long term capital growth (through the rise in property prices over time). It is possible that this view has been tempered by the effect of the pandemic. For example, the tendency towards increased working from home may translate to smaller demand for office space, and therefore a decrease in the rent it can command.
Institutional investors
· Because the institutional investor is concerned with the property in terms of the income it produces, they favour a full repairing and insuring (FRI) lease. This means that the tenants pick up the costs associated with the property, and the landlord receives the clear rent. We will look at this in more detail in the appropriate elements.
· The other issue of concern to an institutional investor is covenant strength. A landlord will want to know that the tenant has the means to comply with its obligations, and also that it has assets that the landlord can recover breaches against. A long established company will generally have good covenant strength, an off the shelf new company will not. If the tenant does not have good covenant strength, the landlord may require a guarantor (such as the director of the company) or a rent deposit.
Essential ingredients of a lease
Exclusive possession
Exclusive possession is an essential ingredient of a lease (distinguishing it from a licence).
The tenant must be able to exclude strangers and even the landlord (except where the landlord is exercising its right to enter the premises, eg, to inspect it) from the premises let.
Certainty of term - fixed term or periodic tenancy
The lease must be for a fixed term (six months, 5 years, etc) or a periodic term (a weekly tenancy, monthly tenancy, yearly tenancy etc).
Generally speaking, it may not be for an indeterminate time (eg, for as long as the tenant is an employee of the landlord). There are exceptions.
Formalities
A legal lease must be created by deed if the term is over 3 years.
A tenancy of 3 years or under may be created in writing, or even orally.
The reversion
The reversion is the interest that the landlord holds subject to the lease. At the end of the lease term, the property reverts to the landlord.
Landlord’s objectives
In many cases, the landlord is in the dominant negotiating position.
Institutional landlords will insist on a full repairing and insuring (FRI) lease, meaning that any costs are met by the tenant, whether directly or indirectly. This means that rent paid by tenants is clear of deduction.
The landlord will want a lease that ensures the premises are:
· insured
· kept in repair
· only used for the permitted purpose
The landlord will also want:
· to control whom may occupy of the premises (eg, if the tenant tries to pass the lease on)
· to have a say over how the premises are altered by the tenant
· to increase the rent in line with market rent over the contractual term of the lease (by way of rent review)
Calculating the expiry of a lease term
Calculating the expiry of a lease term
It is important to understand when the lease term expires. A 10 year term will expire 10 years after the term commencement date, but on what day?
This will depend on how the term is defined in the lease…
If the term of the lease is “from and including” a certain day of the year, the term expires on the day before that day of the year in the relevant year (more common in practice).
For example, a lease with a term of 10 years from and including 24 March 2019 expires on 23 March 2029.
If the term of the lease is “from” a certain day of the year, the term starts the day after that day, and so expires on that day of the year in the relevant year (less common in practice).
For example, a lease with a term of 10 years from 24 March 2019 will start on 25 March 2019 and expire on 24 March 2019.
Break clauses
If the tenant is unsure about the commitment of a lease term, and the landlord is unwilling to grant a shorter term, a break clause can offer a compromise solution.
Note that if the lease does not include a break clause, in general neither landlord nor tenant can bring the lease to an end before the end of the fixed term without the agreement of the other.
A break clause can be a landlord break (meaning only the landlord can exercise it), a tenant break (meaning only the tenant can exercise it – the most common type), or a mutual break (either party can exercise it).
The break clause may specify a date (eg, the fifth anniversary of the term commencement date) or it may be a rolling break (eg, any time after the fifth anniversary of the term commencement date).
Key word: anniversary is used in leases to mean the same day of the year. For example, the fifth anniversary of 8 September 2030 would be 8 September 2035.
Rent in a commercial FRI lease
The rent is usually expressed as a yearly figure (eg, £80,000 per annum) but payable quarterly.
The year is divided into approximate quarters, which may run from the traditional quarter days (in bold), based on religious festivals, as follows:
25 December to 24 March
25 March to 23 June
24 June to 28 September
29 September to 24 December
These are still commonly used, but some leases now adopt the modern quarter days being 1 January, 1 April, 1 July and 1 October.
Although the quarters under neither system are the exact same length, the rent is usually divided equally (so if the rent is £80,000 per annum, £20,000 would be payable for each quarter)
· Rent is usually due in advance on the quarter day – for example, on 25 March for the whole period up to and including 23 June
· However, the lease needs to state if the rent is payable in advance (which an FRI lease will) - if the lease is silent, the rent is payable in arrears. This is more often seen in a residential long lease.
· Earlier in the element, we saw that the parties may complete the lease part way through the term. If this is part-way through a quarter, then the quarter will be apportioned, so the tenant will only pay the appropriate portion of the rent (for example, if the tenant’s lease starts one month into the quarter, they will pay approximately two thirds of that quarter’s rent).
· The lease will set out how the rent is to be paid (usually by standing order) and whether VAT is payable on it.
· The lease will usually describe other payments such as contributions to the insurance premium and service charge as “rent”. The reason for this is covered in the element on termination of leases. The rent proper is often referred to as the “annual rent” or “yearly rent”.
Types of rent review
There is no implied right for the landlord to be able to increase the rent. An FRI lease of 10 years or more will usually contain a rent review clause as an institutional investor will want to ensure that their rents are keeping up with the market.
· Stepped rent – the lease may set out, for example, a yearly rent of £25,000 for the first two years, a yearly rent of £30,000 for the next two years, and so on…
· Turnover rent – the rent may be calculated based on the tenant’s turnover at the property. This is mostly commonly seen with retail leases (eg, shops).
· Index-linked rent – the rent is increased by reference to an agreed measure of inflation, such as the retail prices index.
· Open market rent review – this is the most common type of rent review adopted by FRI leases, and involves ascertaining the rent based on comparable premises and certain principles.
Open market rent review
Open market rent review provisions can be complex and, as they affect the future rent payable, may be a particularly contentious area for negotiation.
Commercial leases almost always have an “upwards only” rent review. This means that the rent can only increase. If market rents have fallen on the date of the rent review, the rent stays the same.
Typically the rent review clauses will give the landlord and tenant the opportunity to agree the new rent between themselves. If they cannot agree, then the lease will set out a mechanism for a specialist valuer to be engaged to determine the new rent.
The valuer will consider:
· The rent payable for comparable premises (ie, premises of similar size and location) plus
· The terms of the hypothetical lease – an imaginary lease based on the actual lease but assuming certain matters and disregarding others
Assumptions
The tenant has complied with all its covenants under the lease.
Yes. If the tenant, say, lets the premises fall into disrepair, it should not be rewarded with a lower rent.
The landlord has complied with all its covenants under the lease.
No. Say that the lift in an office block never works. This would affect the rent that tenants would pay. From the tenant’s perspective, the assumption is unfair, as the landlord is not suffering the consequences of its inaction.
On the terms of the actual lease other than the rent payable.
Yes. If the actual lease, for example, has clauses that are very restrictive on the tenant’s use of the property, the tenant is stuck with those and should not have to pay a higher rent as if those clauses do not exist.
The term of the hypothetical lease is the term remaining of the actual lease.
Maybe! This is a tricky point, and can depend on the particular market, and whether prospective tenants favour short or long lease terms. Say that 5 years are left at rent review, and prospective tenants want 5 year leases. This would work against the tenant who initially took a 10 year lease.
If damaged or destroyed, the premises have been repaired or rebuilt.
Yes. This is because the lease will usually have detailed provisions for what happens in this instance (including suspending the rent). It would be unfair on the landlord if the tenant continues to pay a decreased rent as if the premises have been destroyed once they have been rebuilt!
Disregards
The effect of the tenant’s occupation on the rent.
Yes. The premises will be worth more to the tenant than a new prospective tenant, as the tenant has the convenience of not having to move.
Goodwill attached to the tenant’s business.
Yes. Say the tenant is a restaurant business. If successful, the tenant will make that location more valuable to other restaurant businesses. It is unfair for the tenant to be penalised with a higher rent for this.
Tenant’s improvements (other than as obliged under the lease)
Yes. If the tenant voluntarily improves the property, then it is unfair to the tenant if this is used to increase the rent, and unfair to the landlord if it limits the rent.
What happens after rent review?
· Once the parties have agreed the new rent, or failing that, the new rent has been determined by a valuer, the new rent is documented in a rent review memorandum. This is a short document (usually a single page) that records the new rent, is signed by the landlord and tenant and is kept with the lease for future reference.
· If the rent review is before the 5th anniversary of the term commencement date, the tenant may have to pay further Stamp Duty Land Tax or Land Transaction Tax (as this is calculated on the first five years’ rent).
· If the rent review is on or after the 5th anniversary of the term commencement date, the tenant will not have to pay further SDLT or LTT.
· If the new rent has only been agreed some time after the rent review date set out in the lease, the new rent is backdated to the rent review date. This means that the tenant will have to pay an additional sum plus interest at a rate set out in the lease (this should not be a punitive rate of interest).
Code for Leasing Business Premises
As it is recognised that landlords generally enjoy a stronger negotiating position than tenants, the Code for Leasing Business Premises (1st Edition February 2020) (“the Code”) exists to:
“improve the quality and fairness of negotiations on lease terms”
and
“promote the issue of comprehensive heads of terms that should make the legal drafting process more efficient”
Previous codes existed, but were entirely voluntary, and their influence over landlord and tenant negotiations was limited. The 2020 Code, however, does have stronger powers as this element will explore.
Where does the Code come from, and to whom does it apply?
The Code is written by the Royal Institution of Chartered Surveyors (RICS) and applies to members of the RICS and RICS regulated firms. Many property professionals, whether property firms or in-house property specialists who deal with the letting of commercial property, will be RICS regulated.
Example: a commercial landlord employs a letting agent to find tenants and negotiate heads of terms. The letting agent is an RICS regulated firm. The letting agent will be professionally obliged to take account of the Code in negotiations. Note that neither the landlord nor the landlord’s solicitor are obliged to do so, however, unless they are members of the RICS or RICS regulated firms in their own right.
The Code applies to most commercial lettings but there are exceptions (eg, tenancies of 6 months or less)
What does the Code contain?
The Code concerns itself with negotiations and heads of terms, and is divided into mandatory requirements and good practice.
· Mandatory requirements are indicated by the word “must”. RICS members and regulated firms must follow them.
· Good practice is indicated by the word “should”. RICS members and regulated firms must follow them unless there are exceptional circumstances (and they may need to be justified to the RICS).
Although the Code’s introduction states that it is concerned with the process rather than the outcome, the section on good practice does concern itself with what lease provisions should and should not be included in the lease.
Mandatory requirements
The mandatory requirements include the following:
- Lease negotiations must be approached in a constructive and collaborative manner
- An unrepresented party must be advised about the existence of the Code and recommended to seek professional advice
- The landlord (or its letting agent) is responsible for ensuring that heads of terms compliant with the Code are agreed before the draft lease is circulated
Example: an RICS regulated property agent is negotiating a lease for an institutional landlord. The prospective tenant is a new business which does not have a property agent or solicitor. The landlord’s property agent must advise the tenant about the Code and recommend that the tenant seeks legal advice.
It is also mandatory to prepare written heads of terms, stating that it is subject to contract. The Code specifies certain areas which must be covered in the heads of terms. These include:
· extent of the premises
· length of term and break rights
· rent and rent review (including basis for rent review)
· repairing obligation
· rights to assign (transfer to a new tenant) or underlet the lease
· permitted use of the property (and whether tenant can change it)
· rights to alter the property and any obligations to put the property back in its original state
Good practice
The rest of the Code (which is much more detailed) indicates good practice. As RICS members and regulated firms are obliged to follow good practice unless there is justification not to, it is likely that the provisions of the Code will become standard in time.
Some specific areas of concern are listed below:
Premises
The heads of terms should clearly define the demise, provide a lease plan and refer to all the rights that the tenant will need for its use of the premises (eg, the right of access to the premises, water and electricity, etc).
Length of term, renewal rights and break rights
The heads of terms should clearly specify the length of term and any break rights.
The Code sets out basic conditions to exercising the break that are acceptable; others may be included but must be specified in the heads of terms. (This is an area where landlord-weighted drafting of the lease can make it very difficult for a tenant to exercise the break.)
Rent and rent review
The heads of terms should clearly state the initial rent, frequency of payment (eg, quarterly) and whether VAT will be charged. They should also state whether there is a rent-free period (for example, the tenant may not have to pay rent for the first three months while they are fitting out the premises for their purposes).
If the landlord intends to review the rent, then the tenant should be advised how (eg, market rent, turnover, etc) and how often (eg, every fifth year).
Landlord’s title
The landlord should be responsible for obtaining any consent needed to grant the lease (such as from a superior landlord, mortgagee or any other third party).
Repairs
The tenant’s repairing obligation should be appropriate to the length of the term and the condition of the premises. (An extreme example might be that it would be unfair to ask a tenant on a 6 month tenancy to take a full repairing obligation of premises that are badly dilapidated!)
If the tenant gives a qualified repairing obligation (ie, limited to the initial state of the premises), a schedule of condition should be required.
Where the premises are newly built, the tenant should be given appropriate protection against inherent construction defects.
Insurance and damage
The lease should suspend the rent if the premises are damaged by an insured risk (unless the damage is due to something the tenant has done or not done) or an uninsured risk.
Other provisions of the Code will be considered alongside the relevant elements.
