THE BIG HAGGLE
“NEGOTIATING THE TERMS OF A COMMERCIAL LEASE”
The following is based on some recent leases where Craddock Murray Neumann Lawyers were retained to act for one of the parties.
How much haggling is too much?
This depends on the market. If there is a glut of vacant premises, most keen landlords will put up with a fair amount of haggling. If supply is tight it will be more difficult to negotiate terms. However, we have never acted on a lease where a landlord has refused to negotiate, and if you are a tenant, it is worthwhile having a go.
Base rental and incentives
Many modern leases are prepared in a form that sets out a base rental, often expressed to be an amount which increases each year, and then tenants are allowed an “incentive”. The incentive can be expressed as a dollar amount, and the tenant can for example take the incentive by:
- applying it to fit-out costs, or
- applying it to a rent free period at commencement of the lease, or
- if the landlord agrees, applying the incentive as a rebate or a reduction in the rent payable throughout the lease term. If the tenant takes the incentive as a rent reduction over the lease term, this can give rise to an effective rental that may be significantly below the base rental. The risk is that this form of incentive can have serious consequences if the tenant defaults - because then the base rent will cut in, and the tenant may end up with a liability escalating at a frightening rate.
Often a landlord will be offering commercial premises with multiple tenancies. By structuring the lease with a base rental and then allowing incentives, the landlord will have the flexibility to do separate deals with tenants, while showing a higher rate of return on paper (e.g to a mortgagee) than the actual return received.
Further, if there is a “ratchet” clause in the lease (i.e. where the rent following a rent review or exercise of the option cannot be less than the previous base rent), the “base rent less incentive” structure works in favour of the landlord. This is because such a provision results in the incentive being disregarded in the calculation of the new base rent.
The amount of the incentive will depend on the market. In a recent matter in which we acted, (a five year lease with a three year option, with annual increases in the base rent), the “incentive” allowed by the landlord was 18% per annum for years 1, 2 and 3, and 25% per annum for years 4 and 5. The landlord had agreed to a “break clause” allowing the tenant to terminate after year 3 (see below).
This structure had the advantages:
- from the landlord’s position, that the bulk of the incentive would only be allowed if the tenant stayed on after year 3; and
- from the tenant’s point of view, that there would be no substantial increase in effective rent during the initial term of the lease.
It is very important for your lawyer to advise on any incentive structure to ensure that the party for whom the lawyer is acting gets the best outcome.
Parties to the lease
Even if the tenant is an unincorporated sole trader or partnership, the tenant should always consider using a company as the vehicle to take on the obligations under the lease.
This suggestion is made subject to any accounting advice a tenant might receive in relation to the taxation consequences of acting in this way.
However, from a legal point of view, companies provide some added protection against the liability of those standing behind it (directors and shareholders). This is subject to certain exceptions (e.g. insolvent trading), which are beyond the scope of this article. Another exception is where the landlord insists on a personal guarantee.
If those to occupy the premises are not the same person as the tenant named on the lease (e.g. if a company is the tenant but the actual occupier is a partnership comprised of the directors of the company), there should be specific provision made in the lease to allow a sub-lease or right of occupation in favour of the intended occupier.
Outgoings
Rent sometimes is quoted as including outgoings (sometimes referred to as “gross rent”), in which case the lease should not require the tenant to contribute to the landlord’s holding costs.
If rent does not include outgoings (sometimes referred to as “net rent”), the lease should specify the contribution the tenant is required to make.
Sometimes a tenant is required to pay its proportion of “increases in outgoings” above a base year. The proportion represents the part of the premises occupied, e.g. if the tenant occupies half the premises, then the tenant may be required to pay half the increases in outgoings. The tenant should always insist on the proportion being specified in a lease (e.g. as a percentage) because there is much room for argument when a survey is conducted, e.g. how should common areas be allocated when determining the area of premises? This requirement is mandatory in retail leases (see our article on the Retail Leases Act by clicking here).
It is possible to negotiate in relation to this issue as well – in one lease matter that we acted on, the landlord was prepared to exclude a hallway leading from a lift to the back of the premises even though the tenant occupied the whole floor and had exclusive use of that hallway. A tenant can request the landlord to provide evidence of any increases in outgoings (e.g. land tax, council rate and water rate certificates) and the method used by the landlord in calculating the increase.
Access for fit-out or occupation.
We have seen parties negotiate access for fit-out prior to the commencement of the lease. This can lead to issues down the track if a lease does not eventuate, and we do not recommend this as a practice. If you are a landlord, you should always insist that the executed lease, bank guarantee, insurance and rent deposit be in place before allowing any right of occupation.
Agreements to lease
If you are a tenant negotiating a lease to commence at a future date, you should ensure that, where appropriate, you have an executed agreement to lease with the landlord. An agreement to lease binds the tenant and the landlord to enter into the lease (in terms already agreed) and annexed to the agreement to lease on the commencement date (as agreed).
The agreement to lease confirms such matters as:
- the hand-over date – the date the landlord has completed the landlord fit-out works and is ready to hand the premises to the tenant to commence fit-out;
- the fit-out completion date - the date that the tenant is expected to have completed the fit-out;
- fit-out period – period between the hand-over date and the fit-out completion date; usually rent is not payable during this period;
- the commencement date - the date the parties enter into the lease.
The fit out work the landlord is to perform at its cost and the fit out work the tenant is to perform at its cost should be clearly understood by both parties and set out in the agreement to lease.
Any agreement to lease should be reviewed by a solicitor as a party may wish to have a provision which will enable them to get out of the agreement to lease in certain circumstances (e.g the landlord hands over the premises 6 months late).
Fit-out and fixtures
If, as is usually the case, the lessee intends to make alteration to the premises:
- if you are the tenant, you may want the lease to leave you free in relation to the fit-out you wish to install, subject to council approval and compliance with statutory obligations (e.g. access to fire exits etc);
- if you are the landlord, you may have certain requirements as to the quality and nature of the fit out; this may be set out in a tenant fit out manual; and
- in either case, you should agree in the lease about who will own the fit-out and whether it is to be removed or left in place at the end of the lease and who pays for its removal.
Sometimes the landlord installs the fit-out to the tenant’s specifications. More usually, the tenant will be installing the fit-out, and before commencing any fit out works the tenant should:
- carefully review the landlord’s requirements and the tenant fit-out manual;
- prepare plans for the fit-out for approval by the landlord; and
- obtain all necessary council and other government authority approvals (including occupational health and safety, fire compliance etc).
The lease should require that:
- all approvals (including from appropriate government authorities) is to be obtained prior to commencement of the work, and
- on completion of the fit-out, the lessee is to provide the lessor with a certificate of compliance, and in the case of air-conditioning, air balance readings.
Lessor’s works
If it is required that the lessor conduct work, this should be specified in the lease or the agreement to lease e.g. repainting the premises, replacement of broken or damaged ceiling tiles, provision of electrical power sockets, construction of partitioning etc.
Questions of presentation, access, and facilities available in the building may be very important to tenants. The tenant should, before negotiating a lease, sit down and make a list of their requirements in this regard and any specific requirements should be made the subject of negotiations and included in the lease. For example, in a recent negotiation for rental of a strata floor in an office building, the landlord agreed to renovate a shabby foyer within one year of the tenant commencing occupation. A tenant does have certain remedies where a landlord does work or fails to do work which contributes to a reduction in passing trade to the tenant’s premises in a retail shopping complex (refer to our article on Retail Leases here).
Cleaning
Ongoing cleaning costs can be substantial. If the lessor is to provide cleaning, the rate should be agreed at the commencement of the lease. A tenant should only be obliged to pay its fair portion of these costs (refer heading “Outgoings”).
After hours air-conditioning
The price of providing this should be agreed in the lease.
Legal fees
Most leases provide that the tenant will pay the legal expenses of the landlord. If the Retail Leases Act 1994 applies to the lease, a tenant will not have to pay the landlord’s legal fees unless the tenant requests certain amendments to the lease from the landlord (refer article on Retail Leases here).
If the Retail Leases Act does not apply, some tenants object to paying the landlord’s legal costs, which often also include the mortgagee’s costs of consenting to the lease. Again this is a question for the market. If there are high vacancy rates the tenant’s view will probably prevail. If there are low vacancy rates the landlord will win the argument.
It is possible to compromise by providing that each party must pay their own legal expenses, but that if for example the lessor’s reasonable legal costs exceed an agreed amount, the lessee will pay the excess. It is also possible to provide in pre-lease heads of agreement that if a party withdraws from negotiations, the other party will be responsible for the legal costs of both parties. A term to this effect could be dangerous for a party if the other party (or their solicitors) act unreasonably in the negotiations.
Stamp duty
It is usual that the tenant bears the costs of stamp duty and registering the lease. However, the NSW government has introduced legislation abolishing stamp duty on leases entered into on or after1 January 2008. However, stamp duty is still payable on premiums (amounts paid to landlord) for the benefit of exercising an option under a lease where the lease was entered into after 1 July 2006.
Personal guarantees
Particularly where the tenant is a company (as will usually be the case), landlords will often insist on the directors providing a personal guarantee that the tenant will perform its obligations (usually called a “director’s guarantee”). Such a guarantee will often be a major personal liability for a director and will negate some of the benefit of using a company as the vehicle to take on the obligations of the tenant under the lease.
The ability of the tenant to negotiate the terms of the guarantee, e.g. to limit liability to a specified amount, will depend on the market and the perceived risk faced by the landlord in renting to the particular tenant. Some “solid gold” tenants refuse to provide director’s guarantees, and depending on the market, some get away with it.
Bank guarantee
In addition to a personal guarantee, landlords often require a bond in the form of a bank guarantee, e.g. that the bank will provide a guarantee in favour of the landlord for a sum equivalent to a specified number of months gross rental payable during the term of the lease. If the bank has to pay under the guarantee, then the bank will invariably seek to recover the amount it pays from its customer (i.e. the tenant or often its directors).
Therefore the bank guarantee provides valuable security for the landlord and the tenant should look carefully at the terms of any bank guarantee required. A party should consult their solicitor as to the terms upon which a party may draw on a bank guarantee or security deposit.
Landlords who draw on bank guarantees or security deposits under retail leases must comply with the terms of the Retail Leases Act 1994 (refer article Retail Leases here).
Again, depending on the market, it is possible to negotiate the amount that the landlord requires to be secured by way of bank guarantee, and the outcome of the negotiations will depend again on market conditions and the perceived risk faced by the landlord in relation to the lease.
Make-good provision
From the landlord’s perspective it is important to specify with clarity what is required of the tenant. We recently acted in a matter where the tenant was able to use ambiguities in the make-good provision to reduce the contribution of a tenant to repainting costs.
From a tenant’s point of view, again depending on market conditions and bargaining power, it is possible to negotiate the make-good provision. Amendments we have negotiated include an agreement that the tenant is not required to remove any fit-out installed with the permission of the landlord.
It is usual that the landlord will:
- require the tenant to remove all fit–out and repair any damage caused to the premises at its cost, but
- agree to exempt fair wear and tear from the make-good provision.
Car parking
Whether car parking terms are negotiable will always depend on the market and how much space the tenant is agreeing to rent. We once assisted a tenant who was able to negotiate a free car parking space because it could only fit a small car and the tenant was otherwise taking a substantial portion of the building.
Landlords usually insist that car parking will be governed by a separate licence deed and that the car space will not necessarily be available for the whole of the term of the lease. If this is an issue, e.g. if car spaces are being used to provide customer parking, then the tenant should insist that car spaces be available for the term of the lease and any option period.
Should a landlord request that a tenant enter into a separate car park licence, the tenant should have its solicitor check the terms of the licence. Car park licenses may have disclaimers relating to damage to vehicles, and may permit the landlord to end the licence in certain circumstances. In particular, a tenant should consider how many car park spaces are required, as many leases prohibit employees from parking in customer parking areas. If there are no other suitable parking arrangements this requirement may be inappropriate.
Deposit
Landlords usually ask for about one months gross rental in advance, sometimes as security once a Heads of Agreement is signed, to enable the property to be taken off the market so that terms of the lease can be prepared, negotiated and finalised.
GST
If you are the landlord, you should always insist that GST is payable in addition to rent.
Signage
The question of right to erect signs and the question of who has to pay for the signs should be a term of the lease. If the sign is to be attached to the building the tenant will require the permission of the landlord as well as the owner of the building.
Permitted hours of use
These should also be agreed and specified in the lease. The tenant should speak with the council and obtain any development consents required in relation to the proposed use of the premises. It is the tenant’s obligation to ensure all approvals in relation to the use of the premises are in order (refer heading Fit- Out Works).
Permitted use of the premises
This will depend both on the lease and on zoning (and other government) requirements (e.g a liquor license may be required). Your solicitor can assist in this regard.
Agreement to assign or sub-lease
Particularly if the business is run by a partnership that is interposing a company to assume the obligations of the tenant (in order to limit liability), the lease should always provide that the operator of the business is to be permitted to occupy the premises, whether as licensee or sub-lessee.
The tenant may also insist on a right to sub-lease or assign to an independent third party. This is particularly important if there is a downturn in business and the tenant should insist that such a right exists in relation to the whole or part of the premises. The landlord, on the other hand, will wish to insist (quite reasonably) at least that any sub-tenant or licensee be a responsible party capable of fulfilling the tenant’s obligations under the lease, and the lease should so provide.
In relation to a retail lease, a landlord may withhold consent to a proposed assignment of the lease if the use of the premises will not be the same or if the assignee has inferior financial resources or retail experience. However, the landlord must be reasonable in refusing an assignment of the lease (refer Retail Leases article here). If a tenant wants to assign or sub-let premises or mortgage its lease it should raise these issues with its solicitor so that consent for these items may be negotiated and suitable terms inserted.
Rent deposit
Often when heads of agreement are signed, they will provide that the rent deposit will be forfeited if the tenant does not proceed to execute a lease. From a landlord’s perspective, it is important that this clause be drafted to minimise the danger of a Court holding that the provision is a “penalty” bearing no relationship to the landlord’s actual loss (Courts do not enforce “penalties”).
Draft heads of agreement
Both parties may wish to insist that any draft Heads of Agreement do not constitute a lease or an agreement to lease, leaving the parties free to negotiate the best terms available to them. If the parties do not specify this as the case, it is possible that the parties may be viewed as having already entered into a legally binding agreement.
In addition a landlord should be cautious not to allow a tenant to have possession of premises, or receive rent from the tenant, prior to execution of the lease, because both of these can lead to the law implying a lease where the landlord (or tenant) may want to further negotiate the terms. In relation to retail leases, a lease can be deemed to commence on the date of possession and the implied obligations on both parties under the Retail Leases Act 1994 can therefore arise upon the tenant being given possession (refer Retail Leases Article here). This situation is not a good one for landlords, particularly where the terms remain uncertain and are not in writing.
Break clause
If you are a tenant, you may not be sure that your business will always go as you plan. On the other hand, the tenant should be aware that the longer the term of the lease, the more attractive they are likely to be to a landlord, and the more negotiable will be the rent and other important terms. Therefore, the tenant may be prepared to commit to a long term lease on the basis that there is a “break-clause” which allows the tenant to terminate the lease, e.g. in a five year lease, at the end of year 3 on 6 months written notice. A tenant should consult their solicitor if they propose to serve a notice under the lease. The solicitor will check that the notice is in the correct form, complies with the requirements under the lease and will advise how it should be served on the other party as required under the lease. This will ensure that the tenant’s interests are protected.
From the landlord’s perspective, the landlord will want more of any incentive to be applied after the right to terminate under the break clause has expired, e.g. a five year lease with a right to terminate at the end of year 3 could be structured so that the tenant receives a smaller incentive in years 1, 2 and 3 than the tenant receives in years 4 and 5.
The option for renewal
An option for renewal will normally require the tenant to serve a notice in writing on the landlord to renew the lease. The dates within which the notice must be served are set out in the option clause (“the notice period”). The tenant should diarise an appointment with their solicitor well before this notice period commences. The tenant should ask the solicitor if the tenant should serve a notice and to check that the notice is in the correct form, complies with the requirements under the lease, and the solicitor should be asked to advise on how the notice is to be served on the other party to comply with the lease. This will ensure that the tenant’s interests are protected.
Particularly where there is a long-term initial lease, parties sometimes spend less time than they should in negotiating the formula for determining rent to be charged during any option period.
Sometimes the rent for the initial lease is low as an incentive to the tenant. Often the rent will revert to “market” on exercise of the option to renew. This can lead to a very significant increase in the rent.
Further, a tenant may establish significant goodwill based on their location. The loss and expense that will result from moving premises at the end of the lease is a factor favouring the landlord in negotiating the market rent during the option period, and the landlord knows this.
Therefore, if the lease provides that the rent shifts to market during the new lease term resulting form the exercise of an option, the tenant might seek to insist that the formula for determining market rent exclude any value associated with the premises arising from the tenant’s business, and also that the value of the tenant’s fit-out be excluded from determining market value. The landlord might wish to insist on certain assumptions, e.g. that the value of any incentives offered in the marketplace be disregarded - something a tenant might think is artificial in a market that is likely to continue to offer tenants with high incentives.
Particularly where there is a long initial lease in place, a landlord will usually want rent during the option period to be set by the market. The trouble with this from the tenant’s view, is that many leases require tenants to exercise the option before the landlord nominates the market rent, and it can be very hard to determine the market rent and very expensive to engage in the dispute resolution processes which most leases provide, and as any litigator knows, dispute resolution process can be unpredictable.
For these reasons in a recent matter in which we acted for the tenant, the landlord agreed to provide an estimate of market rental to be claimed during the option period before the time for exercise of the option started. Thus if the landlord was going to be unreasonable, the tenant had time to find new premises. In another negotiation where we acted for the tenant, the landlord did not agree to this proposal. Again, a lot comes down to market conditions.
In relation to retail leases with an option to renew a landlord is obligated to comply with a tenant’s written request to determine the market rent under the lease, where the notice is served between 6 and 3 months before the date of expiration of the notice period. The tenant then has 21 days to serve a notice exercising the option (refer Retail Leases article here).
Agents
A quick word about agents.
If you are a tenant, you can seek advice from an independent agent, as well as your lawyer, on what you can ask for in a lease.
If you are a landlord, retaining good tenants is probably very important to you. An attentive agent can not only help you negotiate a good deal, but if the agent is looking after the building on a day-to-day basis during the term of a lease, make sure they are responsive (within reason) to the tenant’s needs, e.g. making sure facilities are maintained (e.g. lifts and air conditioning etc). This can make the difference between a tenant who renews term after term, or on the other hand, a tenant who vacates at the end of the initial term, leaving the landlord with the inevitable vacancy period before the next tenant takes possession. So if you are a landlord, when choosing an agent, do not buy only on price.
Insurance
All commercial and retail leases will require tenants to take out various forms of insurance, such as insurance for public liability, building, glass, and your fittings. Landlords usually also take out their own insurance on the premises and most leases require the tenant’s insurance policies to either be in the name of the landlord as well as the tenant or to note the interest of the landlord as beneficiary in the policy.
Larger corporate tenants may prefer to carry their own insurance for things like fire and third party insurance rather than have the landlord carry it and then reimburse the landlord for the premium, and so their leases need to provide for this. They have the bargaining power to require it. Often they will have premises in several locations and so they can negotiate a cheaper premium compared to what most landlords would pay.
It is important for both landlords and tenants to consult an insurance broker about their insurance needs and to speak to their solicitor whilst negotiating the lease about ensuring that the lease terms regarding insurance are consistent with the requirements of the insurer. Sometimes the insurance clause in the lease can require the tenant to take out insurance in a way that the insurer may refuse to comply with.
The fine detail
The above represents some of the matters that should be addressed in a heads of agreement, and represents only a fraction of the matters which a good lease should address.
Leases are a major commitment by both parties. Whilst legal costs are significant, a well-drafted lease that protects the rights, which the parties have negotiated may save them from significant expense and disputation down the track.
It is therefore worthwhile taking the time and incurring the expense in having an experienced lawyer look at the lease in detail. It is also important to use a lawyer who is prepared to hold their ground in a negotiation, but within reason. You do not want a lawyer who is so aggressive, unreasonable or intransigent that the other party walks away from the deal.
In other words, your lawyer’s negotiating skills can make the difference not only between a good deal and a bad deal, but also between a good deal and the deal falling over. We like to think that we have the skills to help put a good deal together.
For expert advice on all leasing matters, contact either Julian van Leer, Partner or Nick Houen, Special Counsel
The information contained in this article was current as at 23 November 2007.