Business Lease Terms: a guide for clients as potential tenants

Published on 18 Nov 2008 under category: article

1. Introduction

These notes are written by James Brenan of Cubism Law as a short guide to business people who are considering acquiring new premises for a commercial use, at a full market rent. They are only intended to be a map of the basic points which arise, so that you – the client and intended tenant – can see the overall picture and the details which comprise it more easily. They are not intended as a substitute for detailed advice and representation from a solicitor and no responsibility is accepted for action or decisions taken without obtaining such advice.

2. Tenant beware

You need to think carefully about the level of commitment you make and show to any acquisition as it goes through its transaction or deal stages. Before you invest in the cost of your solicitor carrying out searches and making a full scrutiny of the title and draft lease or contract, you ideally need to have heads of terms in place which lay down a basic structure which meets your requirements. Then, later, there will be no point in your solicitor pointing out to you onerous clauses in the documents which need to be modified in your favour or warranties which need to be insisted upon if you have already taken occupation of the premises under some informal licence and you are so committed that you can’t withdraw: the landlord will know that you have put yourself over his barrel and take advantage accordingly. Don’t commission fitting-out works until you have at least a binding agreement for lease.

You must establish which bridges need to be crossed and cross them in order of greatest risk and importance; for example, if you intend to sell liquor check as early as possible that there is no restrictive covenant on the land title which prohibits this and take a view as to the feasibility of obtaining a licence from the licensing authority. If your intended use needs a particular planning permission to be in place, go to the council offices (or do an internet search if the council has its records available in this way) to confirm that the permission exists. If it exists but has not been implemented check when it will expire. Of course, your solicitor will double-check and report on these matters later but you should do your homework as far as possible. Your solicitor may conceivably have to explain certain esoteric matters to you later so that you see the proposed deal and its risks in a different light - which is even more reason for you to get as far as you can from your own investigations.

If you are being offered premises with any level of repairing duty, consider what expenditure that will require over the term of the lease and indeed when it comes to an end. Bear in mind that a duty to keep premises in repair means to put them in repair if they are not already and that, accordingly, you may be required to hand back premises in better condition than how they were given to you. If you don’t want to speculate the cost of having a survey carried out before you put in your bid for premises, and you are concerned over their possible state, make it a clause of your bid that the premises will pass a survey whereby they are found to be in at least as good a state as they are required to be maintained under the proposed lease. Demand that the landlord or outgoing party gives you a plan of the electrical wiring and have that all tested. Check the premises against the possibility of damp or timber defects just as you would have done when buying a house and have a drains survey done if your business will rely on the drains to function adequately: for example, if you are taking basement space for keeping valuable stock or a ground floor shop or a hairdressing salon.

Consider what changes you will have to make in order to meet legal requirements, and in particular your duty to make premises accessible to the disabled. Your solicitor will explain this. Obtain a consultant’s report on fire safety and other health and safety matters, taking into account the requirements of the insurers both for the building and your premises. If your intended use of premises will require particular levels of services, such as a flue to take away kitchen fumes, or parking for delivery trucks at particular times of the day and night, be sure that you stipulate for these in your bid and consider whether the ability to have these is provided under planning and highways controls. If you are considering having a restaurant in a city centre you will need to consider the refuse collection rules of the local council, and look at the design of the premises in the light of these. If you intend to run a food preparing establishment, such as a bakery or any kind of take-away shop, consider the hours which the council will allow you to operate, and bear in mind the likelihood of neighbours complaining and how you intend to respond. If that is a sensitive issue then take expert advice on it at the earliest opportunity.

The new topic is “green leases”, which give the parties duties to minimise energy consumption and emissions. Your starting point here will be to scrutinise the legally-required Energy Performance Certificate and to take advice from a specialist surveyor as to how much these duties will cost you. From 2009 all commercial premises with air conditioning systems with a total output of more than 250 kw will require an Energy Inspection Report. (These disclosure duties on landlords are policed by local councils and scale fines can be imposed for disobeying them.)

3. The different methods of dealing to obtain your premises

The ideal method is to deal privately with the intended landlord, possibly through an agent, knowing that you are his only or at least his preferred bidder. The landlord will be taking a risk by letting premises and so will be keen to find a good and reliable tenant, who will always pay the rent on time and at the end of the lease term - unless there is a renewal or the premises are to be redeveloped - hand them back in good repair.

A second method – not as attractive but still feasible in many situations - is for you to bid in competition with other applicants. Remember that your bid will not be judged just according to the rent which you offer but also according to your covenant strength. In this situation it will be best to make your bid or proposed heads of terms as simple and landlord-friendly as possible and then, as necessary later, let your solicitor come forward with your stipulations and amendments to the landlord’s paperwork.

A third method of course is for you to take an assignment of an existing lease, or even a sub-lease, from an existing tenant. Again your covenant strength will be very relevant. In this situation you have the advantage of being able to call for a copy of the lease and to consider it with your solicitor and surveyor before making your bid.

A more problematic method entirely is to take premises which are linked to some business franchise or commercial tie which you are about to enter into. Your complications will unfortunately then multiply because you will be looking at commercial terms and feasibility issues at the same time as premises ones, and very often the two are conjoined so that you will be expected to take on lease terms which are more onerous than any set which an independent tenant would consider. For example there may be a cross-default or cross-termination clause, whereby your lease can be brought to an end in the event that the other relationship ends - even if that should be for reasons leaving you in the right. Coffee shop franchises, tied pubs and petrol garages are common examples. If you are seriously considering such a scenario, you should be well experienced in the industry concerned and think very carefully before going forward other than through a limited company and without giving any personal guarantee, or you should feel of your own circumstances that you have nothing to lose.

4. Negotiating the deal structure and heads of terms

Heads of terms are important because they set the agenda for what follows and yet it is remarkable how often business people attempt to negotiate terms of a new lease without having guidance from an experienced surveyor or solicitor. The most important thing though is for you to know the full implications and technicalities arising from your business ideas at every stage so that you can decide when it is most advantageous to demand the terms which you require – knowing that any heads of terms, for all their arguable moral force, are not legally binding. (In exceptional situations, where the lease term will be for no more than 3 years and there is performance of informally agreed terms the position might be different.) The threat accompanying your demands has to be that if you are not satisfied with the final deal terms you will walk away, leaving the transaction as abortive.

There are published property industry norms concerning the contents of leases, in the form of The Code for Leasing Business Premises in England and Wales – which lays down a model for heads of terms - and the RICS’s 2006 Code of Practice for Service Charges in Commercial Property. However, these are not binding and so are only useful for exhortation purposes.

Your solicitor’s role therefore is to ensure that you understand all the legal consequences of your proposed acquisition. It is sometimes said that this leaves you, the client, on your own to decide over the commercial aspects. Life, however, tends not to be so simple and issues often do not fall neatly into ‘legal’ and ‘commercial’ categories: some are mixed, technical, call them what you will but they require you and your expert adviser to work intelligently as a team if you are to get the best outcome.

A critical decision will be whether you should proceed straight to the grant of a lease or whether you should have a prior exchange of contracts which will exhibit an agreed draft lease, possibly with some clause (such as the completion date or the rent amount) left to be determined later in accordance with the contract. It is cheaper to go straight to the grant of lease but there may be a good reason to incur the expense and risk of having a contract in place at an intermediate stage. A contract can also be risky for the selling party: if a serious misrepresentation comes to light in between contract and completion the seller is vulnerable to the contract being cancelled, whereas it would be harder to cancel once completion has happened.

The following sections of these notes deal with the typical important topics which heads of lease terms can cover, or which can be left to be raised in the conveyancing stage.

5. To be or not to be ... protected by the Landlord and Tenant Act 1954

If the lease is so protected then you will be in a much stronger position when it expires, with regard to the possibility of staying at the same premises and not being held to ransom for the privilege.

There are certain types of business where such protection is much more important: any business which depends on remaining in particular premises at a particular location for its success over a period of time which exceeds the lease term. However, if you will be exposed to catastrophic loss from an enforced move you should seriously consider whether to go into the business at all and if you do you should carry special insurance, because other things can happen – such as fires and floods – which can have similar devastating effect and even the protection of the Act does not guarantee that you will never have to move. You should also take necessary steps to secure your future tenure by for example taking a lease with an option to renew.
A much fuller run-through of the advantages of protection under this Act is set out in the other notes on this website: “Terminating and Renewing Leases of Business Premises”.

As soon as the landlord states that he does not want to deal inside the Act and if you are going to be location dependent or would incur heavy costs of relocating in the future, you should challenge this, find out why (if you can; of course, in business negotiations there is never a duty to give reasons) and reconsider the deal – looking out for alternative premises that are inside the Act.

A statutory renewal entitles you to a downwards and upwards rent review, in effect, whereas a typical rent review mid-term will be upwards only. Another advantage of the Act’s protection, as compared with an option to renew is that you can withdraw from taking a renewal term if, once the new rent is established, you find yourself unwilling or unable to pay it – albeit there would be costs to pay. It is unusual to see such flexibility included within a purely contractual arrangement for renewal.

One advantage of taking an assignment of an existing lease is that it may carry the Act’s protection, whereas landlords are more commonly now insisting on excluding the Act when granting new leases.

Tenancies at will and those granted for a fixed term of 6 months or less are excluded from the Act’s protection. A tenancy of one year or less only has partial rights under the Act: the tenant cannot give a notice to the landlord calling for a new lease but can still carry on occupying the premises under the old terms until it chooses to leave (on giving notice) or it is terminated by the landlord following the Act’s notice procedure.

6. The demise

This term refers to the definition of the space to be let, according to such things as a plan and boundary structures and the length of lease term being given. These aspects should be defined as accurately as possible. Leases of 7 years and over and those being granted to come into effect more that 3 months into the future are required to be registered at the Land Registry and so the Registry’s requirements for proper plans will have to be followed in these cases.
The length of term can have an effect on the rental value, depending on the local market for premises.

7. Included rights

You should stipulate for any which will be essential or useful for your business in order to avoid arguments later over what may be implied. Resist having any essential ancillary rights granted to you by a side-letter, as that is an inferior level of protection. If there is to be such a letter, it should say that the landlord will disclose it to any party intending to buy the reversion.

Signage rights can be mentioned and even defined regarding details such as projection and illumination.

When the draft lease arrives you should look out for excluded rights, such as a declaration that you have no rights of light or air so as to prevent the landlord from developing its adjacent land or space.

8. Covenant strength and reinforcement

If your trading vehicle is a limited company with a small net worth it will not be very attractive to any landlord. Consider what level of rent deposit or personal guarantee you are willing to offer. Consider making any guarantee releasable after a certain period once your company has established a record of paying rent on time. Stipulate whether the guarantee will be effective in the event that the premises are assigned and your company gives a statutory guarantee for the incoming party.

Watch out when the draft lease arrives that the original landlord does not provide for a release of its continuing responsibilities upon assigning the reversion, or that there will be adequate cover if it does.

Equally, make sure that your solicitor considers your proposed landlord’s title to the premises – even if there is no strict legal necessity for him to show title - and that you consider the landlord’s reliability. If he owns under lease himself you will be at risk of losing your premises if his lease is forfeited, albeit you will have certain protection which is potentially uncertain and expensive to enforce. Also, if there is a superior landlord then you will probably have to pay double the usual fees for seeking any licence under the lease.

If you are acquiring premises in a serviced building or shopping mall consider the risk of scheme failure and its implications for you as a tenant.

9. Options to break or to renew

One of these needs to be carefully thought through and then defined in the lease. Again, it will have an effect on the rent, which a valuer will advise upon in any detail.

An option to break may be made conditional upon compliance with the lease, in which case you must insist that this is intended to refer to “substantial” compliance only, so as to disregard minimal breaches. It would still be a risky wording to have and it is far better to make the right unconditional. (The above Code of Practice advises that only the following conditions should be imposed: (i) that the main rent, and not service charges, must be paid up to date; (ii) that the tenant leaves the property on time, and (iii) that any sub-lease has been terminated.)

From a Stamp Duty perspective, it is cheaper to have a short lease with an option to renew than to have a longer lease with an option to break. You will have to make a new declaration to the Inland Revenue – possibly accompanied by a payment of further tax, depending on the details - upon exercising the option, whereas if you exercise a right to break you will have paid duty in respect of the longer term and you will not be entitled to any refund. Otherwise, each arrangement is capable of giving the same outcome: it can be just a question of whether you prefer to be bound to the longer term, so that any slip up in giving the notice of exercise of break option locks you in, or whether you prefer to be bound by the shorter term, in which case vice-versa.

10. The permitted use

You must check independently that this has the necessary planning and any other regulatory consent. Landlords always exclude any implied warranty to this effect.

If this is by reference to the Town and Country Planning (Use Classes) Order 1987 (as amended), read through that Order and take advice on it. Some flexibility is usually advisable for both sides.

Consider the ability to seek landlord’s consent to a variation of the use, possibly within certain defined classes under the above Order.
Bear in mind that the narrower the permitted use, the less valuable the premises may be upon rent review and lease renewal

11. The rent

The amount is obviously a commercial matter but it will be affected by a range of legal points. Here area few:

- will it be subject to VAT?

- if so, can you claim back the VAT?

- will you get a rent-free period?

- beware of a ‘headline rent’ which is an inflated amount to compensate for benefits such as a rent-free period; it may be better just to pay the market rent and forego the benefits, especially as headline rents are designed to contaminate the market’s perception of what the premises are worth.

- indexed-linked rents are often a bad idea: if the relevant index (typically the RPI) goes up by a lot (say more than 5%) this may easily coincide with an economic decline which causes the open market value of the premises to go in the opposite direction, downwards; they are also notoriously cumbersome arrangements to operate in practice due to time intervals in the publishing of the index and the possibility of change to the method of compiling the index.

Any rent review regime will need to be considered in detail by your solicitor, regarding its procedure and the definitions of the new rent and the assumptions and disregards. In particular you must avoid having any wording which artificially inflates the rent, for example by deeming your fitting-out works to have been done under a duty or at the landlord’s cost or by deeming the hypothetical lease to include a rent-free period.
Any turnover-related rent will need special consideration. These are demanded by landlords who want to benefit from future growth in your turnover. They are common in certain industries such as car parking, hotels and shopping mall units. Some turnover rent provisions are so complicated that you may need advice from an accountant as much as from a surveyor and solicitor.

12. Outgoings

You should check directly with the local council what the annual business rates will be and make similar enquiries regarding water rates.
It can be a bad idea to agree a rent which is inclusive of the landlord paying rates. If the landlord defaults you will still be held liable by the council, as the rateable occupier.

You should check that all services are separately metered and if they are not insist that the landlord arranges and pays for this to your satisfaction. Agree where any new meters will be placed.

13. The repairing scheme

You may be free of any repairing obligation, or have one which is limited by a schedule of condition, or be liable to keep only interior surfaces and plate glass in repair, or you may have a full repairing and insuring duty regarding the structure as well as the interior. Alongside any lower level of repairing duty you may be asked to contribute a service charge towards the insurance, repair and cleaning of the building which houses the premises. It is important that you fully understand which level of duty is to apply and what the implications will be for your expenditure over the period of lease. When considering the proposed repairing duty you will need to have regard to the risks covered by the landlord’s buildings insurance policy.

Any requirement on you to take measures to reduce energy consumption and emissions can amount to a duty to make improvements and, to make matters worse, these might be rentalised against you upon reviews. You should insist that any “green” objectives are voluntary and contained in a non-binding side letter unless you can discount the rent fully to take them into account.

If you are asked to pay a service charge you should consider a number of points:

- consider the commencement date and the ending date of the landlord’s accounting year.

- if these do not coincide with the beginning and end dates of your lease term, you should consider have a fixed amount for the opening period at least.

- consider what services are to be provided relative to your own needs and consider having a fixed contribution or a capped contribution instead.

- investigate and take advice if necessary on the life expectancy of capital equipment such as lifts in the building and your exposure to pay towards replacing these at the end of their life, or at such time within your lease term when the landlord thinks they should be replaced - these are more factors in favour of having a capped liability.

- beware of any duty to pay into a sinking fund or a depreciation reserve fund.

You should consider excluding from your responsibility any liability to remedy any inherent defects in the property and stipulating that these are for the landlord to remedy instead.

You should also consider taking a covenant from the landlord for the repair and decoration of other parts of the building containing the premises: this duty is never volunteered by landlords and is often omitted, to the occasional annoyance, embarrassment and even the cost of tenants.

14. Ability to assign or sub-let

The less freedom that you have in these regards, the more wary you should be and the less rent you should be paying. When the draft lease arrives you will need to consider laying down some criteria in your favour by which the landlord must consider any application for permission to assign; landlords usually lay down plenty in their own favour to give a basis for refusal.

Any right to sub-let should be at an open market rent, regardless if that leaves you having to make up a shortfall in the rent payable under your lease. Otherwise, if you have agreed to pay a higher than market rent or if the market rent falls, you will find that the premises are impossible to sub-let.
Some leases contain an “offer-back” provision whereby you can be required to surrender the premises instead of assigning them. You will need detailed advice on the related notice procedure and valuation formula.

15. Making alterations upon moving in

These will typically have to be regulated by a licence for alterations, for which landlords seek to recover their professional costs. You can make your bid conditional upon the licence being granted at the same time as the lease. You can stipulate that the licence must not require the premises to be reinstated at the end of the lease term.

The disadvantage from dealing with improvements simultaneously with the commencement of the lease is that you will miss out on the opportunity to follow the notice procedure and so set yourself up to be entitled to claim compensation for them – under sections 1 to 3 of the Landlord and Tenant Act 1927 -upon the lease ending. (This area is more fully explained in other notes on this website: “Additions and Improvements to Leasehold Premises”.)

16. Trading rules and restrictions

If your premises are not directly accessible from the public highway and you require access at all times you should stipulate for this.
You may also want the landlord to promise you a certain trading exclusivity in a defined area under his control. An example would be that yours will be the only gift shop in a particular leisure centre. In that instance your solicitor will later need to define exactly what is meant by a gift shop.
In the other direction, you may be bound by a “keep open” covenant or restrictions on the merchandise which you can sell. You may be tied to sell certain suppliers’ products only.

17. Summary

The pattern is that each of the above issues can cut both ways and that something which you want may raise drafting issues, if not major deal design ones, and so you should check any proposed heads of terms with your solicitor before agreeing them.

When the title documents, replies to enquiries, search results and draft lease arrive, your solicitor should advise you on any issues arising without delay. It can be far less useful to know of a problem and the possible ways of responding to it when you are just about to conclude the transaction.