Following on from the first part of our SME guide on lease terms, this second blog aims to give you a jargon-free explanation on how break options work, what we mean by “Covenant Strength” and how Rent Reviews operate.
1. Break Options
Break options are common place in modern commercial leases. The vast majority of break options are operable by the tenant only but they can be “mutual” – particularly if the Landlord has plans to redevelop the building and is just looking for short-term lets.
A break option gives the tenant the flexibility of being able to leave the premises after an agreed number of years (usually 3 or 5) or stay longer without having to negotiate new lease terms.
Do be mindful, however, that break options usually have certain conditions attached to them:
• Notice Period – a notice period is always specified – anywhere between 3 months and 12 months – and the notice period is always PRIOR to the break date. If you don’t serve notice by the deadline, you will not be able to serve notice afterwards. Make a diary note!
• Vacant Possession – most break options are conditional upon the tenant vacating the premises by the effective date of termination (the break date). This is not the date that notice is served but rather the date the lease comes to an end by service of notice to break. If you serve notice to break your lease, make sure you have vacated the premises (and taken all your furniture, equipment, belongings etc. with you) by the break date.
• Payment of Rent – it used to be the case that landlords would try to make service of break notices conditional upon there being “no breach of covenant” outstanding at the break date. This lead to a series of court cases where landlords challenged the validity of break notices served by their tenants. The most severe example was a landlord successfully claiming a break notice to be invalid because the tenant had only used 2 coats of paint to decorate a building when the lease stipulated 3 coats!!! Nowadays, most landlords accept just payment of rent as a condition of the break option – so make sure you are not in arrears!
• Payment of penalty – some break options have a penalty payable if exercised – usually a way of giving a tenant more rent free at the start of the lease but clawing some of it back if the lease is broken. Check the terms of the lease to establish whether the penalty payment should be made at the same time as serving notice or by the date the lease ends (the break date).
When serving notice to break a lease, this must be done in writing and must be sent to the landlord at the correct address.
The best advice we can give when seeking to serve a break option notice is to use a solicitor to advise you and, indeed, serve the notice on your behalf. After all, solicitors are the experts on lease documents and the law!
If you are going to do it without a solicitor, bear in mind the following:
Check the break option provisions in the lease to establish the correct form of serving notice and who it should be served on
Always send the notice in writing by Recorded Delivery – this is then a record that the letter has been delivered and received
If the landlord uses a managing agent to look after the building, send the notice (in writing) to both the Landlord and the
Send a copy with the original, asking the landlord to acknowledge receipt by signing the copy and returning it to you
Once a break notice is validly served, the lease comes to an end (on the break date). Unlike at lease expiry, there is no security of tenure under The Landlord & Tenant Act 1954, once a break option has been actioned. The only person who can allow the tenant to remain in occupation after the break date is the landlord – and only on a new lease. If you want to stay in occupation, be very careful about serving notice to break a lease just to re-negotiate terms. Have a “plan B” just in case!!!
2. Covenant Strength
Just like renting a house or apartment, landlords of commercial premises want to know who they are entering into a contract with. Commercial landlords are primarily concerned with the financial strength of the tenant, particularly in the case of limited companies.
Commercial property generally involves large sums of money. When entering into a lease agreement with a tenant, a commercial landlord will seek to establish the possible risk of default by the tenant. If a tenant defaults, the cost to the landlord can be significant:
The tenant may be in arrears of rent, service charge etc.
The landlord may have to pay for repairs or reinstatement if the premises have been left in poor condition by the tenant
The landlord will have to pay business rates on the empty premises
The landlord will have to meet the costs of re-marketing the premises to find a new tenant, including marketing expenditure,
letting agents fees, solicitors fees etc.
When entering into a new lease and perhaps having granted a rent-free period to a tenant, the landlord does not want the premises coming back vacant earlier than the expiry of the lease through the default of the tenant.
In the residential market, the landlord’s risk is usually covered by a deposit paid by the tenant and held by the landlord for the term of the tenancy and then paid back to the tenant at the end, assuming everything is ok and the tenant doesn’t owe any rent or has left the property in disrepair.
In commercial property, the landlord will consider the prospective tenant. If this is an established business with a proven track record over a number of years, the landlord will accept the tenant without a deposit. If the proposed tenant is a limited company, the landlord will ask to see the last three years audited accounts to check the financial health of the business. The standard “industry test” is that the limited company’s accounts should show average annual net profits before tax of at least three times the annual rental on the premises in question.
If the limited company’s accounts do not pass the test, then the landlord will do one or a combination of the following to cover or reduce the perceived risk associated with the limited company:
• Request a deposit – usually c. 6 months rental, but sometimes more; sometimes less. The deposit will normally be held in a separate “escrowe” interest-bearing bank account by the landlord’s solicitor and the landlord will only be able to access the money if the tenant defaults. The deposit (together with all interest earned on it) is usually returned to the tenant once the tenant can pass the audited accounts test or at the end of the lease (whichever is earlier). Sometimes, landlords will agree to return a deposit after an agreed length of time (usually a number of years) provided the tenant has paid rent on time etc.
• Request a guarantor – if the tenant is a new or recently established limited company and cannot show the requisite audited accounts, the landlord may ask one or more of the owners/directors of the company to stand as guarantor to the lease – so if the limited company defaults, the Guarantor will step in and perform the obligations of the tenant (payment of rent, repairs etc.). As with the deposit, the parties may agree that the guarantee falls away once satisfactory accounts can be shown or after an agreed length of time provided the tenant has a good payment record etc.
• Alter the terms of the deal – for example, a landlord may not want to grant a long rent free period up front to a tenant that is a new limited company. If a deposit or guarantee is not forthcoming, the landlord may want the tenant to pay full rent from lease commencement for a period of time and push the rent free period back to a later date so that some rent has already been received. The last thing the landlord wants is for the tenant to default having received no rent!
The financial strength of the tenant is of critical importance to the landlord. The stronger the tenant in this regard, the more “secure” the rental income is considered – which makes the building worth more as an investment. This is why established “blue chip” companies are able to negotiate more favourable rental terms with landlords.
3. Rent Reviews
Landlords insert rent reviews into longer leases as, over time, inflation and market forces can cause rental values to rise and landlords are understandably keen that their rental income keeps pace with inflation and the market.
Rent review patterns are normally every 5 years but 3 yearly patterns are not uncommon. The vast majority of rent reviews are upwards only. This has always been the case and market values are based on this assumption. This does not mean, however, that the rent always goes up on review. This is a matter of negotiation between the landlord and tenant and is reliant on market forces at the time.
The landlord cannot unilaterally increase the rent at review. The landlord must justify an increase in rent by providing comparable evidence to demonstrate that rental values have risen and that the open market rental of the premises on the review date is higher than the existing rent payable under the lease (the “passing rent”).
Most leases provide for “third party determination”, so that, if the landlord and tenant are unable to agree a new rent through negotiation, the review can be settled by an independent party – either an “arbitrator” or an “independent expert”. Again, if the market evidence does not support an increase in rental, the third party will not award one and his/her decision is usually final.
Rent reviews can be complex affairs and best handled by experts – rent review surveyors. The landlord usually starts the process by serving notice that the rent should be increased to a new figure (usually a lot higher than the landlord’s true opinion of rental value) and the negotiation begins from there. Until the new rent is agreed, the tenant continues to pay the passing rent. If an increase is agreed, the tenant will then pay the difference between the new rent and the passing rent, back-dated to the rent review date.
Are you worried about signing a lease agreement that you don’t fully understand? Or perhaps you’re looking to move but can’t decide which is the best option for your business. Whatever your questions or thoughts, get in touch via twitter or call us on 0161 244 5500.