A Guide to the Property Market of England & Wales
Part V - Lease Provisions
Introduction
It is wise to remember that an initial draft of a lease is prepared in the landlord's favour as it is almost always drafted by his solicitors. Of course the interests of the tenant are also detailed but the bias, at the initial stage, prior to lawyer’s negotiations is towards the landlord. The draft will include a number of legal principles to protect both landlord’s and tenant’s position.
The paperwork involved in the lease can be lengthy and complex. A single document might be eighty-ninety pages in length – mercifully most are between thirty and fifty pages long. Apart from the main terms of the lease, which would comprise a description of the property or demised premises, the parties, the period of the tenancy and the rent, the lease deals with such matters as the method of rent payment, the permitted use of the property, alienation, the obligations of the parties and the rent review provisions.
Method of Rent Payment
Generally the lease will provide for the rent to be paid directly from the tenant's bank to the landlord's by way of electronic transfer. Rent is normally due in advance upon the four Quarter Days; 25th March, 24th June, 29th September and 25th December. Some occupiers find it contrary to their business requirements to pay rent in this manner and thus a landlord may agree but only very rarely to issue an invoice for the rent due and accept payment by cheque, bankers draft etc.
Permitted Use
The lease will specify within the user clause the permitted use of the premises i.e. offices, banking etc. and will specifically prohibit others.
Alienation
The lease will restrict a tenant's alienation rights of assignment, underletting and shared occupation. Generally leases will allow a tenant to assign his entire interest and in many cases he will also have the ability to underlet the whole premises. Provisions may also be included to underlet parts but these are usually restricted to the number of under tenants or occupiers allowed or by area which may be underlet.
In addition, a tenant will usually have the ability to share occupation with associated or affiliated companies subject to either specified criteria set out within the lease or by reference to the relevant statutes.
It is important for tenants to try to agree the most flexible provision possible not only for his own occupational purposes, perceived or otherwise, but also to aid the future disposal of the premises.
See also page 6 regarding Privity of Contract and the Landlord & Tenant (Covenant) Act 1995. This is also an issue that needs to be addressed at the outset of negotiations.
Rent Review Provisions
It is standard practice for leases of office premises for a period in excess of five years (although this is not always the case) to contain a provision for the review of the rent payable.
This usually occurs at five yearly intervals. The reason for the inclusion of the rent review clause is to update in monetary terms the economic value of the interest conferred by the landlord on a tenant, as the initial rent fixed may no longer reflect the current market value of the interest. The object of a variable rent can be seen therefore as a way for the landlord to periodically secure the true value of the interest.
The provisions of rent review clauses are based upon prevailing market conditions, whether a landlord's or tenant's market, and, in the majority of cases, will be on an upward only basis (i.e. the rent can stay the same or increase but not fall) to protect the landlord if the review takes place during or following a declining market.
The lease will usually include a mechanism to trigger the rent review operation and can often be initiated by either the landlord or the tenant but it is typically activated by the former in order to protect his interest. The usual method is by way of a notice which might include a proposal for the revised rent which, in the opinion of the landlord, is the new open market value for the premises at the specified review date.
Once the review mechanism has been initiated, which can be subject to strict time limits, it is common for the landlord and tenant, or their respective advisers, to discuss the principles behind the rent review clause in order to ascertain the revised rent. The valuation of the revised rental will usually be based upon certain hypothetical assumptions. The basis of the valuation may not therefore reflect the circumstances of an open market transaction in all respects.
Over recent years there has been much legal argument over how these hypothetical assumptions are to be interpreted and this has led to much litigation in the courts.
The principal negotiations between the landlord and tenant at the time of the original drafting of the lease are more normally on the removal/inclusion or modification of these hypothetical assumptions.
Should the landlord and tenant, or their respective advisers, not be able to agree an acceptable new rent, then the lease provides for a method which finally and conclusively settles the amount of the new rent because only in that way can it be rendered certain. This is normally achieved by providing for determination of the rent by an independent third party, who would either be an arbitrator or an expert. Where the rent is to be ascertained in this way, the third party will normally ask for written representations from the landlord and tenant, or their advisers, setting out the reasons for their respective opinions of value.
The third party's decision is binding on both parties and must be accepted in nearly all instances. The tenant is not able to vacate the premises and cease paying rent should he not agree with the revised rent and similarly a landlord cannot evict a tenant should he feel similarly aggrieved.
The only way for a tenant or landlord to break the lease at this stage without negotiation is if either or both benefit from a break option which coincides with the rent review date.
The Obligations of the Parties
The lease will also cover the obligations of both parties. The tenant’s obligations, for example, will include:-
a. To pay the rent;
b. To keep the property in good repair both externally and internally or, in a multi-occupied building, pay a proportion of the cost incurred by the landlord in doing these works (but not within the demise);
c. To pay for insurance and all relevant taxes;
d. To use the property in a manner so as not to diminish its value;
e. To return the property to the landlord in good and substantial repair at the end of the lease so that the property retains its full value. This means that the property should be reinstated to the condition, if not better, in which it was let to the tenant (or original tenant, in the event that an assignment transaction has occurred). In theory this includes the removal of tenant's fixtures and fittings. A list of the works required is served on a tenant which is known as the Schedule of Dilapidations. It is more usual in practice for the tenant to pay a capital sum to the landlord at the end of the term to cover the cost of these works rather than undertaking the works himself.
If the tenant fails to pay the rent or is in breach of the other obligations set out under the lease, then he may be sued for damages or ultimately forced to forfeit the property. However, these remedies are subject to the final decision of the courts.
The landlord also has obligations to the tenant. These include:
a. To allow the tenant quiet enjoyment of the premises;
b. To insure the building against certain risks; and
c. To provide specified services and maintain and repair the property in the case of a multi-tenanted building.
Service Charge and Insurance
If the building is multi-tenanted, a tenant may be liable to pay a service charge. This represents his share of the cost incurred by the landlord in providing, amongst other things, air-conditioning, central heating, security, together with the cleaning and maintenance of the common parts. In addition, this charge will also include a proportion of the cost incurred by the landlord in repairing and maintaining the building both internally and externally. The service charge is payable on the same Quarter Days as the principal rent, normally with the provision for a balancing payment at the end of the accounting year to reflect the actual costs incurred.
A lease that incorporates such a service charge is commonly referred to as a proportional or effective full repairing and insuring lease (FRI) and the tenant's liability is usually defined as a percentage of the total cost. This percentage is usually based on the net internal floor area occupied relative to the floor area of the building.
Should a tenant occupy an entire building then the lease is generally of a full repairing and insuring nature and as such there are no common services. The tenant therefore would be fully responsible for the building and thus the lease would contain no service charge provisions unless it was within an office campus where as estate charge may apply.
An additional service charge may be levied on the occupiers of units within an office campus development in order to pay the cost of maintaining the common areas e.g. landscaping, estate security etc.
A landlord will normally insure the buildings and mechanical services, e.g. lifts, plant etc. and will recover the costs of the premiums from the tenant or tenants. However, since only the landlord's property will be covered by this policy it will be necessary for a tenant to insure his own fixtures and fittings separately. The landlord's insurance premium is calculated on a similar basis to the service charge above.
Guarantor/Rental Deposits
It is worth noting that most landlords prefer to grant leases to organisations who are proven to be of sound financial standing. To ascertain this they are likely to ask for at least three years' audited accounts together with references from existing landlords, bankers, accountants and solicitors, if applicable.
Even if a business is a subsidiary of a multi-national corporation but shows little or no operating profit, or is in a start-up phase, landlords may insist upon additional security, such as a parent company guarantee, bank guarantee or rental deposit.
Security of Tenure and Tenant's Rights to Compensation
In order to protect a tenant, English law provides that he can renew his lease at the end of the term (Landlord and Tenant Act, 1954, Part II). In the event that the property is required by the landlord for redevelopment, or for certain other reasons specified by statute, then the tenant has the right to statutory compensation for forgoing his rights for renewal. Often a landlord and tenant agree to exclude a lease from the Security of Tenure and Compensation Provisions as contained within the Landlord and Tenant Act 1954, Part II (as amended), in which case at the end of the lease a tenant will not be entitled to renew or indeed receive compensation. This is known as "contracting out of the Act".
Value Added Tax
Value Added Tax (VAT) is a form of purchase tax imposed upon the end consumer of certain goods and services and is currently charged at the standard rate of 20% of the contract price. It is intended that the producers should charge VAT on their sales. VAT registered buyers recover VAT paid by them from H M Customs & Excise who administer the tax. End users who are not registered for VAT cannot reclaim VAT charged by suppliers and paid by them.
Land does not normally attract VAT, but was introduced in connection with non-domestic land and buildings by the Finance Act 1989. The owner of an interest in land may elect to charge VAT on the income (rent) from land and buildings although he may not have incurred VAT on its purchase. The implication of this election is that the agreed rent is effectively increased by the prevailing rate of VAT unless the tenant can recover this tax.
Under these regulations all developments and refurbishments have and will incur VAT on construction costs and thus a landlord has the choice to either absorb the VAT or elect to charge VAT on rent to recover the tax paid out initially. In particular, during a difficult market and in a location when the likely tenant is one who cannot recover VAT in full or only in part, a landlord may forgo such an election in order to secure a tenant, higher rent or both.
The effects of VAT legislation on property are very complex and as such each situation must be considered individually to determine whether the instant transaction or works are subject to VAT and at what rate.
It is usually prudent at the outset of negotiations to agree whether or not a lease will be VAT-free or otherwise. Where a tenant is VAT registered and can recover VAT paid on rent, potential successors (assignees or lessees) may not have this ability and therefore may not consider the premises favourably. Such a provision therefore may affect the future lettability of the premises.
In connection with assignments of existing leases it should be noted that any capital inducement from the assignor to any assignee may attract VAT at the standard rate.
Part I - Property Tenure
Part II - Property Leases
Part III - The Legal Principles in the Acquisition of Office Property
Part IV - The Legal Principles in the Disposal of Office Property
Part V - Lease Provisions
Part VI - Property and Associated Costs
Part VII - The Steps to Acquiring Offices
Part VIII - Conclusion
Glossary of Terms