In a series of 3 articles which first appeared in Estates Gazette, Guy Whitehead takes a closer look at leases from the perspective of a retailer.
Article 1 - Heads of Terms
This is the first in a series of three articles which are designed to explore what retailers can do in the current market to improve their position at each stage of the process when entering into a lease. The first article will look at heads of terms, the second at lease negotiation and the final article will look at the life of the lease itself and what issues can arise on exit. Although the articles are primarily written from the perspective of retail tenants and the difficulties they face both on the high street and beyond, they should provide landlords (who themselves are having to contend with unprecedented market conditions) with food for thought on how best to strike a balance between protecting their investments and giving tenants scope to run a profitable business.
Lawyers should be consulted and their views sought before the heads of terms are finalised. A strong set of heads of terms will save money and time as it’s difficult to reopen negotiations on fundamental points once the deal is struck and the draft lease has been circulated by the landlord’s solicitor.
The negotiations that take place and lead to heads of terms being produced and finalised are a key stage that forms the basis for the rest of the lease transaction. The bargaining strength of the parties and location of the premises are key factors and there remains a significant divergence at a national level between high performing major shopping centres (where demand is high and rents continue to outperform the rest of the market) and some high streets which have been decimated by store closures. Retailers shouldn’t underestimate the importance of having an experienced agent who is able negotiate concessions that can give a tenant the breathing space they need when entering into a lease.
It has been well documented that technology is revolutionising consumer behaviour and retailers are searching to find ways (such as experiential shopping) to attract customers into their stores. The market has changed and agents are being pushed hard by retailers to negotiate lower rents to reflect the market conditions which led to RICS issuing a valuation notification in December 2018. RICS felt compelled to issue the notification to reflect the weight of evidence that there has been a structural change to the market. The substantial uncertainty which has permeated the market has meant that agents are struggling to find common ground on what constitutes the open market rent for a store (given that any comparable evidence will be of limited use unless it has been completed recently) which has in turn led to protracted negotiations.
It is important to recognise the prevalence of short term leases which is a reflection of a decline in confidence and the fact that retailers don’t want or feel able to commit to long term leases. It is unusual to see 10 year leases and the status quo now appears to be “5 and 3 leases” i.e. 5 year terms with option to break on year 3 or even 3 year terms with rolling options to break on short notice periods.
Landlords are coming under increasing pressure to find ways to attract retailers who themselves are becoming more demanding when negotiating terms. When faced with the prospect of an empty unit landlords may consider offering turnover only rents where the landlord will take a percentage of the turnover generated by sales from a store without any base rent being payable. In this situation landlords are effectively taking on the risk that the retailer may fail. This can be contrasted against turnover top up leases where tenants have to pay a base rent (ordinarily determined as a percentage of open market value) and the amount (if any) by which the turnover rent (typically around 10% of turnover) exceeds the base rent. The tenant’s rental liability will reduce in poor trading conditions and if the tenant manages to trade above expectations then the landlord will benefit. In some cases retailers are also looking to take on peppercorn rents with the tenant only liable to pay business rates, insurance and service charges.
Retailers need to be alive to the various concessions that can be extracted from a landlord who will not want to be faced with an empty store and the corresponding rates bill.
The most common concessions are:
• Rent free periods. It is not uncommon to see tenants being granted a six month rent free period in the current market.
• Capital contributions by a landlord to fit out works. This is where the landlord will agree to make a payment to the retailer (usually within a specified period after completion of the works) to cover all or part of the cost of the tenant’s fit out works to the premises (or towards the cost of refurbishment works where the tenant is already in occupation and the lease is being renewed).
• Monthly rather than quarterly rent concession in a side letter.
• Service charge caps to limit the amount of the service charge to an agreed amount for the duration or a specified period during the term.
• Schedules of condition so that the tenant is only required to maintain the existing condition of the premises rather than entering into a full repairing lease. Retailers don’t want to be hit with a large schedule of dilapidations claim on exiting a store.
• Will the landlord agree to a soft strip out so the unit can quickly be re-let by the landlord rather than insisting on full reinstatement at the end of the lease?
• Will the landlord agree to a further rent free period if the tenant doesn’t exercise an option to break?
• Will the landlord allow underleases of part (if the retailer wants to downsize) or give the tenant scope to allow concessions to operate from the store? Retailers should resist any automatic right for the landlord to obtain an authorised guarantee agreement on assignment. Given the spate of retail failures, the last thing an outgoing tenant wants is a contingent liability for another retailer’s failure.
• Will the landlord agree to a wide use clause to improve the alienability of the lease and to allow the retailer to offer additional services alongside the traditional A1 retail use?
Options to break need to be considered and break conditions (if any) must be clearly defined and ideally limited to payment of the principal rent (rather than all of the rents payable under the lease). If a landlord is insistent that the option should be conditional on payment of the principal rent together with the insurance rent and service charge, retailers should insist that the insurance rent and service charge must have been demanded in writing at least 28 days before the break date and not be the subject of a bona fide dispute. Retailers should never agree to the option to break being conditional on giving up vacant possession or breaches of covenant relating to the state and condition of the premises which would effectively make the option inoperable. Thought should be given as to whether to include a “Santa clause” by which the parties agree that any break notice which purports to terminate a lease over the Christmas trading period will not be effective.
Given the spate of high profile department store closures, retailers should consider whether the lease should cover off what will happen in the event that an anchor tenant closes (in the context of a shopping centre) or if a major department store closes within a specified radius of a store. Whether the tenant should be compensated to cover the corresponding loss of footfall is a matter for negotiation between the parties but the lease could include mechanisms to deal with this issue including:
- The tenant being able to initiate a rent review.
- The rent being suspended for a specified period of time.
- The tenant being granted an option to break.
It is common in the current market where retailers have been holding over under the 1954 Act for retailers to find that they have been paying more than the rent that is subsequently agreed between the parties. In this situation, retailers can improve their position on renewal by insisting that this overpayment is refunded on completion of the new lease (most commonly by the parties agreeing the amount of the refund and the payment being made to the tenant’s solicitor on or prior to completion)
Article 2 - Lease
This is the second in a series of articles which are designed to explore what retailers can do in the current market to improve their position at each stage of the process when entering into a lease. This article will drill down and look at specific provisions in the lease that can make a real difference in the operation and viability of a store. The provisions are generally designed to protect a retailer’s ability to trade, to prevent competition from temporary trading positions in the vicinity of a store and to prevent landlords being able to pass on costs which should ultimately be borne by the landlord.
Retailers and their advisers typically rely on lease specification documents to cover standard provisions (such as user clauses) that a retailer will either insist on or attempt to incorporate when entering into a lease. The document should be kept under constant review to ensure that the implementation of new legislation and operational changes by the retailer (such as the creation of a new store concept) are covered. The purpose of the specification document is to ensure that retailers achieve (as far as possible) uniformity of lease terms across their estate so that they can be assured that their requirements will be reflected as and when new leases are completed.
As with any lease transaction it is crucial that retailers carry out due diligence on the store before entering into the lease to ensure that the landlord has a clean title to the premises, there is nothing revealed by the usual searches and enquiries which could be problematic and the retailer has full transparency on what the overall costs will be to operate from the store.
The provisions which should be considered for each lease include:
- Scaffolding protection provisions. The provisions (which usually qualify a right which is reserved to a landlord to erect scaffolding) are designed to ensure that no scaffolding (except in an emergency) is erected by a landlord during key trading periods (such as Christmas). The provisions should include obligations on the landlord to ensure that access to a premises is maintained at all times, any scaffolding is removed as soon as reasonably possible with the tenant being able to erect temporary signage.
- Exclusion zones. The provisions prevent the landlord allowing temporary trading positions (such as stalls and moveable kiosks) selling the same products as the retailer within a defined area in the vicinity of the tenant’s premises. The obligation is generally couched on terms that the exclusion applies during such time as the lease is vested in the retailer, the retailer remains in actual occupation and the predominant use remains as a retail shop for a specified use.
- Repayment provisions. It is important that landlords should be under an obligation to refund certain payments that have been made by tenants during the life of the lease. Situations where this is appropriate include (a) where payment of the rent has been suspended following damage by an insured or uninsured risk, the premises are unfit for occupation and use and payments of rent and service charge have been made in respect of the period after the date of the rent suspension; (b) where an option to break has been exercised and payments have been made by the tenant for the period after the break date; and (c) at the end of the lease itself specifically where the tenant has made payments of service charge on account. Each clause should specify when the refund has to be made by the landlord and the payments covered.
- Break clauses. The clauses should reflect the heads of terms but ideally any options to break should be unconditional. If this is not the case then retailers should be advised to limit the conditions to payment of the principal rent and if necessary giving up occupation (rather than vacant possession which shouldn’t be accepted under any circumstances).
- Uninsured risks. It is generally accepted by landlords that damage to premises caused by uninsured risks should be carved out from a tenant’s repairing obligations. The provisions are usually drafted so that a landlord can either elect to reinstate the premises within a certain period (at the cost of the landlord) or terminate the lease with a statement confirming that the landlord will not seek to include in the service charge any costs flowing from damage by an uninsured risk.
- Environmental Performance. The introduction of the MEES Regulations has resulted in landlords seeking to pass on any improvement costs that are required for the premises to tenants. This should be resisted by retailers by removing the ability for a landlord to pass on any costs that are incurred by the landlord including the cost of obtaining an EPC (which is contrary to the new service charge statement).
- Payment of Rent. Retailers should push (at the heads of terms stage) to be allowed to pay the rent on a monthly rather than quarterly basis (to assist with cash flow) and to stipulate their preferred method of payment (such as by BACS transfer). Landlords generally accept these provisions although they may prefer for this to be couched on terms that it is a personal concession to the tenant and documented in a side letter.
- Shop front. It is critical for a retailer to have the ability to alter or change the shop front fascia and fascia signage to ensure that a store bears the usual branding and corporate signage. The lease should allow such alterations and internal non-structural alterations with the qualified consent of the landlord.
- Alienation. The assignment provisions should be amended so that a landlord is only able to obtain an authorised guarantee agreement (AGA) where it is reasonable in the circumstances. This gives the tenant scope to argue that an AGA isn’t necessary in circumstances where the incoming tenant has a greater covenant strength than the outgoing tenant. Retailers should push for any AGA to be limited to the duration of the contractual term (to avoid giving an open ended guarantee if the lease continues under the 1954 Act) with underlettings being at open market rent and not passing rent.
- Rent suspension. If the premises are damaged or destroyed by an insured or uninsured risk so as to make the premises unfit for occupation and use then the rent suspension provisions should apply to both the principal rent and service charge. If the damage or destruction applies during a rent free period this should be allowed once the rent suspension period ceases to apply.
- Service charge exclusions. Exclusions from expenditure should be considered on each transaction and will depend upon whether the premises are located in a new development or established shopping centre. Exclusions to consider include initial capital cost of constructing the centre equipping and fitting out (for new developments), cost of remedying latent/inherent defects (for new developments), damage by insured and uninsured risks, replacement of plant and machinery (except where beyond economic repair), costs where the landlord is entitled to be reimbursed from another source and chancel repair costs (where relevant).
- Rights granted or reserved. The rights should always be approved by the instructing surveyor and depend on the type of premises to be demised. Rights must include adequate rights of access/servicing to the premises and passage of utilities. Consideration should be given as to whether the tenant requires the ability to install air conditioning equipment or to operate a wi-fi network within the store for its customers. Retailers should tightly restrict any landlord’s right of entry and development rights to ensure they don’t interfere with trade and use of common areas.
- Keep open. It is common for leases within shopping centres to include keep open provisions (the justification being that such leases usually have turnover rent provisions so the landlord wants to ensure that the tenant maximises revenue from the store). Such provisions should be resisted by retailers of high street stores.
- Side letters. The use of side letters by landlords to offer personal concessions to tenants are becoming increasingly common and can cover a myriad of scenarios from monthly rather than quarterly payments of rent to waivers in respect of plate glass insurance. From a retailer’s perspective the most important point is that the letter must bind a landlord’s successors in title so that if a landlord sells the freehold reversion to a shopping centre, the buyer is bound to comply with the concession.
Article 3 - Post Completion
This is the third in a series of three articles which are designed to explore what retailers can do in the current market to improve their position at each stage of the process when entering into a lease. This article will look at what steps retailers and their advisers should take following completion of a lease to ensure that key dates are not missed and the retailer is aware of what they can do to limit (as far as possible) their potential liabilities under the lease.
Retailers can save significant amounts of money by asking their legal advisers to pore over key lease terms on rent review, alienation, repair obligations etc. to see whether there is scope to take advantage of sub-optimal drafting or concessions they may have missed.
Retailers and their advisers need to have a clear understanding of what actions need to be taken after completion of a lease. The following is a brief outline of what a retailer should expect and reflects good practice:
- Copies of the lease and any ancillary documents should be sent to the retailer for their records. Any dataroom which is provided for the retailer to access should be updated to include a copy of the lease and any ancillary documents (such as rent deposit deeds, licences for alterations, side letters etc.).
- Memorandum of lease terms should be produced and circulated to the retailer and their advisers. The purpose of the memorandum is to log key dates during the life of the lease such as rent commencement dates, review dates, break dates (including the notice period and conditions), term expiry dates and whether the lease is inside or outside the 1954 Act. The memorandum should detail any provisions which are specific for the premises such as temporary trading exclusion zones or an obligation on a landlord to make a capital contribution.
- SDLT calculated and return submitted to HM Revenue & Customs (if necessary). It is important to note the reduction in the time period for submission and payment of SDLT from 30 to 14 days for transactions in England and Northern Ireland. This applies to leases with an effective date on or after 1 March 2019 (or before where that transaction becomes notifiable on or after 1 March 2019). For lawyers who are instructed to deal with post completion SDLT work it is expected that the reduction will prove to be an issue on complex transactions that do not allow for the SDLT to be calculated ahead of completion. Lawyers will be under increased pressure to produce the calculations and returns quickly and retailers may have to change their internal procedures to ensure that any payments due and returns to be filed with HM Revenue & Customs can be processed within the 14 day period.
- Land Registry application submitted (if relevant) to register the lease (in the case of a lease for more than seven years) and to note the lease (in the case of a lease for more than three years). Any easements which are granted in the lease should be registered against the landlord’s title.
Aside from the work that should be carried out in the immediate aftermath of completion of the lease, retailers can be proactive in the way they manage their estate and should seek to engage with their landlords when it comes to issues such as service charge delivery which represents a significant overhead in the operation of a store. The new RICS professional statement ‘Service charges in commercial property’ which is effective from 1 April 2019 stresses the importance of transparency (so that all parties are aware of how service costs are made up) and communication (so retailers understand what they can expect to receive and how much they are required to pay) in order to reduce the potential for disputes. The statement provides detailed guidance on what constitutes best practice and highlights that:
- Occupiers should be notified of any significant variances to the service charge forecast as soon as possible.
- Managers should issue budgets to occupiers at least one month prior to the start of the service charge year. Annual service charge certificates should be issued within four months of the service charge year end.
Retailers should be encouraged to review service charge certificates to see whether there is scope for any items of expenditure to be challenged in order to reduce their overall liability. Has the landlord sought to introduce a new item of expenditure into the service charge (such as the production of EPC’s or the cost of improvements that have been made to improve the energy efficiency of the centre) which has been specifically excluded from the service charge in the lease? If so, the retailer will be justified in withholding this element of the service charge until this has been resolved with the landlord. Did the parties agree to a service charge cap which has been ignored when the service charge certificate was issued by the landlord? Good lines of communication should hopefully ensure that any issues can be resolved without recourse to any formal dispute resolution procedure.
Do circumstances change to such an extent that the lease should be re-geared? Retailers need to be alive to the possibility of re-gearing their lease(s) which represents a great opportunity for both landlords and tenants to re-balance their commercial objectives in order to achieve a mutually beneficial outcome. The opportunity for a lease re-gear (which can be initiated at any time) is often brought into focus by key events during the lifetime of the lease, such as rent reviews and tenant break options. These may lead to discussions as to whether the deal that was agreed when the lease was entered into still reflects the commercial reality of the market that the parties find themselves in and may allow retailers to negotiate rent free periods or reduced rents in return for extended lease terms or the removal of a tenant only option to break.
The prevalence of store closures in the current market has brought into focus the need for retailers to keep under review key dates for service of break notices. If a decision is made to close a store the retailer needs to arrange for the notice to be served by their lawyers in accordance with the lease. The retailer should be advised on what conditions (if any) (such as payment of the principal rent) have to be complied with to ensure the break notice is effective. The timing of any store closure needs to be managed carefully (by coordinating the actions of the retailer and their advisers) to ensure that landlords do not tip off the staff of an impending closure (following receipt of a break notice) before the staff are informed internally by the retailer.
When a decision is made to close a store, retailers need to consider what their potential costs will be both in terms of exit works by the retailer and a dilapidations claim by the landlord. Thought should be given as to whether a deal can be struck to offset any interim rent claim that the tenant may have against a dilapidations claim by the landlord. The retailer may take the view that it is best to take a proactive approach and seek to agree a scope of exit works (based on a soft strip out) with the landlord on lease expiry with a view to reducing the dilapidations liability and leaving the landlord with the opportunity to quickly re-let the unit.
As part of the key dates that are logged following completion of the lease, retailers need to ensure that they comply with the growing lease SDLT regime. This is relevant where a retailer has been holding over for more than a year (following expiry of a 1954 Act protected lease) and a further calculation is required. It is advisable for a separate schedule for such leases to be produced so that the dates for holding over can be diarised and actioned. Retailers should note that they may be able to claim refunds from HM Revenue & Customs in certain circumstances where a return has been submitted for turnover rent leases. In this instance, SDLT is paid on a reasonable estimate of the rents payable. If it transpires that the estimates were wrong and the rents were less than anticipated, then a claim should be made to HM Revenue & Customs.
To discuss any of these issues in more detail, please contact our real estate expert, firstname.lastname@example.org