Getting To Grips With Leases
Leases lie at the heart of commercial property investment. Miriam Bell reports on what you need to know.
31 May 2018
One of the major attractions of property for investors is its very tangibility. There’s security and value in bricks and mortar, popular opinion has it. While this is true when it comes to commercial properties a huge part of a property’s value is in the lease that should accompany it.
According to veteran commercial investor Olly Newland, after the location of the building, the lease is the most important component of a property. Commercial property is a business and the lease is where a large part of the value of that business is he says.
“A good lease gives a property value so, as a landlord, you want to have as long and secure a lease, with the best quality tenant, as possible, in place. And the more it is the more the property should be worth. So the value of the building goes up and down on the quality of the lease terms. It is that simple.”
But the reality is that most people know little about commercial leases and don’t pay enough attention to the details they contain. This is a mistake for investors who can end up paying, or otherwise running into problems, which could have been avoided if the lease was robust.
For that reason, we set out to discover the finer points of commercial leases and to provide the following comprehensive run-down of all that investors need to know about them.
Commercial Vs Residential
First up, it’s a mistake to think that commercial leases are the same as residential leases. In reality, they are very different beasts.
Duncan Cotterill associate James Murphy says that all residential leases, or tenancy agreements, are based on statute law – in particular the Residential Tenancies Act. In contrast, commercial leases are mostly based on contract law, where two parties – ie: landlord and tenant - negotiate the terms of a commercial lease.
“There are some commercial covenants that are implied in commercial leases under the Property Law. These include payment of rent, no alteration to building without lessor consent, no derogation from grant, quiet enjoyment, power to inspect the premises, as well as other implied covenants. But otherwise, the parties are free to negotiate the commercial terms of a lease.”
‘A good lease gives a property value so, as a landlord, you want to have as long and secure a lease, with the best quality tenant as possible, in place’ OLLY NEWLAND
That means that residential landlords moving from residential to commercial need to familiarise themselves with a very different structure, terminology, and set of rules when it comes to leases. Bayleys Commercial co-head of office leasing Ben Wallace says many elements of the lease can seem straightforward.
“But there are legally binding repercussions from clauses and conditions in a commercial lease that would typically outweigh those in the residential sector.”
Taking it back to its core, a commercial lease should record how the property can be used along with the obligations, or duties of both the landlord and tenant. This includes who’s responsible for payment of outgoings like insurance, rates and cleaning; the maintenance obligations of each party; insurance provisions and rent review procedures. It should also include dispute resolution provisions for potential issues like nonpayment of rent.
In New Zealand, the most common commercial lease form, particularly for standalone commercial and industrial premises, is the Auckland District Law Society (ADLS) lease form. It has been updated recently to include some new provisions.
The latest edition covers tenant and landlord payments, maintenance and care of the premises, use of the premises, insurance, damage to or destruction of the premises, what happens on default, renewal of the lease, assignment or subletting of the premises. It also contains many other clauses.
Murphy says the latest ADLS form is comprehensive, uses easy to read language, is balanced between landlord and tenant and has been tested in New Zealand for a long period of time. “However this lease form will not suit all tenancies and careful drafting will be required for each premises, and the terms of the lease will depend on the circumstances of the parties and the market conditions.”
There are some important considerations investors should be aware of when it comes to leases, he says. These include the length of the term remaining on an existing lease; the frequency of rent reviews; the type of rent reviews; the strength of the tenant and personal guarantees provided; the current condition of the premises; and the condition of the premises at commencement date.
Both landlords and tenants need to pay particular attention to the maintenance obligations under leases to understand exactly who is responsible for what, Murphy adds. “In some cases tenants may at first glance think that they are solely liable for the outgoings as listed in the first schedule of the lease. It is not until you dig a little deeper, or a particular issue arises, that what obligations seem clear under the lease actually become a bit blurred.”
Many people use the ADLS lease as a starting point and then negotiate on additional terms and conditions.
Wallace says that additional clauses added to the agreement tend to include such things as landlord and tenant works, make-good and re-instatement requirements, non-compete clauses, demolition or remediation clauses and tenant incentives, to name just a few. “Outside of the rent and term, this is where the majority of the discussion between landlord and tenants occur, and can often be the most technical.”
Newland says that it is possible for a landlord to effectively negotiate on any additional conditions they might want. “But once it is done, what is set down is what the rules are. So you need to get it right in negotiations to avoid problems further down the track.”
It’s also important to note that with any lease, but particularly an existing one, it is critical to go through it line by- line, word-by-word, he says. “Little tweaks can make a big difference. For example, the words “shall” and “may” mean different things – “shall” means “has to” and “may” doesn’t – and could make a huge difference when it comes down to it.”
Another point worth noting is that there are often some differences in leases when it comes to the different sectors in commercial property. Murphy says that while the ADLS form is commonplace, there are many other different lease forms around, like the Property Council suite of leases for commercial and retail premises.
“Retail leases often differ in the way rent is calculated and paid, and often retail leases will contain clauses which deal with the redevelopment of the retail development in the future. Also, retail leases will often include additional clauses for shared outgoings.”
There are also many bespoke lease forms out there that are used for particular premises, he says. “These are unique and contain clauses specific for a particular development. Such leases have been developed for a specific property emphasising that in commercial leases, one size does not fit all.”
Additionally, there are often particular conditions associated with a sector. For example, in retail and office leases, it is common for there to be a term which requires tenants to redecorate and keep the premises up-to-date and in good working order at their expense, Newland says.
“In retail leases, there might be stipulations about being open during business hours while in office lease there might be a requirement that the premises can’t be used for residential purposes. Then in industrial leases terms around dealing with contamination, fumes, noise, and not annoying neighbours are common.”
Improvements to leases do offer scope for adding value to a property. Murphy says leases are commercial contracts and so they can be drafted and amended in a way that suits the parties to the lease, the premises, and the market in which the lease operates in.
However, if an investor buys a commercial property with an existing lease, they buy the property subject to the lease. This means the purchaser essentially steps into the shoes of the landlord on settlement, and is bound by the terms of the existing lease, he says.
“It is important that a purchaser reviews the existing lease to make sure they are happy with the lease in all respects. A landlord can submit an offer to the tenant to vary the terms of an existing lease, but the tenant does not have to accept the offer of varied terms. But once the lease ends a landlord can then renegotiate the lease terms.”
For Bayleys Commercial co-head of office leasing Brendan Graves, there are a number of ways a landlord can boost their returns and benefit from their situation.
“Market rent reviews are the most obvious opportunity. However, anytime during the lease situations can arise to creatively add value. This requires staying close to the tenant and accommodating their ever-changing needs in return for more favorable lease terms for the landlord.”
Ultimately though, all the experts agree that investors wanting to get the most out of their lease should seek independent, legal advice early on either when purchasing a property or when renegotiating a lease.
Need To Know Lease Terminology
Commercial leases contain a range of provisions and terminology that is critical for an investor to understand. Bayleys Commercial’s co-heads of office leasing Ben Wallace and Brendan Graves give a summary of some of the major ones:
Personal Guarantors (PGS):
Personal guarantors can be used to provide landlord’s financial security over the tenant’s ability to fulfil their obligations under the lease. Graves says, typically, the higher the risk of tenant default or perception of the business’s inability to pay rent, the higher the level of security will be required.
“The guarantor will be required to cover the costs under the written obligation, but it may be extended to some unknown or stipulated costs such as any legal penalties, agent’s fees, and inducements to secure a tenant replacement if their obligations are unfulfilled.”
He adds that while PGs have long been a way to provide an element of security and trust for both parties, there is now a trend towards landlords requiring a bank guarantee or bond instead of a PG.
Leases contain tenant covenants which cover such things as the obligation to pay rent or to repair the property. Graves says understanding the quality of tenant covenants is critical.
“Signing a lease agreement with a tenant is almost like investing in their business. The landlord should ask themselves if they can understand the tenant’s business and get comfortable that they can meet the associated lease obligations. It’s really trying to assess the level of risk so that the level of return can be assessed appropriately.”
Net Vs Gross Yields:
Gross rent is the total rent payable, while net rent is the gross rent less any (or all) of the expenses needed to appropriately operate the property (operating expenses). Graves says there is no clear delineation between which properties or locations use net or gross leases and it often comes down to investor preference.
Most leases contain a method by which the parties will decide on the current market rent at the rent review time. Ratchet clauses are a core part of this. For example, the latest ADLS lease uses a soft ratchet which means the rent at rent review time cannot fall below the rental at the commencement of the lease.
Wallace says there are a number of variations when it comes to setting the rent and how this will escalate over the period of the lease. “What we are typically seeing in the market now is less CPI adjusted rent reviews due to the lower inflation environment, with greater focus on fixed annual rental increases with a market review typically on renewal.”
Commercial leases on leasehold land will have a ground rent associated in some form and it is important to understand what this means. Wallace says the ground rental payment is classified as an operating expense for the building and under a net lease is on-charged to the tenants in the building.
“Climbing land values has resulted in significant increases in ground rent, leaving many occupiers wearing this unexpected cost, completely out of their control. The most common method to overcome this concern for tenants is by capping the ground rent component at an acceptable level but this will result in any overage eroding the net income for the landlord.”
The landlord will also need to take the ground rental amount into consideration when determining the asking net rent.
There are often “make-good” provisions in commercial leases. They require that, at the end of the lease, the tenant has to restore the premises to the condition it was in when the lease commenced, taking into account fair wear and tear.
Graves recommends that investors put together comprehensive documentation and photos recording the condition of their property at the beginning of a lease - in case of future disputes. They should also ensure they understand what sub-leasing or assigning the lease could mean for them and the tenant.