Commercial Leases: 4 Things To Consider Before Signing
A commercial lease is a binding contract between a landlord (lessor) and a tenant (lessee) which gives the tenant exclusive right to occupation of a premises. The key word here is “binding”. Once the lease has been executed by both parties, your ability to renegotiate or get out of the lease is limited. This can prove to be really costly if you jump into a lease without getting the right advice.
Let’s take a look at a few of the key issues you wouldn’t want to overlook as a tenant.
A commercial lease will typically be for an initial term with an “option” for the tenant to receive an additional period once the initial term ends. This is known as an “option to renew”. Having options in the lease provides some comfort to a tenant. If it’s not happy at the end of the initial term, it can vacate the premises. Rather than exercise the option to stay for the additional term.
Option to renew
An option to renew is a right given to a tenant which the landlord cannot take away. Provided that the tenant has complied with the lease to that point. However, occasionally we see commercial leases where an additional term will only be given with the consent of the landlord. This is deceiving as it doesn’t really give the tenant an “option” per se, as the landlord would still need to agree to extend the term. This type of oversight could have devastating consequences for a tenant who has for example, undertaken a substantial and costly fit out of the premises, only to find out down the track that they had no guaranteed option to renew the commercial lease.
Choosing between a short-term or a long-term lease
Despite what some people believe, it’s not always in the best interest of both parties to have a long lease term. For instance, securing a premises for a longer period of time can be of great value to a tenant’s business. But it can also be risky, say if the business was to go belly up and unable to meet its financial obligations under the lease.
If you’re a tenant trying to get out of a lease before its expiry, a lengthy term could really hurt the wallet if the lease terms are not attractive enough for another tenant to take over. Even if a new tenant is found to step in, if the only way to bring this new tenant in was to decrease the rent, the outgoing tenant would likely have to pay the difference in rent until the end of the term of the lease (not including further options).
For example, if you enter into a 5 year lease with a 5 year option and you want to get out of the lease after 2 years, you would be liable for the costs suffered by the landlord up to the end of the first 5 year term. There are laws which require the landlord however to mitigate its loss. So they cannot simply sit there twiddling their thumbs knowing they have you under contract.
2. Permitted Use
Commercial leases will almost always require the premises to be used in a specific way or for a particular activity, and will prohibit the tenant from using the premises in any other manner. This is called the “permitted use”. The permitted use provision describes the type of business that the tenant has the right to operate from the premises. This is often not given the attention it deserves.
The permitted use can work both on the tenant’s and the landlord’s favour
When preparing a commercial lease, we’ve had landlord’s and tenant’s say, “well, why does it matter, can’t we just leave it blank?”. Unfortunately, there are number of reasons a permitted use must be included, such as council’s zoning or a neighbouring tenant’s rights to exclusive use. Or, when a landlord owns 4 shops in a building, it may be that the landlord promised to one tenant which operates a hair salon that it would not grant a lease in another shop to another hair salon. Further, the landlord may only have agreed to lease the premises to the tenant because of the proposed use.
Because the permitted use must be included, careful consideration needs to be given to ensure it is described broadly enough to capture all of the plans for the premises which the tenant has. For example, a tenant may be opening a café, and also plan to operate as a bar at night. In this case, we would advise the tenant to ensure that the permitted use in the lease is described as “Café and Bar” rather than just “Café”. Otherwise the landlord would have the right to veto the tenant’s cool bar idea. If the tenant went ahead with the bar anyway, breaching the permitted use clause generally constitutes a “material breach of the lease”. This would entitle the landlord to terminate the commercial lease and potentially seek damages.
A good lawyer will be able to flesh out the tenant’s commercial objectives. And guide them accordingly to ensure that there are minimal barriers in achieving those goals down the track.
3. Rent and Outgoings
The rent and outgoings provisions are arguably the most important provisions of the lease. Breaching these terms often gives the lessor the right to terminate the lease. Subject to the terms in the commercial lease, this could result in the landlord locking the tenant out of the premises without notice. Even if the tenant is only one or two weeks behind rent and/or outgoings.
The rental amount is generally determined between the parties in the early negotiations, before the lawyer gets involved. This includes any incentives such as a rent-free period or a fit out contribution. Be in the know and get advice from professionals as early as possible.
Outgoings such as council rates, strata levies, electricity, water and other expenses which the landlord incurs for the premises will typically be passed onto the tenant or are otherwise factored into the rental amount. The benefit of having outgoings excluded from the lease is greater certainty in the amounts payable under the commercial lease.
The lease will typically provide for how the rent will increase over the course of the commercial lease. Increases usually occur annually and are usually calculated either by reference to the Consumer Price Index (CPI), market review, by a fixed percentage increase (such as 3-5%), or a combination of the three. This is known as the “method” of rent review.
All the above can be negotiated. A good lawyer will be able to recommend what can, and often should, be negotiated.
4. Make Good and Renovation
A careful review of any “make good” and/or renovation provisions is strongly recommended. This isn’t easy to do if you aren’t dealing with commercial leases regularly. We find that the conditions imposed on tenants can be often unreasonable in the first draft of the lease. And heavily in the landlord’s favour.
For example we’ve seen provisions drafted which required the tenant to repaint and recarpet the premises every 3 years, despite the lease being a 5 year term with a 5 year option. These unreasonable provisions can typically be removed during negotiations.
We also tend to find a number of unreasonable provisions relating to the upkeep of the premises, such as “the tenant must keep, and deliver to the landlord at the expiry of the lease, the premises in good and substantial repair… satisfaction of this provision to be determined in the absolute discretion of the landlord”.
A good lawyer will be able to identify such provisions lurking in the lease and renegotiate the terms to make them more reasonable and commercially fair.
This is why it’s important to get your lease reviewed by a lawyer before you sign it.
Let’s consider the above provision and how a good lawyer may be able to negotiate the provision to make it fairer on the tenant, but also palatable for the landlord. For instance, it’s very unlikely that a landlord would agree to deleting the provision entirely.
So, being reasonable in negotiations, the example above would ideally be amended to read “the tenant must keep, and deliver to the landlord at the expiry of the lease, the premises in the same repair as when the tenant first took occupation, subject to fair wear and tear. in good and substantial repair which will be determined in the sole discretion of the landlord”.
If the landlord insists that the condition of the premises be determined at the discretion of the landlord, then the last sentence could be amended to “…in the sole discretion of the landlord acting reasonably”. This may seem pedantic and insignificant. But this amendment could save the tenant time and money down the track if a dispute was to arise.
Key Takeaways: Commercial Lease
Most of our clients are commercially savvy and understand the terms of the lease. But a good lawyer won’t just explain the lease. It’s unlikely you’ll be able to spot certain provisions. Unless you know what you’re looking for, and deal with commercial leases regularly. These provisions can often be negotiated out or at least amended in the tenant’s favour.
There are many important provisions which we have not addressed in this article. Naming those relating to assignment of the lease, subletting, termination, lessor obligations, security, costs, insurance, and many others. Each clause requires detailed consideration and may be able to be negotiated more favourably, without stifling the transaction.
Don’t be the tenant that’s burdened by a tough commercial lease because it didn’t seek the advice of an experienced lawyer before signing the dotted line.
Written by Alex Beagley, Lawyer at Progressive Legal.
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