Legal Briefing

Limiting lease liabilities

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Real estate | 01 December 2009

Previous articles have discussed the effective exercise of break clauses, thereby bringing the existing lease liability to an end (p63, IHL170) and former tenants being held to account for their historic lease liabilities (p56, IHL174). This article deals with how to minimise the cost of lease liabilities for premises that are currently in use, especially during a recession.

A lease contains several liabilities for a tenant. Often the quantum for these liabilities is not determined at the grant of the lease but instead principles (and sometimes a process) for establishing the amount of the quantum are provided in the lease. It is important to be familiar with the precise terms of a tenant’s liabilities and how these are to be quantified. Without this knowledge, opportunities to reduce liabilities will be missed.

Rent

Most leases require a specified amount of rent (often subject to review on an upwards-only basis) to be paid quarterly on specified dates and the tenant will, no doubt, have budgeted its cash flow to cater for these payments. In the current economic conditions, many organisations’ financial circumstances have become constrained and may remain so for the foreseeable future.

Although having no express right to do so, a tenant faced with financial difficulties should consider approaching their landlord for a rent concession: this could include a temporary reduction in the rental payable and/or the payment of rent monthly rather than quarterly. A tenant should be prepared to share details of their financial position, including income projections, with the landlord so that a thoughtful consideration of such a request can be made. Tenants may also find that landlords ask for an additional premium to cover the landlord’s increased administration costs. A landlord would need to be persuaded that the tenant’s circumstances are genuine and is more likely to agree to temporary rather than permanent concessions. Most landlords would prefer to reduce the risk of empty premises should a tenant become insolvent, particularly if there is a reduced market for such properties.

Rent reviews

If a tenant receives a rent review notice from a landlord, a detailed consideration of the rent review provisions in the lease should be undertaken. Points to be considered include:

  • Does the lease actually provide for a rent review at that time and, if so, on what basis?
  • Has the landlord’s notice been served correctly in accordance with the requirements of the lease?
  • Is there any date by which a landlord’s notice has to be served (and is time of the essence for that date) and what information, if any, needs to be specified in the notice?
  • Is there a deadline for a tenant’s response to the landlord’s notice (and again, is time of the essence for that task), and does the lease provide that where no such notice is served by the tenant, the rent will automatically be reviewed to the figure set out in the landlord’s notice?
  • Can either party apply to a third party for determination of the reviewed rent or can only the landlord do so?

The answers to these questions could demonstrate that the landlord’s notice is ineffective and the rent under the lease should remain at the current passing rent, rather than being increased. Alternatively, some points of uncertainty may create a negotiating position and put pressure on the landlord to agree a lower reviewed rent than they might originally have intended, rather than incurring the cost (and delay) of proceedings to have the points determined by the court.

Service charges

Amounts sought to be recovered by landlords for service charges can be very significant and will warrant a close examination. The lease will usually provide what type of services the landlord is to supply and how the tenant’s proportion of the cost of doing so is to be calculated. Do the services listed in the landlord’s service charge demand match those set out in the lease? If a service item has been charged for but not covered by the lease, there is no basis to claim it and it should not be paid. Further, the following approach should be adopted:

  • Have the services stated in the service charge demand actually been provided?
  • Have the services been provided to a reasonable standard?
  • Is the cost charged for the services reasonable?
  • Has the cost of any particular service increased significantly because of the default of a third party from whom the extra cost should be recovered (rather than from the tenants)?
  • If the area over which the services provided has been enlarged and/or further tenants now use the ‘common parts’, there may be a case for the original service charge percentages (which are often calculated by reference to each tenant’s floor area expressed as a percentage over the total lettable floor area) to be changed (subject to any provisions in the lease for such circumstances).

More generally, tenants should encourage their landlords to look at reducing the service charge by providing a more efficient delivery of items, such as security and cleaning, the introduction of energy-saving measures, or even just a reduction in the level of services for a period.

Dilapidations

With budgets tightened and cash flow restricted, expenditure on maintaining and repairing premises may well be reduced or deferred. However, paying for some repairs now could avoid more significant (replacement) expenditure later.

From a landlord’s point of view, premises at the lease expiry should be in such a condition that they can be easily re-let and an income stream maintained. Essentially a tenant has two choices: either comply with the repair obligations and carry out works necessary to achieve this prior to the lease expiry; or pay the landlord for the cost of the works (and no doubt also professional fees for monitoring them), together with an amount for loss of rent (taking account of any rent-free periods that may be given to an incoming tenant) while the repair works are carried out by the landlord after the expiry of the lease.

A well-advised tenant will review the condition of the premises at least one year before the lease expiry or, and which is perhaps more common, do so on receipt of a landlord’s schedule of dilapidations. The following should be considered:

  • Does the tenant have the benefit of a schedule of condition of the premises prepared at the time the lease was taken? The usual effect of such a document is to dilute the extent of the tenant’s repair obligations.
  • A surveyor appointed by the tenant should assess the condition of the premises and, in the context of the repair obligations in the lease, establish what is in disrepair, what works will be reasonably required to remedy the disrepair and what will be the reasonable cost of such works.
  • If the tenant has granted any sub-leases, check the extent of the sub-tenant’s repair obligations in those leases to see whether any of the tenant’s repair obligations can be ‘off-loaded’ to the sub-tenant.

Assuming that the tenant accepts there is some disrepair at the premises for which it is responsible, the works proposed by the landlord to remedy the disrepair are reasonable and the cost of those works is reasonable, there is a further exercise that the tenant and its advisers should undertake. Section 18 of the Landlord and Tenant Act 1927 provides a cap on the damages recoverable by a landlord for breach of the tenant’s repair covenants. The damages will be the lesser of the cost of repairs or the diminution in value of the landlord’s interest as a result of disrepair arising from the tenant’s breach of the repair covenants. For example, if the cost of repairs would be £300,000, but the diminution in value calculation shows a value of £50,000, the maximum damages recoverable by the landlord for breach of the repair covenants would be £50,000.

Further, it may be the case that the premises have outlived their useful life – the value being in the site rather than the buildings. In these circumstances, the condition of the premises would most likely be irrelevant and the diminution in value as a result of the breach of the repair covenants could be zero with no damages payable.

Section 18 provides a further defence available to the tenant whereby no damages for a breach of the repair covenants will be payable if it can be shown that the premises, at or shortly after the termination of the lease, would have been or will be pulled down, or structural alterations made to them as would render valueless the repairs for which the tenant has a prima facie liability. Whether or not a landlord has in mind carrying out such works will be a matter of evidence, including any planning applications made for the premises.

Tenants should, however, keep in mind three warnings, namely:

  1. Where alterations have been carried out to the premises, the terms of the lease and/or any licence given for the alterations should be checked for the tenant’s obligation, if any, to reinstate the premises. A breach of the tenant’s obligation to reinstate could result in damages being payable to the landlord for the cost of any reinstatement works and to which the section 18 provisions will not apply – the breach not being that of the repair obligation.
  2. Where the lease reserves the right of the landlord to enter the premises during the lease to rectify any disrepair and charge the tenant for the cost of such repairs actually incurred by them, the section 18 cap on damages will not apply to this debt.
  3. Where the tenant decides to let the landlord carry out the repair works after the lease expiry at the tenant’s cost, it is probably inevitable that when carrying out the repair works further items of disrepair will be uncovered for which the landlord will seek recompense.

In summary, for these and other tenant liabilities, it is prudent to carry out an audit of the lease obligations (both for the landlord and the tenant), cross-check and verify demands made (especially costings), and to be aware of the various statutory protections given to tenants. Ignorance or partial knowledge could result in cash being expended unnecessarily.

By Andrew Walker, partner in real estate disputes, CMS Cameron McKenna LLP.

E-mail: andrew.walker@cms-cmck.com.