Real estate strategy and how a business occupies premises generate more emotion and irrational opinions than any other strategic or operational issue faced by corporate occupiers.
The chief executive wants to occupy a new landmark building reflecting his corporate aspirations (provided it is close to his commuting station). The finance director wants modest, second-hand premises (but with a basement gym for his workout). The personnel director and many employees commute from Essex. Canary Wharf is perfect for them.
Meanwhile, the premises manager is still recovering from having converted the business to open plan (save for those senior to him who refused to vacate their corner offices or river views).
Such issues, alongside the obvious need to avoid risks with real estate strategies (any business without premises will not survive long), can often result in occupation costs being omitted from corporate austerity programmes. However, there are steps that general counsel can take to reduce these costs and enhance business flexibility while preserving and maintaining corporate culture, as well as business continuity.
The institutionally acceptable lease, which regulates most corporate occupation, has changed little since the 1960-70s with landlords concerned about the impact on capital values. Only legislation (eg, Landlord and Tenant (Covenants) Act 1995) has introduced improvements for tenants. However, with current market pressures, the Brexit effect and the diversification of real estate landlords (hedge funds, wealth funds, private equity, etc), the institutional lease is no longer the market shibboleth. Tenants taking new premises or with an opportunity to renegotiate lease terms can secure greater flexibility through more favourable terms to unlock significant occupational costs savings.
Added flexibility will facilitate the disposal of excess premises and minimise liabilities in response to changing business needs. Lease amendments that tenants should seek include:
- Term – few landlords still seek 20 or 25 years, most accept 10 or 15 years. Shorter terms and the security of tenure afforded to business leases give tenants the option on expiry to leave or take a new lease on similar terms at a rent, which, if not agreed, is determined by a court/arbitrator.
- Breaks – lease breaks at regular intervals provide opportunities to renegotiate (although avoid onerous conditions to the exercise of the break).
- Alienation – avoid limits on subletting or sharing occupation and on rights to assign.
- User – traditional office buildings are now being used as hotels, hospitals, universities and apartments. Your business may not anticipate a radical change of direction, however, user restrictions in your lease could drastically limit your future potential to assign or sublet excess space.
- Insurance – historically landlords insured buildings and recovered the cost from tenants. However, they are not obliged to secure the best premium nor to share any commission received. In appropriate cases tenants should insist on insuring direct or require landlords in the lease to secure the best deal and to account for any commission or other benefits obtained on taking out insurance.
- Rent – this is treated as a debt to be paid without set off or deduction with onerous penalties for non-payment. Landlords seek to include in the definition of ‘rent’ payments such as service charges and insurance, making challenges to such payments difficult and to be avoided. Most leases contain rent review provisions at five-yearly intervals to adjust the rent to reflect changes in value. Landlords historically insisted on reviews operating upwards only leaving the tenant with the risk of falls in the rental market. Political pressure to outlaw such clauses has failed, however, the current market gives tenants opportunities to resist this.
- These issues should all be raised by tenants negotiating lease terms. Opportunities to achieve savings also arise during the term and on lease expiry.
Rent review clauses have generated significant litigation due to often flawed attempts to create hypothetical lease negotiations, assumed to occur on the review date, to ascertain a rent the parties would have agreed. The scope for disputes is obvious due to the need to introduce numerous assumptions and disregards for the scenario to achieve fairness. Rent reviews, however, are rarely fair as an increase in rent gives landlords a double benefit of extra income, and a consequential increased capital value. Tenants can only seek to save expenditure. Cynical landlords will contest reviews vigorously to achieve a marginal increase and most tenants will agree to avoid the costs of fighting the review even absent valuation justification. This creates a false market and long-term detriment to corporate occupiers generally. By being proactive tenants can force the pace and require landlords to disclose their evidence early which will often result in a favourable settlement. Calderbank (without prejudice save as to costs) offers can also be effectively deployed to force a landlord to concede that no uplift is justified. Landlords always prepare well for reviews. Tenants too need to plan and secure specialist advice to achieve an early, effective settlement of reviews at minimum costs.
The cost of common services (reception, security, lifts, toilets etc) and facilities (boilers, generators, condensers etc) provided by landlords can be the source of significant costs savings by tenants. Landlords providing services directly or through associated companies have no reason to control costs. The same is the case when services are provided by third parties but the cost passed directly to tenants sometimes with a landlord’s handling charge being a percentage of the total cost.
Conflicting objectives can occur when a landlord institutes an unnecessary and extravagant refurbishment to attract new tenants to the building at the expense of existing tenants. Landlords sometimes delay significant works until just prior to the end of a lease term and recover the cost from the departing tenant so that it can offer new tenants modern facilities.
Tenants should seek maximum transparency in lease service charge provisions and appropriate consultation rights in relation to major works and contain clear obligations on the landlord to act reasonably in providing services. There is no implied duty to do so. Tenants should undertake full audits of service charge accounts by reference to the lease to ensure that:
- the cost reflects the work undertaken;
- the proportion charged to the tenant reflects a fair reflection of the tenant’s occupation of the building;
- the reasonableness of the works; and
- the charges are recoverable under the lease.
Leases will include an obligation on the tenant to keep the premises in repair and to deliver them back to the landlord in substantially the same condition as at the grant of the lease. At the end of the lease, the landlord will inspect the premises and prepare a schedule of defects. Typically they then look to recover the cost of repairing these defects from the tenant together with the cost of removing any alterations and reinstating the premises. There are a number of statutory restrictions on the landlord’s claim: it cannot exceed the amount by which the building value is diminished by the disrepair and no claim can be made if the landlord intends to demolish or undertake works to the building which would render the works futile. The nature of the works required is often the subject of disputes especially where works to return the building to a 25-year-old standard would be worthless due to advances in building design which dictate tenant demand or where the building might require a significant overhaul to meet new EPC requirements.
An important decision for any outgoing tenant will be whether to undertake repairs or not and wait for the landlord’s claim. Often this will be governed by business needs and the availability to relocate early to enable the works to be undertaken. Significant savings can be achieved by tenants who plan their exit and dilapidations strategy carefully in advance. Research the landlord’s intentions, understand what would need to be done to the building to attract modern tenants and engage with the landlord at the earliest opportunity to seek to agree an allocation of responsibilities and costs. In any event, if you have not reached an agreement with the landlord before you vacate make sure that you have a complete and accurate photographic record of the state of the building as you may need this in any subsequent dispute.
Landlords using the institutional lease transferred most occupational risks and responsibilities to tenants. Market conditions and the like-minded institutions which dominated the landlord market have stifled change. There has never been a better time for tenants to break the mould and insist on leases that provide the flexibility to respond to business imperatives and greater control on occupation costs. The result would be significant cost savings – perhaps the first real estate strategy to receive unanimous approval.