Recent times have seen a rise in online business presence and work-from-home arrangements. However, in certain industries like the construction industry there will always be a need for a bricks and mortar business premises.
This article outlines some of the key considerations to keep in mind when negotiating your next commercial lease. Specifically, we’ll run through:
- Key commercial terms;
- Industry specific requirements;
- Standard tenant’s obligations;
- Common landlord’s obligations;
- Some other important provisions;
- Due diligence when leasing; and
- Final tips and traps in commercial leasing.
Key Commercial Terms
A standard lease will include provision for how often rent is to be paid, in advance or arrears, and whether a GST amount is included.
Additionally, you will need to be aware of how rent is reviewed and adjusted, from year to year throughout the term of the lease and throughout any option period.
Rent review – CPI
If rent is reviewed by reference to a consumer price index (CPI), factors such as the location and comparison period will be relevant. Depending on the terms of the agreement, the location of the CPI may be a weighted average of all Australian cities, or only the capital city of the state which the premises are located.
Likewise, the comparison period may be the previous month, quarter, or most commonly by reference to the same specified period the previous year.
The CPI formula will usually look much like this:
New Rent = Old Rent x Recent CPI
CPI rent reviews may give rise to significant increases in periods of high inflation. Given Australia’s current and forecasted inflation rates, you should be careful in examining how these terms effecting the review are defined in the lease.
Rent Review – Market
Market reviews are most commonly employed at the end of a lease term (including upon the exercise of an option).
Some factors that are relevant to a market review provision in a lease include the requirements of the notice period; the identity of the person conducting the valuation; the share of costs for a valuation, and prescribed considerations in how the property is to be valued.
Parties may also have alternate views on whether the valuation decision should be final and binding, or open to further review. Typically the ability to deal with any disagreement about rent increases on market review should be included, if it is not appropriately covered by the normal “dispute resolution” provisions.
Security for your lease obligations is usually provided in the form of a bank guarantee or cash bond, representing rent for an agreed number of months. The number of months is negotiated by the parties, but beware – landlords may leverage weak tenant trading figures or rental history to negotiate larger and more easily cashable bonds.
The terms of the bond must also align with the policy of your bank.
One particular issue that comes up regularly is the landlord requesting a bank guarantee without an expiry date, but the bank being prepared only to offer a guarantee that ends either on the expiry date or within a certain period after expiry of the lease term.
Landlords will generally push for the guarantee to include the term ‘irrevocable’ so that it cannot be denied by the bank if they attempt to cash in.
You should engage with your bank early to determine if the landlord’s requirements for the bank guarantee are acceptable under the bank’s policies. Naturally the bank will usually want its own form of protection in exchange for granting the bank guarantee, and you will need to be comfortable with those commercial arrangements too.
Outgoings broadly refer to the regular expenditure of the landlord such as taxes, services, maintenance and insurance costs.
A commercial lease can be net (outgoings are additional to rent) or gross (outgoings are incorporated into rent).
Generally, you should avoid accepting responsibility for capital costs or works of a structural nature. These should be borne by the landlord as owner of the premises.
To ensure that the practical and operational needs of the business are met you should always physically inspect the premises prior to the commencement of the lease, or at least have a trusted agent do so for you.
Most leases will include a disclaimer from the landlord that it does not warrant the premises to be fit for the permitted use as defined in the lease. Engaging a town planner before signing the lease is the best way to ensure that your type of business can legally operate from the premises.
Lease term/ duration
Practical business requirements should direct your commercial decision as to the term of the lease. Relevant considerations include the importance of the location to the ongoing success of your business, the age of the premises, your future plans for growth or expansion, and the risk profile of the business you are operating.
It can be safer to look for shorter term leases with additional options, to hedge your bets on whether you’ll need something bigger (or smaller) in a few years’ time. However, shorter lease terms also sometimes give rise to significant rent increases after market review as we mention above.
Landlords may offer incentives to entice prospective tenants to occupy their premises. Often these will be driven by market dynamics, including, recently, the COVID pandemic and ensuing growth in work-from-home arrangements.
It always makes sense to shop around for the best incentives offered on the market, which might include rent free periods, reduced rent periods or contributions to fitout costs.
As part of lease negotiations, you should ensure the fitout of the property is suitable for your business needs (or will be) from the commencement date.
This may include ensuring you have early access to the premises – that is, prior to the commencement date – in order to install the fitout.
In addition to agreeing who is responsible for performing/paying for the fitout works, it’s also relevant to consider which party owns the fitout and what is intended will happen to it at the expiry of the lease. For example, are you required to remove the fitout and “make good” the premises before departure, and have you factored those costs into your business decision making?
Industry Specific Requirements
You should also take into account any requirements that might be specific to your industry.
As mentioned above there will be a provision in the lease which specifies the permitted use of the premises by the tenant. The obligation will therefore be on you as tenant to ensure that all relevant licences, council zoning and workplace health and safety requirements are complied with. This will require consideration of the staff and machinery necessary to conduct your business.
In the construction industry, tenants should consider how aspects of their business operations might breach a standard lease term, and therefore ensure the lease addresses these points to avoid issues down the track.
Some such operations might include the use of toxic chemicals, large vehicles and loud machinery, which could impact upon maximum floor loads of the premises and the peaceful occupation of neighbouring properties. Checking local zoning laws before the lease is signed will also mitigate the risk of these issues arising.
Remember that liability in relation to these issues will rest on your shoulders, not the landlord’s, once the lease commences.
Certain obligations of the tenant are standard under a commercial lease.
Payment & repair
Outside of the primary payment considerations, including rent and various forms of security, the tenant will commonly be liable for maintenance and repair costs.
However, remember that this obligation should not extend to carrying out works of a capital or structural nature. As a cautionary example, it is common for leases to contain a provision obliging the tenant to enter into an air conditioning maintenance contract, but you should avoid liability for replacement of air conditioning systems. That would more rightly be considered a capital cost.
You should be aware of any communal costs you will be liable for as tenant, such as body corporate fees or costs of maintaining common property like gardens, carparks, escalators and communal bathrooms.
A commercial lease will also oblige the tenant to pay for all costs of the landlord relating to lease preparation and registration, and obtaining the consent of the mortgagee. (It’s worth noting that in a retail shop lease, the landlord cannot necessarily recover all of these costs.)
A commercial lease will require you to effect and maintain certain insurances such as public liability, contents, business interruption and plate glass insurance.
Commonly, the lease will also require the tenant to take out additional insurance as reasonably required by the landlord, and to list the landlord and any mortgagee as interested parties on the policy. An insurance broker can assist where these matters become complicated by the size of your organisation or by having multiple tenancies.
The lease will include a number of use covenants and prohibitions.
Positive covenants may include the requirement to keep the premises clean, engage a security services provider and obtain landlord consent before installing signage.
Negative covenants are likely to include the obligation not to cause damage or disturbance and not to carry on offensive or illegal business.
Depending on the specific terms of the agreement, to ‘make good’ typically requires the tenant to reinstate the premises to its condition at the commencement of the lease for the landlord to inspect.
In reviewing your make good obligations under the lease, you should look to see what the lease says about how often the obligation arises, including how you will compare the current condition of the premises to its previous condition.
Be careful about option periods in the timing of these obligations – if you have a 5 year lease with a 1 year option, without careful thought you could find yourself replacing the carpets in years 5 and 6 – which isn’t likely necessary.
You should aim to negotiate fair terms for making good including that consent or approval of the landlord should not be unreasonably withheld.
You can also reduce the likelihood of dispute at the expiry of the lease by taking photographs of the premises and landlord’s fixtures and obtaining condition reports at the commencement of the lease.
The landlord must allow you quiet possession and enjoyment of the premises and must make ‘reasonable endeavours’ to ensure facilities are maintained. This includes allowing you full use and occupation of the premises without substantial interference.
Courts have said “substantial interference” includes disconnecting services, failing to make structural repairs, or erecting items that affect customer flow or otherwise affect business profitability.
In the event of significant damage and destruction (such as fire or flood) to the premises the lease should provide for a rent and outgoings abatement for the period that the damage persists or the premises are not able to be fully utilised for their intended purpose.
Clauses dealing with such events usually give the landlord a choice, but not obligation, to restore the premises. Your aim in relation to these clauses should be to limit and define the notice periods, so that you know as soon as possible what decision the landlord will make.
Be aware of the landlord’s reservation of rights under the lease. These will usually include a right to inspect the premises and to carry out work. Look to ensure these rights are only exercised upon provision of reasonable notice and without impact to your business.
Other important provisions and considerations
You should be aware of the consequences of defaulting under the lease, including the landlord’s right to pursue you for damages and/or to terminate in the event of an unremedied breach.
If the lease is entered into after 30 June 2018 and defines insolvency as an event of default, corporate tenants should additionally be aware that the landlord’s right to terminate is stayed where you become insolvent but have entered into a specified insolvency or restructuring procedure. You can read our article on this prohibition for more detail here.
The terms of the lease will specify the process the landlord has to follow in seeking remedy of a breach by the tenant, including notice requirements.
Failing this, legislation (such as in Queensland, the Property Law Act 1974) provides that a landlord must give the tenant a reasonable time in which to remedy any breach before progressing to more severe action such as termination. A reasonable time is commonly interpreted as not less than 14 days.
One thing you should be very aware of in a commercial lease is any term allowing the landlord to demolish the premises and/or relocate you.
If it is not possible to have this clause deleted from the lease, you should seek to limit the landlord’s rights to the greatest extent possible, make any notice periods as long as possible and ensure that you’re sufficiently compensated in terms both of remuneration and quality of relocated premises.
Transfer/ sublease/ mortgage
Commercial leases commonly contain provisions prohibiting the assignment of a lease, the subleasing of part of a leased premises or mortgaging of a lease interest by the tenant without the prior written consent of the landlord.
This consent will be conditional upon various factors including the tenant not being in breach of its obligations and, in the case of assignment or sublease, the landlord being satisfied with the financial capacity of the proposed assignee or sublessee.
You should be aware that a change in control of a corporate tenant will be deemed a transfer of lease, which means that any significant changes in shareholding or voting rights in a company will need the prior written consent of the landlord.
Registration/ mortgagee consent
Why should you register the lease? Registration of the lease on title gives the tenant what’s referred to as indefeasibility of title, or an absolute and unchallengeable right to occupy the premises.
If the landlord (or its bank!) sells the premises, a registered lease will offer you significantly more protection from being ejected than an unregistered lease.
Similarly, obtaining the consent of the mortgagee is an acknowledgement of the tenant’s right to occupy and use the premises. This will provide you, the landlord and the mortgagee with more comfort about the lease agreement.
As a prospective tenant you should look to obtain comfort by conducting all relevant property searches, such as title searches, dealing searches and council searches including zoning and development approval searches, as well as some basic searches on the landlord such as bankruptcy searches and, if the landlord is a company, an ASIC search.
You might also look to satisfy yourself as to the environmental impacts of the building, for example, the sustainability measurement provided by the National Australian Built Environment Rating System, or NABERS.
Tips and Traps
Some final tips and traps to consider before entering into a commercial lease agreement:
- Make sure you intend to be bound only to the terms of the lease; if not careful you may unintentionally be binding yourself under a heads of agreement or letter of intent.
- A lawyer will be vital in advising, preparing and negotiating formal documentation, but you should also speak to your financial and tax advisors as to the commercial obligations under the lease.
- Shop around to ensure you are getting the best commercial deal, including possible incentives.
- Negotiate to remove or limit the landlord’s absolute, broad or vaguely termed rights.
- Carefully consider your make good obligations and document the condition of the premises at the commencement of the lease.