FREE CHAPTER from ‘Short-Term Commercial Lets for Lawyers, Agents, Landlords and Tenants – A Practical Guide’ by Mark Shelton

CHAPTER ONE

WHAT MUST I PAY?


This chapter outlines the principal financial obligations under commercial leases.

While there are a considerable number of Acts of Parliament which regulate the landlord and tenant relationship, the most important source of the parties’ rights and obligations is the terms of the contract, i.e. the lease.

The journey away from the ‘institutional lease’

Thirty or forty years ago, commercial leases were typically granted for a 25-year term. Tenants would be responsible for the repair of the entire structure, from foundations to roof. The landlord would insure the building, but the tenant or tenants would reimburse the insurance premiums.

This is sometimes referred to as an ‘FRI lease’, the initials standing for ‘full repairing and insuring’. In this model of lease, all the risk of fluctuation in the property overhead is thrown onto the tenant, leaving the landlord a clear rent, hence another common name for it: the ‘clear lease’.

This was the dominant commercial lease form, and it was developed by and for property investors, to be a relatively straightforward investment vehicle. It was attractive to institutional investors such as insurance companies and pension funds (hence yet another name for this type of lease: the ‘institutional lease’).

As regards the rent, under this model of lease it would be reviewed every five years, and could only ever go up, or stay the same. The level of rent would never reduce, even though the rental market might have fallen in the meantime. Security of income over the 25-year term was underpinned by the rule of ‘privity of contract’, under which a tenant remained liable to pay the rent and perform all the other tenant’s obligations despite having transferred the lease to someone else. The transferee would in turn be bound in the same way, after having transferred the lease again, and so on, so that as time went on the landlord stood to accumulate an ever-growing list of parties against whom the lease terms might be enforced.

A lease following that template was not obviously a good deal for tenants, and much has changed since then, partly as a result of legislation, partly as a result of self-regulation initiatives within the property industry, but mainly as a result of the market turning in tenants’ favour over a long market-cycle.

The average length of new lease terms has been falling for years, and has been at or around five years for some time. In a lease of that length, or shorter, there may be no rent review. Repair obligations are often now more limited, and there may be a cap on service charges. Break clauses feature in leases regularly, allowing tenants to terminate the lease early. The old ‘privity of contract’ rule has been abolished.

In this and the next three chapters we consider the key content of commercial leases. In many respects that content owes much to the institutional lease, and it is still routine to speak of a lease, or a specific lease provision, as being ‘institutionally acceptable’. However, that template may often now be departed from in important respects.

Obligation to pay rent

The most fundamental of the tenant’s obligations in a lease is to pay the rent. The lease will often require that it be paid by direct debit or standing order, or by bank transfer. It is usual for it to be paid in advance, rather than in arrears.

One consequence of payment in advance is that if the lease comes to an end in the middle of a rental period (actually, on any day other than the last day of a rental period) an issue arises as to whether a lesser, proportionate amount is payable on the final rent day prior to the end of the lease. For example, if rent for the period 29 September to 24 December would ordinarily be payable in advance, on 29 September, but it is known that the lease will come to an end on 10 October, is the tenant entitled to pay, on 29 September, a lesser amount calculated for the period up to 10 October? If not, and a full quarter’s rent must be paid, is the landlord then obliged to refund, after the lease has come to an end, an amount calculated for the period following 10 October?

The answer to either question is not fixed in law, but depends upon what the lease says.

Rack rent leases

The traditional pricing structure is what is known as a ‘rack rent’, meaning simply that the tenant pays the full open market rental value of the property. However, in the case of leases for long terms (say, 99 years or more) it would be conventional for the tenant to pay a ‘premium’, that is a capital sum, in the same way as one would if buying a house. There will usually be a rent payable as well, but this is more as a ‘badge’ of a lease than anything else, and it will be a nominal amount, sometimes “a peppercorn”. This is not encountered that often, since commercial leases are rarely that long. They are typically on a rack rent basis.

In commercial leases, it is unusual for the rent to be expressed as anything other than an annual rate, though of course rent falls due for payment more frequently than once a year. The rent payment days have conventionally fallen quarterly, though monthly payment days are encountered now more often than previously, and monthly payment is usually better for a tenant’s cashflow. Where payment is monthly, the lease will of course specify the day of the month on which it falls due. Where it is quarterly, leases very often provide for payment on ‘the usual quarter days’, which are 25 March, 24 June, 29 September and 25 December (historically, significant dates in the Christian calendar). More modern leases may instead specify 1 April, 1 July, 1 October, and 1 January.

As mentioned above, modern leases are often so short that there is no provision for the rent to be reviewed. Where a lease does contain a rent review clause, it is still usual for it to provide that the review process is upward-only.

Turnover rent leases

Not all leases are on a rack rent basis. In certain economic sectors, principally retail and hospitality, the value of the premises to the tenant can be assessed very directly by reference to the sales achieved there. An alternative model is therefore for the rent to be calculated, at least in part, on the tenant’s turnover.

The usual structure is that the tenant pays a ‘base rent’, typically around 80% of the open market rental value, plus a percentage of its turnover as a top-up. For tenants who have a very simple business model, and for short leases, landlords are increasingly prepared to agree to a turnover-only arrangement, where there is no base rent, and the tenant simply pays a percentage of its turnover to the landlord.

Where there is a base rent, it will be paid quarterly in advance, just as in a rack rent lease. Calculating the turnover, and paying the turnover-based rent, is administratively more complicated, and of course it cannot be known or paid in advance. With many retailers operating online as well as at bricks and mortar premises, and with increasingly ingenious and innovative ways of generating income being devised all the time, capturing all the turnover referable to a store can be very challenging.

The knock-on implications of a turnover-based rent for the other terms of the lease are surprisingly wide-ranging, and these arrangements can be dauntingly complex. Nevertheless, tenants are often attracted to the idea that the landlord will be taking on some of their business risk, and that their property overhead will have some downward adjustment in difficult trading circumstances. Turnover rents are increasingly common in the retail and hospitality sectors, particularly in the light of the Covid-19 crisis.

Service charges

If a landlord lets an entire property to one tenant, the expectation is that the tenant will bear the entire cost of repair of the building. If on the other hand the building is, say, an office block which is let in parts to a large number of tenants, things have to work differently. Each tenant will be responsible for the upkeep of their own part of the building; the landlord will be responsible for the repair of the main structure and roof, plant and equipment for heating, air-conditioning etc., also lifts and escalators, and other ‘common parts’ such as landings, lift lobbies, reception areas and communal toilets. However, the sums spent by the landlord in repairing those elements will be charged to all of the tenants through their individual contributions to a service charge. The end result, from the landlord’s point of view, should be exactly the same, in financial terms, as if it had let the whole building to one tenant, responsible for the repair of the entirety.

Service charges will, moreover, allow the landlord to recoup expenditure on other matters, not just repair. That might include the cost of heating and lighting, promotions and advertising, provision of security services, managing agents’ fees, and so forth.

In terms of payment mechanism, the most common arrangement is for the landlord or its managing agents to produce a budget for service expenditure on an annual basis, and for the tenant to pay quarterly instalments determined by the amount of the budget. At the end of the service charge year, the landlord prepares accounts showing the actual expenditure on services over the year. Either the tenant is required to pay an additional charge, if the quarterly payments have fallen short of the actual expenditure; or, if they have exceeded it, the landlord may be obliged to make a refund of the overpayment (though it is more common for the amount to be credited against the next year’s service charge instead).

Service charges are a common flashpoint between landlord and tenant. The landlord is apt to feel aggrieved if it cannot recover in full the sums expended on providing services for the tenants, while for tenants the service charge mechanism looks suspiciously like a blank cheque. However, it is hard to find a satisfactory alternative.

First, there is a simple practical necessity: an obligation to repair and maintain common parts such as foundations and roofs cannot sensibly be divided up between tenants. Secondly, tenants may be sceptical as to whether the landlord will provide services to the required standard, if not underwritten by the ability to recover the cost from the tenants.

So both parties know they have to live with service charges; but that does not mean that they are not sometimes hotly disputed, especially as compliance with environmental and other requirements continually raises new heads of expenditure on multi-let properties. Tenants may sometimes succeed in negotiating a cap on their annual service charge contributions, which gives some degree of control over the cost.

Service charges for residential property are subject to extensive legislation. As regards commercial property there has been no such statutory regulation. There is, however, a code of practice applying to commercial service charges. The Code of Practice: Service Charges in Commercial Property published by the Royal Institution of Chartered Surveyors (“the RICS”) was first launched in 2006, and since 1 April 2019 it has been incorporated into the RICS’ professional conduct framework in the form of the RICS Professional Statement on Service Charges in Commercial Property. It addresses provision of information when the lease is being negotiated, when services are being purchased and provided, and when the service charge is demanded. It makes recommendations as to the content of service charge provisions, and as to the provision of services, and financial management of the service charge.

As it is a Professional Statement, the RICS will take account of its provisions when deciding whether a member has acted professionally and with reasonable competence and it is also likely to be taken into account in court proceedings regarding the competence of surveyors.

Insurance

Leases invariably provide for landlords to insure the building. This is because it is thought that tenants will be inclined to buy cheap insurance which does not give the comfort the landlord requires. If the landlord insures, it can be certain that the relevant risks are covered, and that the insurer is a reputable and financially sound one. In accordance with the idea of the ‘clear lease’, though, the tenant will be required to reimburse the insurance premiums.

Reserved as rent”

The rent may often be referred to in the lease as ‘the Main Rent’ or ‘the Principal Rent’, while service charge and insurance premiums may also be said to be “reserved as rent”, or “payable by way of additional rent”. Alternatively, they may be called something like “Service Rent” and “Insurance Rent”. It is common to find that other sums payable to the landlord too, like reimbursement of professional fees, and interest on rent paid late, are “reserved as rent”.

Historically, there were two main purposes of this. One is to do with forfeiture (that is, termination of the lease by the landlord, on the ground that the tenant has breached its lease obligations). This can be done by simply changing the locks to the premises, though generally speaking the tenant must be given a warning notice, and time to put right the breach of the lease. However, no warning notice is required, and no time need be given, where the breach is non-payment of rent.

The other, and more important, reason was that landlords used to enjoy the right to use a procedure known as ‘distress for rent’. This enabled them to recover any arrears of rent by instructing bailiffs to go to the property and seize and sell tenants’ goods found on the premises. This could be done without warning and without having to go to court, and so it was a very effective and relatively quick and cheap process for landlords. From the tenant’s point of view, of course, it appeared to be an unnecessarily aggressive and harsh measure. It could only be done in relation to rent, and so it became normal for leases to describe all sums due to the landlord as different heads of rent. Distress for rent was replaced in 2014 by Commercial Rent Arrears Recovery (“CRAR”), which is a much more regulated and restricted procedure. It cannot be used without prior warning, and it can only be used in relation to rent properly speaking, not service charge or insurance premiums or anything else.

The replacement of distress for rent by CRAR means that the landlord does not gain much of an advantage by having all sums due under the lease described as rent, but it is still very common to see this in leases.

Other bills

Of course, the cost to the tenant of running the property is not confined to the sums due to the landlord. Business rates is a large expense, potentially as much as 50% of the annual rent. Services such as heating, lighting, water and telephone may also have to be paid for.

Inclusive rents

As well as turnover rents, another model which is increasingly finding favour is the ‘inclusive rent’. That is, the tenant pays only the fixed amount of rent. The landlord may provide services and insurance, the landlord may have responsibility for repair of the premises occupied by the tenant as well as any common parts, and the landlord may even pay the business rates, but none of these costs are recouped from the tenant. It is the opposite, or the negative image, of the clear lease. It gives the tenant certainty as to the amount of its property overhead, and for this reason it is attractive. However, the rent will be higher than it would be if the tenant were bearing these costs.

Summary

Rent is usually payable in advance, by equal quarterly instalments. If the lease is of sufficient length, the rent may be reviewed at intervals, and may go up as a result.

Rent is usually at the full open market rental value, called a ‘rack rent’, though in some retail and other leases it may be calculated at least in part by reference to the tenant’s turnover, so that the amount fluctuates.

Other amounts that tenants must usually expect to pay are service charge, insurance premiums, business rates and other outgoings. So-called ‘inclusive rent’ is sometimes seen, where the rent is a fixed amount, and no additional charges of those sorts are payable. They are borne instead by the landlord.

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