Filling the spaces: Negotiating tenant-friendly leases in troubled times

By Nikki Robinson and Laura Duesbury.

Key Points:
With commercial office vacancy rates increasing in Australia, it is a great time to be – and to attract - a desirable tenant. Landlords and tenants alike should approach lease negotiations with a flexible attitude aimed at creating a contract which is fair and balanced for both parties.

With commercial office vacancy rates increasing in Australia, it is a great time to be – and to attract – a desirable tenant.

The Property Council of Australia reported a vacancy increase to 6% nationwide, in the six months to January 2009, fuelled by a rise of 8.5% in Canberra in the same period - the sharpest six-monthly increase in 17 years. Premium and A-Grade spaces were most affected by the downsizing of the finance sector, with Canberra's sharp rise in vacancy rates particularly driven by a doubling of vacancy rates for A grade space to reach 12%.

While the pace of new office space coming on line has slowed, some development is continuing. As the need for space contracts, commercial vacancy rates are expected to escalate.

Landlords who wish to attract long-term and solvent tenants to their properties should take note that market conditions are more favourable to negotiate tenant-friendly leases than they have been for years. Negotiating a lease which is fair and balanced for both parties, and which offers both parties some comfort against market forces, should be the goal of both landlords and tenants seeking to negotiate new leases.

Tenant’s options and assignment provisions for troubled times

Signing up for a long-term lease can be a cause for concern for tenants who are unsure how their business will look, or whether it will exist at all, in three or five years' time.

Options

Using tenant's options to break the term of the lease into a number of shorter terms is an effective and commonly used strategy for limiting the risk of a long-term lease to more easily forecast periods of three or five years at a time, without compromising security of tenure. For example, it is common to structure a ten year lease as a five year fixed term with a five year option on agreed terms at the tenant’s election. Granting a three, plus three, plus three year term may even be more advisable than dealing with an insolvent tenant in the future.

Assignment

More than ever, tenants will wish to take this flexibility further with tenant-friendly assignment provisions which enable the tenant to mitigate the losses associated with their business failing, even during the fixed part of the term.

Further, when negotiating a lease, tenants should review their business and ask themselves whether they have any contractual arrangements or future growth or diversification plans which may see them sharing occupancy or assigning their right to the lease - for example, with a joint venture or franchise partner, a related company, or a licensee. If so, the tenant should discuss those issues upfront with the landlord and obtain express consent in the lease.

In any commercial lease, a tenant-friendly assignment provision should include some or all of the following rights:

• an ability to sublease or license the whole or part of the premises for the whole or any part of the term;
• an ability to assign the lease to a related company of the tenant; and
• an ability to introduce one or more joint venture partners to the business.

From the tenant's perspective, all of these rights should ideally be exercisable by the tenant without triggering assignment provisions and without requiring the landlord's consent.

In order to provide the landlord with some comfort about the suitability of the subtenant or assignee of the lease, the lease could include defined suitability tests for the proposed assignee, which prevent the landlord from unreasonably withholding its consent on any other basis. For example, a usual indicator of suitability is the assignee's ability to meet the tenant's financial obligations under the lease.

Tenants should avoid change of control provisions which:

• deem group restructures or changes in the shareholding of the tenant to be assignments of the lease, to which the landlord may or may not consent; or
• the appointment of a liquidator or trustee in bankruptcy becoming a breach of a covenant against assignment.

Any consent rights retained by the landlord should be exercised reasonably.

Financial guarantees

In the past, it has been standard practice to require financial guarantees from all tenants for a portion of the rent, either in the form of a deposit, bank guarantee or corporate guarantee. This gives landlords comfort that where the tenant is in breach of their obligations under the lease, losses suffered by the landlord are covered by the level of the guarantee. It is customary to take an amount reflecting the number of months rent it may take to relet the premises. However, landlords should be prepared to negotiate the amount of the guarantee as well as the form, taking into account the strength and desirability of the particular tenant.

In the current economic climate, corporate group guarantees are likely to be unpopular with both landlords and tenants. However, with the availability of cash also limited, many tenants may also strongly resist providing a cash or bank guarantee. It may be possible for tenants to negotiate a waiver or a deferral of the bank guarantee provision for an initial period or unless a specific event occurs, ie. the lease is assigned to a third party.

Rent and incentives

Conventional rental wisdom has it that, in a falling market, tenants should strive to have the rent reviewed to market as often as possible, without any ratchet clause - meaning that the rent can fall as the market falls.

Reviewing rent in line with market value is, of course, inherently speculative and is only good value for the tenant until market conditions begin improving.

With that in mind, tenants may wish to couple incentives with more conservative rental review provisions such as:

• only reviewing the rent to market at the commencement of an option (which allows the tenant to move on and not exercise the option if the market movement is unfavourable to the tenant);
• requiring the market valuer to consider the "effective" rather than "face" rental of similar properties to ensure that the market rent is not falsely inflated by incentives;
• electing more CPI reviews, also without ratchet clauses.

Rental incentives which tenants should consider requesting are:

• limiting outgoings payments, for example, refusing to pay for lifts or air conditioning;
• lower base rent;
• rent-free periods; and
• contributions to any fit-out works which are required.

Turning the tables

With corporate insolvency rates rising, tenants may be less concerned about their own solvency and more concerned about how the solvency of their landlord will affect the security of their lease.

The best advice to tenants is to know the solvency of their landlord before they sign on the dotted line. Tenants should:

• consider requiring unconditional mortgagee consent to the lease and any subsequent assignment;
• if the landlord is a trust, ask to check the trust deed to determine whether any indemnity given by the landlord is backed by the assets of the trust;
• if the lease is for the whole of land, consider requesting an option to purchase the land at an agreed price if the landlord suffers an insolvency event;
• seek the right to net off against rent owed under the lease the relocation costs incurred by the tenant where the landlord suffers an insolvency event that results in the termination of the lease; or
• if the tenant’s concerns about the landlord’s insolvency do not extend to the wider business of the landlord, consider requesting a guarantee of the landlord's obligations from a parent or other member of the landlord's corporate group.

Landlords should remember that none of the rights which a landlord-friendly lease typically includes are necessarily sacrosanct. Depending on just how desirable the tenant really is, even the following provisions might be worth revisiting:

• rent abatement clauses which stop rental payments when defined events happen, such as when lifts, escalators or air-conditioning services fail - the most tenant friendly rent abatements will kick in as soon as the failure is identified, but landlords typically require a longer continuous period of failure;
• repair and redecorate clauses which place the onus on the landlord to paint the walls and replace the carpet every 3-5 years; and
• no competition clauses which require the landlord to keep your competitors out of the building.

Growing with the good times

This article has been concerned with describing the sorts of things a tenant may seek to have built into a lease to help them navigate through a period of market uncertainty. When the market changes and good times return, however, a tenant-friendly lease should be able to grow with the business. Tenants and landlords should consider negotiating expansion rights including:

• the right to relocate to a bigger or better floor of the building; or
• the first option to lease more space as it becomes available.

As commercial office vacancy rates rise in Australia, landlords who are willing to offer some flexibility in terms of their leases are likely to have a market edge to attract and retain more desirable tenants, and carry them into better times.

Leases are long-term arrangements and should be mutually advantageous for the landlord and for the tenant. Both landlords and tenants should be prepared to discuss each other’s concerns and negotiate a document which works for everyone, both now and in the future.

For further information, please contact Nikki Robinson.