COMMERCIAL LEASES – IMPORTANT TERMS TO CONSIDER BEFORE SIGNING by Atticus Legal, Lawyers Hamilton.
For small businesses signing up to a commercial lease (and a personal guarantee) is a major commitment. It is very difficult, if not impossible, to extract yourself once you have signed an Agreement to Lease. Early legal advice before you sign the Agreement to Lease is essential. At Atticus Legal, Lawyers Hamilton we know commercial leases inside out.
Commercial leases often begin with an Agreement to Lease
Many commercial leases start out life as an ‘Agreement to Lease’; often prepared by an estate agent. An Agreement to Lease is a preliminary (but legally binding) agreement setting out the basic terms of the lease. It is often used where there is some agreement as to works to be completed (whether by the landlord or tenant) before the lease term commences or where there is some condition to be satisfied before the lease commences (e.g. the tenant obtaining a building consent for ‘tenant’s fit out’).
The Agreement to Lease states that a formal deed of lease will later be prepared by the landlord’s lawyer and signed by the parties, usually in the form of the Auckland District Law Society (ADLS) deed of lease. The ADLS lease is regarded as ‘standard’ for most commercial leases, except for office tower leases, shopping mall leases and other specialised tenancies. The deed of lease will contain the detailed terms of the lease and will also contain the full terms of any personal guarantee.
However, it is not legally necessary to first enter into an Agreement to Lease. Sometimes, but not often, the parties go straight to a deed of lease. Again, the same recommendation applies; get advice from your lawyer before you sign.
The following are the main terms that need to be addressed in commercial leases, including the Agreement to Lease if there is one.
Definition of premises
If landlord’s fixtures and fittings (and/or chattels) are included, these should form part of the premises description. Schedule 5 of the ADLS deed of lease allows for these to be listed. The premises define what the tenant will have ‘exclusive use’ of. Are carparks included? Are the carparks (and other areas appearing to be common areas) for common use or for use exclusively by you and your customers?
Investigate zoning before signing the Agreement to Lease
Tenants should, but often don’t, check the zoning of the property (i.e. the permitted activities under the Council’s district scheme zoning) before signing the Agreement to Lease to ensure that their intended activity at the premises is permitted by the zoning. There is no implied promise by the landlord that the tenant’s intended use will comply with the zoning. So if a tenant signs an Agreement to Lease and later discovers that their ‘permitted use’ under the lease is not allowed by the zoning, the tenant will still be bound by the lease.
If you are leasing commercial premises in a complex owned by the same landlord, you should consider asking for a term to be included in your lease whereby the landlord promises not to lease other premises in the complex to persons who sell competing products/services.
Personal guarantees & how to limit guarantor liability
If the tenant under a commercial lease is a company the landlord will almost certainly require personal guarantees from the directors and major shareholders. We recommend that guarantors always try to limit their liability under the guarantee. Any agreed guarantee limit must be spelt out in the Agreement to Lease. For example, you may be able to negotiate a limit on your guarantee liability equal to say, 12 month’s rent or that your guarantor liability will end on assignment of the lease – see below re ongoing liability where there a tenant assigns the lease.
At Atticus Legal, Lawyers Hamilton we recommend another way of limiting tenant and guarantor liability which is to slice and dice the term and renewals into relatively short periods (e.g. 2 to 3 years each as opposed to say, a 10 year lease term). The reason for this is that the tenant and guarantor are liable for the rent and outgoings (and other tenant obligations) for the whole of the term. If the tenant assigns or sublets then the tenant (and guarantor) will remain liable to the landlord for the remainder of the term if the assignee or sub-tenant defaults.
From the landlord’s perspective, another possibility (either in addition to or in the absence of a personal guarantee) may be to require a bond to be paid up front by the tenant (e.g. say, 3 to 6 month’s rent) to be held in the landlord’s solicitor’s trust account pending expiry of the term or earlier default by the tenant. Another alternative is a performance bond (say, equal to 6 month’s rent) from the tenant’s bank. However, in our experience at Atticus Legal, Lawyers Hamilton bond payments and performance bonds are quite rare in commercial leases and will depend on the respective bargaining power of the parties.
Term & rights of renewal
As mentioned above, from a tenant’s perspective (and guarantor’s perspective) it is better in terms of liability limitation to have a short lease term with multiple short rights of renewal. Whereas from the landlord’s perspective, generally the longer the term and rights of renewal, the better.
Note that the exercise of a right of renewal is at the tenant’s option, assuming the tenant is not in breach (not the landlord’s option). Tenants should also be aware that a lease term is not renewed ‘automatically’. The tenant must give the required written notice to the landlord of intention to renew, usually 3 months before expiry of the term. If the term expires and the lease is not renewed but the landlord continues to accept rent from the tenant then the lease becomes a monthly tenancy, which either the landlord or tenant can terminate by giving one month’s notice.
If the renewal date coincides with a rent review date then the tenant cannot make its exercise of the renewal conditional on agreement on the rent for the renewed term – i.e. the two processes (renewal and rent review) are independent.
Commercial leases will provide for rent review dates; often, but not always, coinciding with renewal dates. The lease may specify that the rent reviews will be either ‘market rent review’ or ‘CPI adjusted review’ or a mixture of both. A market rent review involves the adjustment of rent to the then current market rent for the premises. A CPI adjusted rent review involves an increase in the rent based on the inflation rate over the period concerned. Almost always a commercial lease will provide that the reviewed rent can not fall below the existing rent prior to the review (called a ‘ratchet clause’).
At Atticus Legal, Lawyers Hamilton we recommend tenants should bear in mind that if a landlord offers an initially reduced rent, to induce the tenant to enter into the lease, the next rent review (if a market rent review) may substantially increase the rent payable for the remainder of the term.
Outgoings & insurance
Most commercial leases are ‘net leases’ which means that the tenant must pay outgoings (or a share of outgoings) on the property in addition to rent – e.g. rates, landlord’s property insurance premiums, common area maintenance costs, etc. These outgoings are listed at paragraph 18 of the First Schedule of ADLS Agreement to Lease and deed of lease. If you are leasing part of a building then the lease will usually specify the tenant’s proportion of the outgoings, normally based on a proportion of the total floor area.
Outgoings can be a significant cost to the tenant and should be assessed by the tenant before signing an Agreement to Lease.
Tenants should also note that the landlord’s property insurance will not cover the tenant’s stock, chattels, plant and equipment. It is up to the tenant to insure its own business assets. At Atticus Legal, Lawyers Hamilton we recommend that tenants should preferably also take out their own business interruption insurance – i.e. to cover business costs and lost revenue while the premises are damaged (e.g. through fire, flood or earthquake) and the tenant cannot carry on its business. Christchurch commercial tenants definitely found out the value of business interruption insurance when the earthquakes struck.
Tenant’s maintenance obligations
Schedule 6 of the ADLS deed of lease allows for the recording of a ‘premises condition report’ regarding the premises and the landlord’s fixtures, fittings and chattels. We recommend that a joint tenant/landlord inspection be carried out before commencement of the lease and the results recorded in the schedule.
The tenant is required to maintain the interior of the premises (and landlord’s fixtures, fittings and chattels, if any) in the same condition they were in at commencement of the lease, subject to fair wear and tear. So evidence of the condition of the premises at commencement may be crucial. In addition, we recommend that the tenant takes plenty of photographs of defects in the premises at the commencement of the lease. Evidence is everything!
The ADLS commercial lease also provides for specific tenant obligations to repair breakages, paint and redecorate as reasonably required and to keep the premises clean. The tenant will also be obliged (if required by the landlord) to reinstate the premises at the end of the lease (i.e. return the premises to their original condition) where the tenant, with the consent of the landlord, has carried out alterations or additions (including signage) – see further below.
Under the ADLS lease the landlord must keep the building (i.e. roof and exterior) ‘weatherproof’. The landlord must also maintain shared ‘building services’ such as lifts and air-conditioning and common areas, although the tenant may be required to contribute to the cost of maintenance of ‘building services’ and common areas as an outgoing.
As mentioned above, if the tenant makes alterations or additions to the premises then the landlord may require the tenant to ‘reinstate’ the premises at the expiry or earlier termination of the lease. Reinstatement costs can be substantial. From a tenant’s perspective, where tenant alterations or fit out are contemplated, the ideal would be to include in the Agreement to Lease a provision to the effect that the tenant will not be required to reinstate the premises at the end of the lease.
Note that if you take over a lease (as assignee) from an existing tenant (e.g. you purchase the existing tenant’s business and take over their lease) then as assignee you will be required at the end of the lease to reinstate the premises to the same condition they were in as at takeover of the lease (not to the same condition as at commencement of the lease). Again, a joint landlord/assignee inspection (recorded in writing plus photographs) at the time of takeover would be helpful to establish the state of the premises at that time.
Commercial leases usually define the type of use/business activity to which the premises may be put by the tenant. From a tenant’s perspective, a general broad description of the permitted use is preferable – e.g. ‘retail’ or ‘offices’.
As mentioned above, tenants should check the zoning of the premises before signing an Agreement to Lease to ensure that their intended use of the premises is permitted by the local authority zoning. The tenant can not generally terminate the lease in the event that the zoning does not allow an intended use. If a resource consent (or say, Council approval for a ‘controlled activity’ under the zoning) is required for the tenant’s intended use then obtaining such consents and approvals should be made a condition of the Agreement to Lease.
WANT TO KNOW MORE? Just ask Atticus Legal, Wizard-like Property Lawyers Hamilton & Business Lawyers Hamilton
CALL ANDREW SMITH, the owner of Atticus Legal, for expert professional advice on any of the matters referred to in this information sheet.
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Disclaimer: The information contained in this information sheet is, of necessity, of a general nature only. It should not be relied upon without appropriate legal advice specific to your particular circumstances.
This information sheet is copyright ©Atticus Legal, January 2018