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Costly hidden liabilities in leases

by
01 January 2016, at 12:00am

Stuart Darlington offers an insight to the traps that await unwary lease holders, such as rent reviews and service charges, highlighting the fact that landlords are in it for themselves.

APART from hiring staff or buying capital equipment, taking on leased premises is one of the biggest fixed costs a business will face.

While headline costs are a major worry, firms taking on leased premises need to be aware of the many hidden liabilities when acquiring commercial leased premises. Many of these are not immediately apparent and all will have a cost.

Right to break

It is well known in the property world that where a tenant has a right to terminate a lease, any conditions imposed by the lease must be strictly complied with or the right to terminate is lost, leaving the tenant liable under the lease to continue to pay rent, service charges and rates, etc., for the remainder of the lease term – which could be more than 10 years.

As a result, tenants should resist agreeing any pre-conditions to termination, particularly those that are extremely difficult to comply with. Prime examples include “no breaches of the lease” – there will always be minor breaches no matter how diligent a tenant, or that the tenant must give “vacant possession” by the break date – any failure to strip out fitting out works or even leaving behind a few loose items could count as still being in possession and cost the tenant the right to break. 

Rent deposits

Providing a rent deposit as security is not as simple as it sounds and some deposit clauses can seriously affect cash ow. For example, landlords often add VAT to the base amount of security so that in the event of default the deposit is not 20% short. 

The problem for tenants is that until there is a default and the landlord draws down, payment of the VAT element is not actually VAT and so the tenant will not get a VAT invoice and cannot recover the tax in the usual way.

Deposits given to landlords can often be a substantial sum. Interest will be earned on the money and it should accrue to the tenant. However, it is only likely to be nominal and will not be at a commercial rate of interest.

Tenants often don’t appreciate that a rent deposit is actually an unlimited liability and not just limited to the initial fixed sum. This is because rent deposits always contain requirements to pay more into the deposit account to cover any amounts withdrawn by the landlord.

At the same time, landlords often insist that if the rent under the lease is increased following a rent review, the deposit is topped up by a corresponding increase. This is often not appreciated and can affect cash ow.

Turnover rent

Retail leases in shopping centres or large landlord schemes often charge a rent based on the gross turnover of the leaseholder. This tends to be the amount by which a certain agreed percentage of gross turnover exceeds the base rent.

The lease will often list a few sources of income that will be excluded from the calculation of the gross turnover, but there is one exclusion that is often ignored and which is important – that of online sales. These should be excluded from the calculation unless orders are being fulfilled from the premises.

If this issue is ignored, centrally collected online orders could be caught and charged by this provision. Worse still, online orders could be caught by the turnover provisions of the leases of other stores in the area with each sale being counted multiple times.

Repair and the end of the lease 

Any lease obligation to keep the property in repair implies an obligation to first put that property into repair. This means in simple terms that if a property has any defects or disrepair at day one, the tenant will be liable for bringing the property up to a good state of repair and decoration before they start trading.

This could be costly. Therefore, it is strongly advised that tenants arrange a survey that includes the roof, structure and foundations where they are included in the property being let, as any defects here could be extremely expensive to repair.

Similarly, most leases often require a full strip-out of the premises and removal of all t-out when the term of the lease ends. This costly liability is often ignored.

Rent review

Leases in excess of five years often include upwards-only rent reviews based on the open market value at that time. However, some leases contain yearly increases (or other review provisions) linked to the increase in the Retail Prices (All Items) Index.

The point here to consider is whether the increase is “compounded”. Compounding occurs where the rent is increased in year one by the increase in the Index, and then in each subsequent year the rent is further increased by the change in the Index since the previous year, and so on. This is not always immediately apparent and could increase the rent over time far higher than was anticipated.

To avoid this, each yearly increase should be calculated using the initial (year one) base rent as the benchmark. Each year that year one rental figure should then be increased by the increase in the Index from the month immediately before the start of the lease term to the relevant date of review. That way, increases aren’t applied to already increased rents but the rent is still uplifted in line with RPI.

Service charges

Few realise that in the scrum to secure premises, overlooked service charges and rates can often double charges due under the lease. It’s important to exclude as many of these from the service charge as possible while also negotiating a cap to the charges.

There are a number of common exclusions that prospective tenants should be alert to. A good example includes any monies paid into a reserve fund. Here a landlord is planning for large or recurring items of expenditure in the future. However, tenants will not get these monies back if they sell the lease or when the lease ends, even where the monies have not been spent.

Allied to this are construction and building equipment costs as well as any relevant defects that need fixing. These costs belong to the landlord as the risk of building is theirs. Similarly, any costs that related to getting the premises ready to hand over to tenants should be disbarred.

Some service charge provisions contain rights for a landlord to recover the costs of refurbishment of the building. It is not reasonable for a landlord to be able to recover costs of upgrading its own asset and so this should be limited to repairs only.

Another area for contention involves the costs of lease renewals, rent reviews, lettings, collection of rents and arrears, etc., from other tenants. These are the landlord’s own administrative expenses and should not be borne by a tenant. 

And then there are costs of services from which the tenant does not bene t. For example, if premises are self-contained and on the ground floor with direct access from the highway, without use of a loading bay, it is not reasonable for a tenant to then have to contribute towards repair and maintenance of the common parts of any offices above or any lifts, or any such parts the tenant does not use.

By extension, costs that are attributed to parts of the building which are unlet should not be passed on to tenants either.

Landlords have to pay a tax – the Carbon Reduction Commitment – on the basis of the carbon footprint generated by their properties. This is a tax on the landlord’s asset and these costs should not be passed on to the tenants.

Moving on to service charge caps, there are a number of key points for tenants to remember. Firstly, the date of annual increases must be linked to the anniversary of the lease start date and not the landlord’s service charge accounting dates as this could result in a premature increase in the cap to a tenant’s disadvantage. Also, great care should be taken to make sure that any increase in the cap is not compounded as this could effectively add an increase on top of an increase.

Tenants should also aim to have all costs payable to any merchants’ or tenants’ association included in the service charge cap. This especially applies to marketing and promotion costs which are often charged through the tenants’ association. Likewise, all contributions to reserve funds can sometimes be excluded from the list of service charge costs – they need to be included.

To conclude

Tenants need to be on their guard as landlords are not in the business of framing lease contracts in anything but their own favour. Contracts are onerous and need careful consideration and it is worth remembering that landlords are essentially looking for pro t through rent while as much of their own costs are covered by tenants.