The Fundamentals of Leasing: part 2
The Real Estate industry is a complex one, with its own, very particular, terms. Continuing our lease fundamentals programme, and as part of our Real Estate and Construction blog series, Real Estate partner Owen McKenna starts to explore the financial obligations on the part of a tenant commonly found in a commercial lease.
Payments under the lease
A commercial lease will usually provide for the tenant to make various payments to the landlord. These typically include annual rent, insurance rent and service charge (and any VAT payable on those sums), as well as payments for utilities, business rates and (in certain circumstances) the landlord’s costs. Sometimes, in a short-term lease, the annual rent will be expressed to be inclusive of certain other payments (for example, insurance and service charge contributions).
When the tenant is late making a payment, it will usually incur interest at a specified rate.
Most commercial leases with a term exceeding five years provide for the rent to change over time. There are several different rent review methods. Most commonly, rent is reviewed by reference to the open market rent for the premises at specified dates or intervals during the term. This involves an objective valuation of the rent at which the demised premises might reasonably be expected to be let in the open market on the relevant review date by a willing landlord to a willing tenant, on the terms of a hypothetical lease and subject to a set of specified assumptions and disregards.
Well-drafted rent review provisions should set out the review dates, the rent review process, the valuation formula and a dispute resolution procedure.
For a landlord, the primary purpose of service charge provisions is to ensure it receives a “clear” rent. This means that the landlord can keep the whole of the rent (subject to tax) and is not obliged to spend any part of it on the maintenance and other expenses of the building. The landlord, therefore, wants all expenses to be paid by the tenant. This will help to protect the capital value of its reversion.
A tenant’s main concern will be to minimise its financial liability by ensuring that it only contributes towards necessary expenditure. Drafting a service charge provision should therefore be a balancing exercise, looking to protect the landlord’s interest while remaining fair to the tenant(s).
Unlike residential service charges, there is currently no statutory regulation of service charges in commercial leases, apart from the RICS 2018 Professional Statement, Service charges in commercial property (1st edition) (RICS Professional Statement) which is binding on RICS members and regulated firms only. In general, therefore, the parties are free to negotiate whatever service charge provisions they want.
In a commercial lease at a rack rent it is usual for the insurance obligation to fall on the landlord. The landlord is the party with a capital interest in the property that it wants to protect and it will often be best placed to assess the appropriate level of insurance cover. Even in a lease of whole, the tenant will not want to take on the responsibility (and administrative burden) of insuring and reinstating insured damage, or to bear the risk of inadequate insurance.
The tenant will reimburse to the landlord all monies incurred by the landlord in insuring the premises.