Back to Basics: Deconstructing alterations and landlord’s consent

Last time, in the article Bringing alienation back down to Earth, we considered the issues surrounding landlord’s consent in respect of alienation in commercial leases. Similar principles inevitably tie into this discussion regarding landlord’s consent in respect of alterations, but what is deemed reasonable in relation to withholding consent will turn on different factors.  Why are alterations required? The majority of commercial tenants will want to undertake a fit out or make alterations at the start of their tenancy to ensure the property suits their needs. The constantly evolving demands of business means that change further down the line may also be necessary. From requiring updated service installations to deciding that the space works better without a dividing internal wall, a tenant may encounter the need to carry out alterations during its occupation.  In addition to this, consider a business which takes an assignment of an existing lease or occupies pursuant to an underlease: its business needs may differ from those of the original tenant, and so too its requirements in respect of the property. In these situations, landlord’s consent (and potentially a superior landlord’s consent) is often required and that will usually involve the negotiation and entering into of a licence for alterations to document the consent.  Consent may also be required from the landlord’s insurers, its mortgagee and/or the tenant’s guarantor. In certain circumstances, consent may be required retrospectively, where works were carried out by the tenant without first obtaining consent, whether intentionally or due to an oversight on the tenant’s part.  There is no one-size-fits-all approach here: it is always prudent for landlords and tenants to understand their rights and obligations from the beginning of the commercial relationship and to ensure agreed terms are formally documented, first in the heads of terms and then in the lease and any licence for alterations.  Types of restrictions Broadly speaking, a lease will contain one or a combination of three provisions: n No prohibition If the lease either states that there is no prohibition in respect of alterations or is silent on the point, the tenant is free to carry out whatever alterations it wishes, provided that the alterations fall within the tenant’s demise. Ordinarily, a landlord will want to balance maintaining as much control as possible to protect its assets with ensuring they are offering a reasonable and commercially acceptable lease to prospective tenants.  There are situations whereby fewer and less stringent means of control are more common; for example, in long leases where a premium is paid followed by a low or peppercorn rent. Alternatively, it might be that a landlord chooses to permit certain alterations, for example, installing demountable partitioning but restricts or prohibits other types of work, such as structural changes. Some alterations will require works beyond the tenant’s demise, such as the installation of plant and equipment on the roof or other external parts of the landlord’s building. So, even with no prohibition, landlord’s consent may still be required in certain instances.  n Absolute prohibition A cautious landlord may seek absolute prohibition in respect of all or certain types of alterations. The absolute prohibition may prevent alterations which could cause damage to the premises or a diminution in value to the reversion and can provide comfort to a landlord who does not feel it can rely on the tenant to reinstate the property at the end of the term.  A tenant may wish to resist accepting an absolute prohibition on alterations during negotiation because the lack of flexibility could lead to later problems. While the premises may be suitable for the tenant at the commencement of the lease term, can they be sure that the premises will be fit for purpose throughout the term, as their business needs change? Would a prospective assignee or under-tenant want to inherit these restrictive terms should the tenant need or want to vacate?  A landlord may, as a personal concession or through a deed of variation, permit alterations despite an absolute prohibition, yet this is not ideal for a tenant who remains at the mercy of the landlord.  It should be noted that while many commercial leases include an absolute ban in respect of any structural and/or external alterations, they may permit the tenant to make internal non-structural changes subject to obtaining the landlord’s prior written consent. This is often an acceptable compromise. Even where the lease includes a prohibition in respect of all or certain alterations, section 3 of the Landlord and Tenant Act 1927 can provide a back door for alterations which constitute an “improvement” to a trade or business premises. An improvement is an increase in the value or usefulness of the premises to the tenant, even where it results in a reduction in the value to the landlord’s reversion (Lambert v FW Woolworth & Co Ltd (No 2) [1938] Ch 883). Practically speaking, it will be rare for a tenant to consider works which will not increase the value to them, making section 3 a wide-reaching provision.  A tenant can serve notice on a landlord of its intentions to carry out improvements, which should include a plan and specification and be as detailed as possible. If consent is refused, a court declaration authorising the works can be sought.  The court may only authorise the proposed improvements where they:  Are considered to add to the letting value of the property;  Are reasonable and suitable to the character of the property; and  Will not diminish the value of any other property which belongs to the landlord.  On receiving notice, a landlord has three months within which to consent or object. Alternatively, the landlord may offer to carry out the works itself in return for a reasonable uplift in rent, although the tenant is not obliged to accept this. The tenant is free to undertake the works if the landlord does not object to the proposed works within three months.  Note that a section 3 notice may be served irrespective of the restriction type in the lease, and applies to all leasehold premises occupied for a trade or business, other than mining leases and certain agricultural tenancies.  Qualified prohibition Most commonly, a lease will require landlord’s consent in respect of some or all types of alterations. Like alienation, alteration clauses normally adopt the caveat such consent “not to be unreasonably withheld”. Absent of that express wording, section 19(2) of the 1927 Act implies it into qualified alteration covenants where the alteration is an improvement. Note that section 19(2) does not refer to unreasonable delay – this will only be relevant where there is an express provision in the lease.  Refusal to grant consent? If landlord’s consent is refused, a tenant has three options: Abandon the proposal; Carry out the works, considering the refusal unreasonable; and/or Apply for a court declaration authorising the works on the basis that the refusal was unreasonable. Option 2 is highly risky and not advisable. It may transpire that, for reasons unappreciated by the tenant, the landlord’s refusal was in fact reasonable. The risks to the tenant are substantial, potentially with damages being payable to the landlord, an injunction (particularly if the works are major) to stop the works, or even forfeiture of the lease.  Option 3 involves judicial assessment as to the reasonableness with which the landlord has refused consent. What is reasonable? Determining reasonableness is a two-stage process, whereby the court will consider the reason given by the landlord for refusing consent (a subjective test) and whether that decision was reasonable (an objective test).  Rather unhelpfully, there has been little case law as to when a decision will be deemed reasonable but it will, of course, turn on the details of each individual case. It is generally accepted that the landlord’s decision need not relate purely to grounds of suspected damage or diminution in the value of the property, and may turn to aesthetic, historical or even sentimental grounds.  Where consent is to be granted, a landlord is entitled to impose reasonable conditions, such as the following: Monetary contributions Frequently, the tenant will be required to cover the landlord’s legal and other costs associated with the application for consent. In addition, the tenant may have to pay a reasonable amount towards any diminution in value of the property. Significantly, this can extend to the value of any neighbouring property owned by the landlord too. Materials That the works are carried out using new, good quality materials.  Deadlines That the works are commenced and/or completed by a certain date.  Reinstatement At the end of the term, the tenant may be required to remove any fixtures or fittings installed and alterations made during the term. Though it may be unreasonable for reinstatement to be required where the tenant’s works add to the letting value of the property.  Compensation A tenant in occupation of premises for the purposes of its trade or business may be entitled to compensation at the termination of the tenancy under Part 1 of the 1927 Act. This potential compensation arises in respect of an improvement which adds “to the letting value of the holding”, whereby a section 3 notice of an intention to carry out improvements was served on the landlord prior to the commencement of those works.  While the potential for compensation may seem attractive to a tenant, it is rare in practice because most leases contain reinstatement clauses which require the tenant to return the premises to the landlord in their pre-alteration condition. Yet, as noted, it may be unreasonable for the landlord to require reinstatement of certain improvements where, for example, the incoming tenant has the same business needs as the outgoing tenant. Why would reinstatement be reasonable in this situation? Proceed with caution Taking into account all of the above, it is clear that provisions relating to alterations in leases need to be considered and negotiated carefully, to ensure the commercial terms are acceptable to both sides and offer the flexibility and/or protection they need.  Whatever the desire of either party, the lease provisions will guide what can and cannot be done, subject to the effect of “improvements” as implemented by sections 3 and 19-(2) of the 1927 Act, which facilitate a potentially greater scope for tenant alterations. Careful planning and clear drafting, including when negotiating heads of terms, will help avoid future uncertainties, issues and costly disputes. Common pitfalls When serving a section 3 notice on the landlord (regarding an intention to make improvements), the tenant should ensure the specifications and plans are as detailed as possible. An insufficiently detailed notice will lead the court to question how a landlord was to reach a properly informed decision and so may uphold the refusal. That was the case in Kalford Ltd v Peterborough City Council [2001] PLSCS 76. Landlords should be exceedingly cautious in providing tenants with consent for alterations “subject to licence”. In Prudential Assurance Co Ltd v Mount Eden Land Ltd [1997] 1 EGLR 37, the landlord’s agent had provided a letter granting consent for alterations “subject to licence”. The Court of Appeal concluded that, in doing so, the tenant had inadvertently been granted the landlord’s consent to carry out the works, and so any intended negotiation on the landlord’s part was lost. Landlords, or their agents, should therefore avoid granting consent unintentionally (even where qualified) until they are comfortable that the tenant’s proposal is acceptable and can be formally documented.  A landlord taking too long to deal with an application runs the risk of losing the right to make a decision. City Hotels Group Ltd v Total Property Investments Ltd [1985] 1 EGLR 253 demonstrates that a failure by the landlord to deal expeditiously with an application will amount to an unreasonable refusal. Therefore, best practice for landlords is to deal with the application as soon as possible to prevent a situation whereby alterations, for which refusal may well have been reasonable, are nevertheless permitted to be carried out.  Talking point Landlords should take care when granting a licence for alterations to ensure they do not inadvertently release guarantors from their obligations. In Topland Portfolio No 1 Ltd v Smiths News Trading Ltd [2014] EWCA Civ 18; [2014] 1 EGLR 38, a “relevant variation” of the lease occurred when the landlord consented to works despite an absolute prohibition in respect of alterations in the lease. Among other things, the works included an extension which increased the size of the demised premises. This therefore increased the tenant’s obligations and liability pursuant to the lease, thereby increasing the guarantor’s obligations in the event of default by the tenant. In cases where a lease variation is the likely result of consent to alterations, a guarantor is “entitled to expect that its consent [will also] be sought”. However, that expectation was not met in this instance. Consequently, the landlord was unable to call on the guarantor to cover the tenant’s arrears: the guarantor had been released from its obligations.   Krista Powell is a partner and Will Ford is a trainee in the investment and property management team at Brabners Next time: Richard Hepworth takes a look at some of the key contractual provisions to consider in a property joint venture Image © Global Warming Images/Shutterstock