Lease negotiations: initiating the discussion

The negotiations that take place and lead to heads of terms being produced and finalised are a key stage that forms the basis for the rest of the lease transaction. The bargaining strength of the parties and location of the premises are key factors and there remains a significant divergence at a national level between high-performing major shopping centres (where demand is high and rents continue to outperform the rest of the market) and some high streets that have been affected badly by store closures. Retailers shouldn’t underestimate the importance of having an experienced agent who is able to negotiate concessions that can give a tenant the breathing space they need when entering into a lease. Lawyers should be consulted before the heads of terms are finalised. A strong set of heads of terms will save money and time as it’s difficult to reopen negotiations on fundamental points once the deal is struck and the draft lease has been circulated by the landlord’s solicitor. It has been well documented that technology is revolutionising consumer behaviour and retailers are searching to find ways (such as experiential shopping) to attract customers into their stores. The market has changed and agents are being pushed hard by retailers to negotiate lower rents to reflect the market conditions that led to the RICS issuing a valuation notification in December 2018. The RICS felt compelled to issue the notification to reflect the weight of evidence that there has been a structural change to the market. The substantial uncertainty that has permeated the market has meant that agents are struggling to find common ground on what constitutes the open market rent for a store (given that any comparable evidence will be of limited use unless it has been completed recently), which has in turn led to protracted negotiations. It is important to recognise the prevalence of short-term leases, which is a reflection of a decline in confidence and the fact that retailers do not want or feel able to commit to long-term leases. It is unusual to see 10-year leases and the status quo now appears to be “five and three leases” – five-year terms with an option to break on year three – or even three-year terms with rolling options to break on short notice periods. Points for consideration Landlords are coming under increasing pressure to find ways to attract retailers, who themselves are becoming more demanding when negotiating terms. When faced with the prospect of an empty unit, landlords may consider offering turnover-only rents, where the landlord will take a percentage of the turnover generated by sales from a store without any base rent being payable. In this situation, landlords are effectively taking on the risk that the retailer may fail. This can be contrasted with turnover top-up leases, where tenants have to pay a base rent (ordinarily determined as a percentage of open market value) and the amount (if any) by which the turnover rent (typically around 10% of turnover) exceeds the base rent. The tenant’s rental liability will reduce in poor trading conditions, and if the tenant manages to trade above expectations then the landlord will benefit. In some cases, retailers are also looking to take on peppercorn rents, with the tenant liable to pay only business rates, insurance and service charges. Retailers need to be alive to the various concessions that can be extracted from a landlord who will not want to be faced with an empty store and the corresponding rates bill (see above for the most common concessions). Options to break also need to be considered and break conditions (if any) must be clearly defined and ideally limited to payment of the principal rent (rather than all of the rents payable under the lease). If a landlord is insistent that the option should be conditional on payment of the principal rent together with the insurance rent and service charge, retailers should insist that the insurance rent and service charge must have been demanded in writing at least 28 days before the break date and not be the subject of a bona fide dispute. Retailers should never agree to the option to break being conditional on giving up vacant possession or breaches of covenant relating to the state and condition of the premises which would effectively make the option inoperable. Thought should be given as to whether to include a “santa clause”, by which the parties agree that any break notice that purports to terminate a lease over the Christmas trading period will not be effective. Given the spate of high-profile department store closures, retailers should consider whether the lease should cover off what will happen in the event that an anchor tenant closes (in the context of a shopping centre) or if a major department store closes within a specified radius of a store. Whether the tenant should be compensated to cover the corresponding loss of footfall is a matter for negotiation between the parties but the lease could include mechanisms to deal with this issue, including: the tenant being able to initiate a rent review; the rent being suspended for a specified period of time; and the tenant being granted an option to break. It is common in the current market, where retailers have been holding over under the Landlord and Tenant Act 1954, for retailers to find that they have been paying more than the rent that is subsequently agreed between the parties. In this situation, retailers can improve their position on renewal by insisting that this overpayment is refunded on completion of the new lease (most commonly by the parties agreeing the amount of the refund and the payment being made to the tenant’s solicitor on or prior to completion). Common concessions from the landlord Rent-free periods. It is not uncommon to see tenants being granted a six-month rent-free period in the current market. Capital contributions by a landlord to fit-out works. This is where the landlord will agree to make a payment to the retailer (usually within a specified period after completion of the works) to cover all or part of the cost of the tenant’s fit-out works to the premises (or towards the cost of refurbishment works where the tenant is already in occupation and the lease is being renewed). Monthly rather than quarterly rent concession in a side letter. Service charge caps to limit the amount of the service charge to an agreed level for the duration or for a specified period during the term. Schedules of condition so that the tenant is required to maintain only the existing condition of the premises rather than entering into a full-repairing lease. Retailers don’t want to be hit with a large schedule of dilapidations claim on exiting a store. Will the landlord agree to a soft strip-out so the unit can quickly be relet rather than insisting on full reinstatement at the end of the lease? Will the landlord agree to a further rent-free period if the tenant doesn’t exercise an option to break? Will the landlord allow underleases of part (if the retailer wants to downsize) or give the tenant scope to allow concessions to operate from the store? Retailers should resist any automatic right for the landlord to obtain an authorised guarantee agreement on assignment. Given the spate of retail failures, the last thing an outgoing tenant wants is a contingent liability for another retailer’s failure. Will the landlord agree to a wide use clause to improve the alienability of the lease and to allow the retailer to offer additional services alongside the traditional A1 retail use? Coming up Next week we look at lease negotiation and the following week at the life of the lease itself and the issues that can arise on exit. Although the articles are primarily written from the perspective of retail tenants and the difficulties they face both on the high street and beyond, they should provide landlords (who themselves are having to contend with unprecedented market conditions) with food for thought on how best to strike a balance between protecting their investments and giving tenants scope to run a profitable business. Guy Whitehead is a senior associate at Irwin Mitchell