FIRST BASE
Whether setting up an operation in the UK, acquiring an existing business or investing in real estate, an understanding of the ways in which land and buildings are owned, acquired and let in the UK will save time and money and assist in budgeting for the cost of ownership.

Real estate in England and Wales is usually owned “freehold” or “leasehold”. A freeholder owns his or her land indefinitely; a leaseholder, or tenant, owns land for a limited period. Most commercial freehold property is held for the purpose of investment, not occupation. This article focuses on leasehold property held for occupational use and deals only with the law in England and Wales. Different laws apply in Scotland and Northern Ireland.

LEASEHOLD PROPERTY
Fortunately for tenants, institutional landlords no longer insist on lease terms of 25 years with no break options. Terms are usually shorter and break clauses common, giving tenants more flexibility. However “upward-only”, five-yearly rent reviews to market rent are still the norm and landlords still expect tenants to take “full repairing and insuring” (FRI) leases (under which the tenant, as well as paying rent, is responsible for the cost of all repairs and insurance). Those unfamiliar with the commercial property market in the UK may be surprised at how onerous the tenant’s obligations appear.

In recent years, the UK property industry has been taking steps aimed at ensuring those involved in negotiating commercial leases are properly informed and there is greater flexibility in the terms offered to tenants. The second edition of the voluntary Code of Practice for Commercial Leases, published in April 2002, included the recommendation that the parties should negotiate “openly, constructively and considering each other’s views” and “should seek early advice from property professionals or lawyers”. The government, which as recently as 2004 published proposals to ban upwards-only rent reviews, is monitoring the impact of the Code. It remains to be seen whether the threat of government intervention will lead to widespread adoption of the practices recommended.
As in any market, the terms which can be negotiated will depend on the strength of each party’s bargaining position. However, to understand what can be achieved, it helps to have some knowledge of the market and how legislation and common law affect the relationship between landlord and tenant. There are many traps for the unwary and some of the rights and obligations of the parties to a lease are governed by legislation or case law; the lease on its own does not tell the whole story. Here briefly are just a few of the issues which may be relevant when taking a new lease of commercial property. Many will also be relevant when taking a transfer of an existing lease.

OCCUPATION COSTS
In addition to rent, a tenant usually has to pay:

• Uniform business rates. This is a local property tax, payable annually, based on a percentage of the “rateable value” of the property as determined by the Valuation Office. After rent, it is likely to be the next largest occupation cost. Specialist surveyors will advise whether there are grounds for seeking a reduction in the rateable value and whether any reliefs are available
• Value Added Tax (VAT) on the rent, if the property is not exempt; VAT will often be fully recoverable but, if not, will add 17.5% to the cost of the rent
• The cost of insuring the property (and loss of rent, typically for three years) against damage by fire and other risks. Usually, the landlord will insure and recharge the premium to the tenant
• Service charge. If the lease is of part of a building, the landlord will usually recover from each tenant a percentage of the cost of repairing, maintaining and generally running the building. Recent service charge statements are not necessarily an indication of future service charge. Unless there is an adequate reserve fund to meet the cost of substantial but infrequent items of expenditure, the service charge for previous years may be deceptively low. If the building is not new or the term is only short, it may be advisable to seek the landlord’s agreement to cap the service charge
• The cost of repairing and maintaining the property. Even if the property is in poor condition when the lease is granted, the tenant will be liable, unless otherwise agreed, to put the property into good condition and then to keep it in good repair and also to carry out any work required by statute, for example to comply with health and safety legislation. A building surveyor should be employed to inspect the property and advise what works are necessary. If the property is in poor condition, the landlord may agree to limit the tenant’s repairing obligations
• The cost of reinstatement. When the lease ends, the landlord usuallly requires reinstatement of the property to its original layout, making good all damage and redecoration. If tenants wish to make alterations, they should first try to persuade the landlord that an obligation to reinstate is unnecessary or only to require reinstatement when the lease ends if reasonable at the time. A tenant taking a transfer of an existing lease should be aware that it will inherit the reinstatement obligations of previous tenants
• Stamp Duty Land Tax (SDLT). SDLT is charged at 1% of the amount by which the net present value (NPV) of the rents payable over the term of a commercial lease exceeds £150,000. The longer the term, the higher NPV will be

LENGTH OF TERM AND BREAK OPTIONS

• Lease terms of five years or less are increasingly common. Lease terms of more than five years (and sometimes more than three) normally have rent reviews every five (or three) years. Despite government concern that tenants should be offered a choice of rent review type, upwards-only rent reviews are almost universal
• Tenants may request an option to terminate the lease early. Courts view conditional break options strictly and care is needed to ensure the option wording will not prevent the tenant breaking the lease.

STATUTORY PROTECTION

• A tenant protected by the Landlord and Tenant Act 1954 (“the 1954 Act”) is entitled to renew its lease at a market rent (unless the landlord convinces the Court that a statutory ground for possession is satisfied). If the 1954 Act will apply, a tenant may wish to take a shorter term rather than a longer term with a break option. Less SDLT will be payable because the NPV will be lower and, unless the landlord successfully opposes renewal, the tenant will have the opportunity to renew the lease at a market rent (which may be lower than the rent it has been paying). If the tenant finds the terms offered by the landlord or ordered by the Court unacceptable, it does not have to renew the lease. This affords the tenant far greater flexibility than a break option but carries with it the risk of the landlord satisfying one of the grounds for possession and defeating the tenant’s right to renew.
• A landlord letting part of a building will often require the lease to be “contracted out” or “outside the Act”. The 1954 Act allows the parties to agree to exclude the sections of the Act which protect the tenant. Whilst there may be circumstances where the landlord will insist on this, it is not something a tenant should concede readily. Without the Act’s protection, the tenant will have no right to renew the lease or to remain in the property even for a day after the lease ends. It will also forfeit the right to compensation, which is payable when the landlord opposes renewal of the lease on grounds other than default by the tenant. What is perhaps not so widely recognised is that excluding the Act makes the lease less marketable as the remaining term gets shorter. If the tenant wants to assign the lease and move to another property, it may have difficulty finding a new tenant willing to take on its contracted out lease for the remainder of the term, and may have no choice but to continue paying for the lease until it expires or to negotiate an expensive surrender with the landlord. For this reason a break option, particularly one which can be exercised on a choice of dates, is especially valuable in a contracted out lease.

PROFESSIONAL ADVICE
Usually you will find the property you want through estate agents or surveyors. It is probably better to avoid any temptation to negotiate directly with the owner’s estate agents or surveyors without obtaining independent advice from your own surveyors. Your surveyors will have access to essential information about the rent being paid for comparable properties and will have the knowledge and experience to negotiate favourable terms, taking account of the property’s condition and location and any other factors which affect its value.

Solicitors are usually involved once surveyors have agreed heads of terms. They will advise on all legal aspects of the acquisition and will seek to ensure that the terms agreed are documented in accordance with the spirit of those negotiations and in the most effective way, that the proposed form of contract or lease does not contain onerous terms or conditions which were not foreseen in those negotiations and that you are fully aware of the obligations you are taking on.

For more information, contact:
Mark Barber, Partner, Head of Real Estate
Lane & Partners LLP
15 Bloomsbury Square
London WC1A 2LS
Tel: +44 (0) 207 242 2626
E-mail: mark.barber@lane.co.uk