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Time to smarten up your lease covenants?

Posted: 11/04/2019


Gone are the golden days of commercial landlords securing leases for 20 plus years with no option to break and regular upwards only rent reviews. Fast forward to 2019 where ever-changing trends and economic uncertainty have left tenants craving flexibility and top-notch technology in return for a premium. With buildings now becoming smarter than ever, repairing and reinstatement covenants are likely to need a good nip and tuck sooner rather than later.

Forces changing the office lettings market

Buildings of the future - Buildings such as The Edge (Amsterdam), the Glumac buildings (LA and Shanghai) and 22 Bishopsgate (London) are leading the way with regard to what is possible, and offer a window to the future.

More affordable technology - The demand for ‘smart buildings’ is booming. Tenants are aware that previously aspirational tech - such as the ability to control internal micro-climates via user determined temperature, lighting and ventilation levels - is now within their reach.

The ‘WeWork’ effect - Tenants are seeking out future-proof, flexible space with the capability to host ‘plug and play’ office layouts - preferably with the ubiquitous beer tap and barista thrown in for good measure.

The desire for green offices - There is real demand for energy efficiency through the use of heat recovery systems and smart glass which can maximise natural light and drive down energy consumption and costs.

The traditional approach

Traditionally, landlords have recovered the (often sizeable) cost of modernising commercial property through long-term FRI leases where the tenant is responsible for repairs. The model allows the landlord to recover a lump sum from the tenant (by way of a dilapidations payment) at the end of the term which can then be funnelled back into maintenance and modernisation. However, with average lease terms shrinking to around seven years and the advancement of technology running at the speed of Usain Bolt, is lease drafting keeping apace?

Arguably not. The obligations to repair, redecorate and maintain fixtures, fittings and M&E installations routinely each take up less than a page in new leases. On repairs, it is common to see a short clause simply requiring the tenant to keep media, plant, equipment and fixtures forming part of the premises ‘properly maintained and in good working order in accordance with good industry practice’. Individual M&E/tech installations generally are not dealt with separately and it is rare to see any definition for ‘good industry standard’.

A move towards bespoke covenants?

Where tenants are in a position to take a complete building lease, bespoke, detailed clauses might offer numerous benefits for both landlords and tenants. In Langham Estate Management Ltd v Hardy HHJ Hazel Marshall made the observation that an obligation to maintain ‘may well require proactive preventative maintenance work, or [the] carrying out of adjustments or general servicing before any actual fault develops or want of repair exists’. If prevention really is better than cure then in the context of very costly or sophisticated systems or products it will significantly assist all parties to spell out at the outset what technical standards should be met, narrowing the scope for disputes at the end of the term. But these concerns need to be balanced against the commercial drivers – shorter leases are quicker to negotiate, which means the asset becomes income producing sooner.

The need to modernise schedules of condition

The traditional method of recording repair and condition in a photographic schedule is akin to fitting a square peg in a round hole when it comes to technology, yet parties routinely omit to do more than append such a schedule to the lease, leaving wide scope for disputes. Commissioning reports from a number of suitably qualified professionals (lift engineers, heating and cooling specialists, etc) at commencement would assist in resolving issues arising in relation to whether the tenant has properly maintained installations. Professional advisors will need to step up to ensure such reports are settled and agreed promptly to avoid possession being unnecessarily delayed, albeit that standards of maintenance and inspection could feasibly be agreed after commencement once the tenant is in.

Moves away from capital contributions

Similarly, the traditional approach saw tenant fit-outs specified and built at lease commencement, with costs amortised over 10 or 15 year terms. As such, longer term leases made sense. Now, to keep pace with changing business requirements, tenants are demanding buildings with ‘plug and play’ capability, that is, fitted with air-con and electrical installations which are compatible with regular changes to layout via internal demountable partitioning and fewer structural columns. A decline in the popularity of landlords’ capital contributions towards extensive fit outs seems likely, as does a trend towards the provision of services by landlords, such as wi-fi, which tenants are obligated to take as part of the lease terms. This is already relatively common in retail, (for example, units in Westfield come with requirements to sign up to landlords’ services for wi-fi and utilities). It may be that landlords find that they can shift a greater proportion of the costs relating to maintenance and modernisation onto tenants by charging a premium on such services throughout the duration of the term rather than looking to recover a lump sum at the end of the term.

The cost of modernisation has always been high, but in the context of an uncertain economic outlook, the growing pace of technological change looks to increase the tension between landlords and tenants over who will foot the bill. Who will be left out of pocket may well depend on who is paying attention to the finer details.

 

This article was published in Estates Gazette in April 2019.


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