Commercial leases is one of the topics I am most often asked about, and an understanding of leases can often open the door to adding huge value to commercial property.  It’s important to remember that retaining commercial property as commercial may often yield more profit than undertaking development, and, of course, not all commercial property is suitable for conversion to residential.

It’s also important to understand the big difference between residential AST’s (Assured Shorthold Tenancies) and commercial leases. In residential investments, the lease is just a mechanism to document and manage the tenant’s occupation of the property. However, with commercial investments, properties are valued on an investment basis specifically because tenants occupy the property under a commercial lease. This means both the rent and the yield (multiplier of the rent) can be improved by putting the correct lease in place!

Tenanted properties are usually worth more than those that are vacant as tenants are tied into their occupation via a lease for a set period of time, with lease terms governing this.  The existence of a commercial lease can therefore significantly reduce the risks associated with a property for an investor.

When entering into a lease the landlord will want to generate a reliable income stream from their investment. The tenant, on the other hand, will want a lease that allows their business to operate effectively and at a cost they can predict and afford. These two objectives lie behind all the detailed provisions of the lease: 

• what will be let (the ‘demise’)
• by whom (‘landlord’) and to whom (‘tenant’)
• for how long (‘term’)
• at what price (‘rent’)
• what for (‘use’) and
• what they can / should do with it once they are in there (‘repair’ and ‘alterations’, ‘alienation’)

Of course, the quality of leases can vary drastically depending on how well they have been negotiated and the relative bargaining positions of each party.  There are huge implications in the quality of the lease in investment terms and the type of lease that is in place with a tenant will tend to impact the price that the property achieves in the market, as risk is priced in.  Equally, there are liabilities for each party set out in the lease which will have monetary implications.  The market tends to like long leases with ‘institutional’ lease terms – i.e. a lease that most investors in the market would be willing to take on as it is more ‘hands off’ and hence lower risk.   

The ‘best’ type of lease in this regard is the full repairing and insuring lease (FR&I).  This is possibly one of the most ‘hands off’ type of real estate that you can invest in.  An FR&I lease facilitates the tenant occupying a property for a set period of time, with them taking responsibly for the whole property for the whole lease term, handing it back in exactly the same condition at the end of the lease, as it was at the start.

Investors tend not to like the following, and hence the price they are willing to pay for the asset reduces:

• Short leases (unless they want to develop, or asset manage) as there is a risk of vacancy at the end of the lease term;  
• Leases with ‘abnormal’ clauses that don’t comply to ‘market norms’ – e.g. upward and downward rent reviews; strange ‘user’ clauses, too relaxed subletting clauses etc.  This exposes them to risk that will be priced in;
• Over-rented properties where there is no potential for future rental growth; but they like tend to like under-rented properties where, as long as there are mechanisms in the lease to increase the rent over the lease term (rent reviews) there is potential for rental growth.

The Landlord and Tenant Act 1954

Most commercial leases are governed by the Landlord and Tenant Act 1954 which governs the rights and obligations of the landlords and tenants of premises which are occupied for business purposes. What this means in practice is that, at the end of leases, tenants’ businesses are not automatically terminated but rather the tenants have the right to renew their lease unless the landlord can prove grounds to terminate their occupation. 

There are 7 grounds that could be used by a landlord to end a lease.  These grounds include breaches of the lease by the tenant (for example, a failure to pay the rent or a failure to repair etc) and also, amongst others, the landlord requiring the property for redevelopment, the landlord wishing to occupy the property themselves or to split the property.   

In all cases the onus will be on the landlord to prove the grounds (e.g. if they cite the redevelopment ground, they must show an intent to develop – such as having planning and funds in place to do so).  Should this be successful the tenant has a right to compensation which is calculated as a multiplier of the rateable value of the property.  

Leases can be excluded from the Landlord and Tenant Act 1954, but this can only be done by agreement and with a statutory declaration or similar in place signed by both parties.

It is therefore important to remember that if you take over an existing lease you cannot automatically remove the tenant if you want to redevelop or relet as, in law, there is a very clear process to go through.  As with all matters relating to commercial leases, it’s important to get some great advice from a good commercial lawyer.

How you can add value through leases  

The way you set up your leases, and the terms contained within them, can materially affect the value of your property as well as give you more hassle-free management of your tenants.  As an example, if you were letting three adjacent, but separate, units to one tenant you probably would not want to grant one lease over all three units.  Depending on the local market, it is likely that you would wish to grant them a separate lease per property as this would not only mean that you could you sell the properties one by one, but you would be likely to obtain more rent over each one, both at day one and over the term of the lease at rent review anniversaries.  This is because there would probably be more demand for the smaller units, and more comparable evidence of similar lettings in the market.

Similarly, if you try to over-restrict the tenancies of the property – for example, to unreasonably restrict the tenant’s ability to dispose of the property – this will have implications on the tenant’s ability to exit the property if it becomes surplus to their business needs, and so the rent they will be willing to pay for the property will be reduced.  

Heads of Terms

The first stage in agreeing a lease with a tenant is to set out heads of terms which will be negotiated to make the path of agreeing the lease more straightforward.  Usually, the landlord will provide the first draft of the heads. These can include the following:

1. Landlord
2. Tenant
3. Property (‘demise’)
4. Term (and break clauses if appropriate)
5. Rent per annum; payment dates and whether VAT is charged   
6. Rent free / lease incentives
7. Rent review
8. Rent deposit?
9. User clause
10. Alienation
11. Repair and reinstatement / Service charge
12. Alterations
13. Security of Tenure – inside or outside the Landlord and Tenant Act?
14. Any other property specific terms
15. Subject to contract (always)
16. Subject to other matters including planning / works etc

Usually, if the letting is subject to some factor such as planning or refurbishment works, an Agreement to Lease will be put in place which provide the conditions that need to be satisfied before the tenant can take occupation under the lease.  

Lease Regears 

If you have a property where there is an existing tenant in situ, there may be the opportunity to change, extend or restructure the lease, remembering that a longer lease length and better lease terms can add value and could provide a great opportunity to recycle your money out of a commercial property.

For example, opportunities exist to restructure leases when:

• There is a short lease (e.g. an unexpired term of less than 5 years). There could be an opportunity to negotiate with the tenant to extend.
• Less than ‘institutionally acceptable’ lease terms that could reduce value – more acceptable lease terms could be negotiated.
• Break clauses – attempt to insert or remove them by negotiation.
• Rent review clauses (or no rent reviews) – insert rent reviews or change the rent review clauses to reflect market norms.
• Tenant has a lease over a larger property and don’t use part – the opportunity could exist for a tenant to surrender or part-surrender their lease.  This can be used where, for example, a tenant occupies a ground floor shop with upper parts and there exists the opportunity to add value by redeveloping the upper floors to higher value uses, such as residential.

It’s important to note that in all the circumstances above, this can only be done by negotiation, so speaking to a tenant before you buy a property to determine their intentions will be important, as will ideally agreeing a deal with them prior to purchase (via a lease option / exchange and delayed completion or similar) so that you obtain a value uplift from day 1.   

Making changes to a lease is primarily a paper-based exercise and is a useful strategy to have up your sleeve when asset managing commercial property.  So how do you achieve a great lease?

The best tip I can give you is to get some education – form your own understanding as to how leases work so that you can be on the front foot in your negotiations.  Appointing a good commercial property agent can be a great way to help you get the very best lease in place and then appointing a good commercial lawyer is crucial to making sure you have the very best lease in place.  It may not be the most glamorous of topics but negotiating great commercial leases can be a fantastic way to add massive value to commercial property assets.