Twitter Logo Youtube Circle Icon LinkedIn Icon

Lease re-gearings and extensions: some issues to consider

June 2009 - Real Estate & Property. Legal Developments by CMS Group.

More articles by this firm.

As a result of the recession, lease re-gearings and extensions are becoming increasingly popular for landlords and tenants.

Take an example that is fairly typical at the moment. A tenant occupies an office building in central London on a 20-year lease from June 1999. There is a tenant break at the end of year ten with the normal five-yearly rent review pattern. The rent agreed at the 2004 review was £40 per sq ft but on a letting today, the rent would be £32.50 per sq ft. Therefore, from the tenant’s point of view, the premises are over-rented. There is a potential shortfall on sub-letting or assigning (assuming somebody is prepared to take over the premises). From the landlord’s point of view over-renting affects capital value and there is no chance of a rental growth at the next review date. It is, however, an opportunity for both parties to benefit. Under a re-gearing arrangement the tenant would surrender its break clause but the existing rent would be reduced. By the removal of the break clause, the landlord has guaranteed income for the remainder of the term and the possibility of an uplift in rent at the next review date.

Sometimes these arrangements will be coupled with a lease extension, say, adding a further five years to the term or changing the rent review arrangements to an index-linked basis. There are a wide range of issues that arise from re-gearings and lease extensions that landlords and tenants need to consider. The purpose of this article is to examine some of these issues.

How to vary the terms

To simply revise the rent or rent review provisions and delete the break clause a deed of variation of the lease is required. However, if the parties also want to extend the term of a lease, there are three possibilities:

  1. in addition to the variation of the existing lease the landlord and tenant enter into a future lease (a reversionary lease that will basically come into effect when the existing lease expire);
  2. the existing lease is surrendered and replaced by a new lease (which includes the new rent or rent review provisions and is for the longer term); or
  3. the parties could use a deed of variation to vary the term, rent and rent review arrangements (however, as a matter of law, a variation to the term amounts to a surrender of the existing lease and the grant of a new lease so this option is no different to the second option in practice.

While the second option is easier in practice, it has several other consequences that are explained further below. There is little point in pursuing the third option. Landlords and tenants may as well just pursue the second option if they are happy for the arrangements to amount to a surrender of the existing lease and grant of a new lease.

Particular issues

Variation and grant of reversionary lease

A deed of variation is used to revise the rent, remove the break clause and alter any other terms of the existing lease that need changing. The reversionary lease is granted for a term that commences on expiry of the existing lease. The term of a reversionary lease must commence within 21 years of the date of its grant. By and large the reversionary lease will be based substantially on the terms of the existing lease so the tenant/landlord covenants will be very similar to the existing lease. However, as the tenant will now have two separate leasehold interests, provision needs to be made so that neither the existing lease nor the reversionary lease can be assigned without the other, so that both leases are held by the same tenant at all times. Likewise, provision needs to be made to ensure that if the landlord forfeits the existing lease (for example on the default or insolvency of the tenant) the reversionary lease automatically determines as well.

A separate point to remember is that where there is a guarantor to the existing lease, the guarantor should also be required to execute the deed of variation so as to ensure that the guarantor’s obligations also apply to the revised rent and rent review arrangements.

Surrender and new lease

On the surrender of the existing lease the existing lease is determined and both parties are released from their obligations and for liability for any prior breach. The parties need to consider the extent of this release, for example, if there is a service charge payable at the property, the landlord will want to ensure that it can still recover any balancing payment that might be owed by the tenant after the annual reconciliation has been undertaken. This future liability would need to be carved out from the tenant’s release. Similarly the tenant will want to ensure that credit is given against money due under the new lease for any rents or other money paid under the old lease to the extent that these are not being reimbursed.

As to the terms of the new lease thereare two alternatives. The landlord and tenant could simply agree to base thenew lease substantially on the existing lease but only making such changes as are necessary. This has the advantage of minimising the amount of the negotiations although depending on the terms of the original lease this may be disadvantageous to one party or the other. In the current, more tenant-friendly climate it is likely that following this approach will be more disadvantageous (especially in relation to older leases) to the tenant. Tenants should resist the temptation to simply replicate the terms of the existing lease.

The landlord should bear in mind that if the existing lease is an ‘old’ tenancy for the purposes of the Landlord and Tenant (Covenants) Act 1995 (ie granted before1 January 1996), in surrendering the existing lease, the landlord may lose a valuable covenant.

Stamp Duty Land Tax (SDLT) will be payable on the new lease and the tenant should check whether it can off-set any SDLT paid on the lease being surrendered against the SDLT to be paid on the new lease.

More general points on the new lease

In agreeing the terms for either the reversionary lease or the replacement lease, both parties should also remember to consider several other points.

First, what is the intention/expectation regarding alterations that have already been undertaken by the tenant during the term of the existing lease? The landlord will want to ensure that it can require the removal of the alterations and reinstatement of the premises at the end of the new lease or reversionary lease. The tenant will want these alterations disregarded on rent review if there is still to be some form of arrangement for an open market review.

Secondly, the parties need to consider when changing from open market rent review to fixed/index-linked increases what provisions are needed to deal with the rent at which underleases can be granted. Under the existing lease it is likely that on any underletting the tenant is required to underlet at an open market rent (or even in some cases the higher of the open market rent and the passing rent). Where a lease provides for fixed/index-linked increases in rent, should the tenant be required to simply underlet at an open market rent? Alternatively should the tenant be required to underlet on the same fixed/index-linked increase basis?

Also the parties need to look at any timing arrangements under the existing lease and review what should happen in the case of the new or reversionary lease. The best example is the normal decorating covenants. These will probably provide for the tenant to redecorate every three years in the case of the exterior. In the case of a ten-year term the tenant will be decorating in the ninth year. Redecoration should therefore be undertaken in the second year of the new or reversionary lease.

Personal concessions or covenants contained in the original lease may now be redundant. For example, a landlord’s covenant to be responsible for inherent defects in the first, say, six years of the term should not be repeated in either the reversionary lease or the new lease (unless the original six-year period under the existing lease has not expired at that time).

Lastly there may be other aspects of the existing lease that need updating to reflect either changes in the legislative framework or market practice since the existing lease was granted, for example the new rules relating to Energy Performance Certificates and recommendations introduced in the 2007 Code for Leasing Business Premisesor the 2006 RICS Code of Practice on Service Charges.

Many of these points are points of detail. They can all easily be addressed by the parties and dealing with the issues at the start of the negotiations obviously simplifies matters going forward in terms of properly and quickly documenting the arrangements.

By Mark Heighton, partner, Cameron McKenna LLP.