Leases: where next?

Market changes could mean the demise of the full repairing and insuring commercial lease. This article examines the drivers for change and the direction that might take

16th July 2012 | Phil Hunter, Euan Mellor

The current FRI (full repairing and insuring) commercial lease structure has been with us since the 1970s and is generally fairly well understood by experienced landlords, commercial tenants and funders. The landlord insures, reimbursed by the tenant who takes on a full repairing and maintenance liability. In a lease of part of a building or development, the landlord assumes responsibility for providing services in exchange for full reimbursement.

This structure is very different from leasing structures seen in other countries (see first panel below). Tenants who are new to the UK market are often taken aback by the obligations they are expected to accept in a typical commercial lease. While we have seen some evolution of the basic model in recent years, there is an underlying market expectation of what most lease agreements will look like and the type of provisions they will contain.

Post the 2007-08 banking crisis, the sands have shifted in the wider property market, and with legislative changes and continuing lease trends it is clear this process will continue. Here, we examine some of the challenges that the commercial leasing market will need to meet in the coming years.

Now trending

There is a constant evolution of the commercial terms of leases and the wider market. The world of the 25-year FRI lease has gone – the average term is now estimated by the Scottish Government at 5 1/2 years (the authors’, admittedly anecdotal, evidence is of an average of 7-7 1/2 years). This has brought with it a review of the commercial requirements of both landlords and tenants – is what was appropriate for a 25-year arrangement appropriate for a shorter-term agreement?

The more sophisticated (and powerful) tenants are increasingly flexing their muscles by seeking to restrict their repairing liabilities through the use of service charge caps and/or schedules of condition; and in recent years we have seen evidence of shifts from quarterly to monthly rent payments (particularly in parts of the retail sector) to assist tenant cash flow. Upwards-only rent reviews may well be next on the tenant “hit list”.

There has been a significant increase in litigation over lease terms and an increased focus on dilapidations from both landlords and tenants, particularly as 25-year leases granted in the 1980s near expiry. The dynamic of the landlord-tenant relationship is changing, with tenants managing their portfolios more actively and looking at lease breaks, renewals, deals in relation to dilapidations, and lease re-gears in a way that maybe only the most sophisticated did before. There are significant sums at stake (in Co-operative Insurance Society v Fife Council [2011] CSOH 76; 2011 GWD 19-458, for example, the landlord’s dilapidations claim totalled £1.3 million), and we would seriously question whether the outcomes we have seen in some recent cases could possibly have been in the minds of either party when entering into the leases all those years ago.

The "green agenda"

There is clearly a significant appetite within the EU and domestically to use legislation as a tool to reduce carbon emissions from existing and new building stock – see the CRC Energy Efficiency Scheme, s 63 of the Climate Change (Scotland) Act 2009 (covering energy performance certificates and the soon to be introduced assessment of carbon and energy performance), and the Green Deal (see links in second panel below).

These schemes merit, and frankly demand, more time and consideration than can be afforded in this article. It is, though, evident that each is designed to incentivise developers to build energy efficient buildings, and owners to carry out works to improve the performance of their existing stock. The drivers for larger organisations may be reputational, but more pertinent for all property owners or developers will be the financial reward, or more accurately the absence of financial penalty, that will follow compliance. (As far as the authors are aware there is no proposal in Scotland – as yet – to prohibit occupancy of poorly performing buildings. However, there are proposals in England to prevent letting of buildings with energy performance ratings of F or G (the poorest categories), and it would be prudent to anticipate that these schemes will continue to evolve once they have come into force, and that practices which are established and accepted in England may well migrate north of the border.)

The costs of implementing these schemes will be a significant burden for the property industry to absorb. They are targeted at owners (landlords rather than tenants), so there is a fundamental question of who will bear the costs of, for example, retro-fitting a 20-year-old building with improved roof insulation, energy efficient light bulbs, replacement boilers/air conditioning units, modern electricity meters and so on.

The tenant will benefit from this work through reduced energy bills (though under the Green Deal it is proposed that loans for improvement works are repaid through a tariff on energy bills for the property), but will landlords choose to seek recovery of their costs? Doing so may make their property more difficult to market – if a prospective tenant has a choice between two buildings of similar condition, both in need of improvement, the landlord’s position on retro-fit costs could be a key factor. There is also the practical question of whether the lease will allow them to seek recovery. In a multiple occupancy building or shopping centre there may well be a “good estate management” catch-all provision to allow recovery through service charge; in a lease of a whole building the issue may be whether the costs can validly be categorised as costs incurred in compliance with statutory provisions (as currently proposed, the CRC and s 63 schemes seek to encourage, rather than oblige, owners to carry out works).

Evolution or revolution?

We believe that the traditional leasing model is heading towards a crossroads, and while we do not have a crystal ball, we foresee two possible outcomes: either a continuing gradual evolution of existing structures, or a wholesale revolution. We understand that some of the large institutional landlords are actively and openly already considering variations on the traditional leasing model in their constant quest for innovation and to be market leaders.

In seeking to establish a premium for their property, and to differentiate it from other similar premises, landlords may adopt a strategy of embracing the green agenda and ensuring that their buildings have excellent energy performance and consumption characteristics, and therefore as small a carbon footprint as possible. Coupled with this, they may decide that the lease structure which best fits is a far simpler and clearer one – one possible change being that the landlord retains control of/liability for maintenance and repair of the structure of the building, in return for which the tenant pays an enhanced “all inclusive” rent. The benefit to the tenant is clear: certainty of a fixed rent, the tenant’s only obligation being in relation to internal repairs beyond fair wear and tear, and no unexpected service charges or dilapidation costs at expiry.

It is worth adding that the attitudes of funders to landlords will be a key factor in determining what happens here. At the moment, a fully let investment property is a fairly well-understood commodity, and funders know and like that certainty. Changing the status quo, while not impossible, will not be easy.

While the future road that commercial leasing will take cannot be predicted with certainty, it is clear that the changes we have seen in the wider market are here to stay and the market will continue to shift in the coming years, and the green agenda can only increase in significance as legislative requirements kick in. A way will have to be found to tackle these challenges, and in our view the biggest question for the commercial leasing market is whether we will see the continuing gradual evolution of commercial terms over a period of years, or whether the desire for change among landlords, tenants and/or funders will be enough to build a momentum towards a complete overhaul of the commercial leasing structure.

Panel: A broader view

In France, for example, typically the landlord is responsible for major repair work whilst the tenant is liable for ordinary repairs; in Germany a common lease structure is “roof and structure” where the landlord retains responsibility and can charge a repair fee in addition to rent; in Italy structural repairs are always the landlord's responsibility and are not recovered through service charge.