Understanding commercial leases
Negotiating a commercially viable lease requires you to know and understand the key terms and conditions contained in the lease clauses.
Some of the key terms and conditions typically included in a lease are:
- lease duration (or term) and options to renew
- rent and rent reviews
- permitted use
- tenancy mix and competition
- repair and maintenance
- compensation for disruption caused by landlord’s works
- assignment and sub-leasing
- default and breaches
- redevelopment and relocation
Your proposed lease is also likely to include other terms and conditions. Read our publications on commercial leasing for more detailed information.
TIP: Before signing a lease or lease related documents, taking possession of the premises or paying any monies you should obtain independent legal, financial and business advice.
You need to ensure the duration (term) of the proposed lease is long enough for you to recoup your investment and make your required profit. Remember, once your lease has expired the landlord is under no obligation to renew it and you may need to find alternative premises. Much of your business goodwill could be attached to your premises, so it is important to protect this.
Ensure that the proposed lease provides you with options to renew so that you can continue trading from the premises after the end of the initial term.
If you are starting out in business and don’t have a proven track record, you may decide to negotiate a short initial term and short options to renew, such as a one-year lease followed by two, two-year options.
However, if your business is established and you are seeking security you may prefer to negotiate a longer term lease, for example a two-year lease followed by a three-year option and a five-year option.
For many leases covered by the Commercial Tenancy (Retail Shops) Agreements Act 1985 (CT Act), a tenant entering into a new lease for a retail shop has the right to a minimum tenancy period of up to five years. If the lease does not provide for a five year period, under the CT Act a tenant has the option to extend it (statutory option).
To exercise this statutory option a tenant must complete a Notice of Exercise of Option and give it to the landlord at least 30 days before the end of the lease.
Exercising your option
Your lease should include information on how and when you will need to inform the landlord that you want to exercise your option. Typically, options are usually exercised (actioned) in writing between three to six months before the end of the lease period.
The CT Act requires the landlord to provide you with at least 6-12 months notice before you must exercise (action) your right to renew.
TIP: Failure to exercise an option by the due date or in the manner set out in the lease may result in your lease not being renewed by the landlord.
You will need to negotiate the rent and frequency of rent reviews with the landlord. Rent reviews are usually annual but you can negotiate for them to be less frequent.
Leases covered by the CT Act must only have one basis of calculating a rent review.
Some of the most common types of rent reviews to choose from are:
- consumer price index (CPI)
- fixed percentage increase
- fixed amount
- market rent
It is important to ensure you can afford any proposed rent increases over the period of your lease and any renewal period.
If a market rent review applies upon the exercise of an option to renew your lease, it is important before making any decision that you first establish the market rent with the landlord to ensure the proposed rent is acceptable and commercially viable.
In negotiating a lease, try to avoid rent reviews based on percentage of turnover. This means that you agree to pay a base rent and once a certain level of turnover has been reached, additional rent is paid based on a percentage of turnover.
If this clause is included in the lease you will be required to provide details of your turnover to the landlord. This information could be used against you in later negotiations or if you decide to sell the business.
A lease usually includes a clause that outlines the permitted use of the premises.
You should ensure that the permitted use allows you to do all the activities required to operate your business. This includes all the types of goods you want to sell and services you want to provide.
Don’t just think about your current activities, consider what you may want to offer to expand your business in the future. For example, if you are only permitted to sell pizza this could cause problems if you want to add hamburgers or coffee to your menu.
The permitted use may also limit your opportunities to assign the lease to another person if you want to sell the business or leave the premises before the lease expires. You should try to negotiate a permitted use that is sufficiently broad enough to protect your future business interests.
Carefully consider the mix of tenants in a shopping centre or precinct. Ideally the mix of businesses should complement rather than compete with your business.
It’s a good idea to include an ‘exclusivity of trade’ clause in your lease. This prohibits direct competition and gives you the sole right to sell a particular product category, or conduct that type of business in the shops controlled by the same landlord.
You may be attracted to particular premises because there is a significant tenant in the same location, such as a supermarket chain or department store (known as an anchor tenant). Your business may even rely on the foot traffic generated by them. If so, negotiate a clause in the lease that gives you the right to terminate the lease or receive a rent reduction if the anchor tenant leaves or if there is a reduction in the overall number of tenants within the building or shopping centre.
Other costs associated with leasing commercial premises also need to be considered in your negotiations. These costs are additional to the rent and can be significant. In some cases they may be ongoing and increase during the lease. Some of the common additional costs are:
- operating expenses or outgoings
- legal costs
- security bond
- marketing and promotional funds
Operating expenses are generally the costs incurred by the landlord in operating, repairing or maintaining the leased premises. These costs may include land tax, council rates, water rates, security, cleaning of common areas, and general repairs and maintenance.
It is important for you to be aware of any operating expenses that you will be required to pay before signing a lease as they can significantly add to your overall costs.
Try to negotiate so that you aren’t obliged to pay for operating expenses incurred by the landlord. If this isn’t possible, try to limit them so that it is only those that will be of benefit to your premises. Also negotiate a maximum level of increase over the term of the lease.
Costs such as structural repairs and capital items (something considered an asset) should be strongly argued as being at the landlord’s expense as the landlord has the ongoing benefit of these items.
Leases covered by the CT Act must individually itemise any operating expenses you will be required to contribute towards.
The lease should also stipulate that you should have access to invoices and receipts to confirm the actual operating expenses.
You may be required as a term of the lease to take out insurance to cover such things as damage to the building and public liability. You should avoid any indemnity clauses in a lease that require you to compensate the landlord in the event of any loss, unlawful act or damage.
These clauses can breach your insurance policy. It is a good idea to discuss any insurance clauses with your insurer before agreeing to them.
In general, the legal costs associated with preparing and negotiating the lease can be agreed between you and the landlord. It is a good idea to try to negotiate that each party pays their own legal costs, or at the very least there is a limit on your contribution to the landlord’s costs.
You should also avoid any clauses that require you to pay the landlord’s legal costs if there is a dispute.
However, for leases regulated by the CT Act a landlord cannot require you to pay legal costs associated with:
- the preparation, negotiation, execution, renewal or extension of a lease
- obtaining consent to the lease from their financial lender (if there is a mortgage on the property)
- complying with the CT Act
The landlord is able to claim any legal costs and other expenses associated with an assignment of lease or sub-lease from you.
You may be required to provide a security bond at the start of a lease; the amount is usually negotiable. If you agree to a bond, the lease should outline the conditions for the use, withholding and repayment of the bond.
It is recommended the bond be placed in a separate interest bearing account that identifies the name of the tenant or details of the premises.
‘Fit-out’ is the process or action of preparing the leased premises for occupation as required by the tenant and agreed to by the landlord. It can include installing things such as the shop front, wall and floor coverings, fixtures and fittings.
It is possible to negotiate who is responsible for fit-out or parts of the fit-out. It is important that the lease specifies the fit-out requirements and who will be responsible for the associated costs. Try to negotiate as much as possible so that the fit-out items you purchase will remain your property (can be taken with you) at the end of the lease.
Fit-out costs can be a major cost. Be sure to allocate sufficient budget towards it when considering leasing premises.
For leases regulated by the CT Act, you are not required to contribute to the cost of the landlord’s finishes, fixtures, fittings, equipment or services unless you are notified of these costs in the Disclosure Statement provided to you at least seven days before entering into the lease.
TIP: Allow time for delays in completing the fit-out. There may be seasonal shortages of tradespeople (for example at Christmas) which could delay your fit-out being completed.
You may be required to refurbish the premises during the lease period. This is most common in shopping centres where the overall image of the centre is kept updated. In your negotiations try to limit refurbishment to every five or six years.
For leases regulated by the CT Act a clause requiring you to refurbish or refit the premises will not be legally valid unless sufficient detail, including the nature, extent and timing of the refurbishment or refit is included in the lease.
You may be required to contribute to marketing or promotional funds if specified in the lease. These funds generally are for advertising or other promotional activities of a shopping centre
You should clearly determine your contribution to marketing or promotional funds before entering into the lease. Try to negotiate terms that limit your contribution and allow you to have a say in how the funds are spent.
Responsibility for repairs and maintenance should be clearly outlined in your lease. Try to negotiate for the landlord to be responsible for the structure of the building and major capital items (i.e. roof, walls, air-conditioner, exterior fittings such as gutters and downpipes, plant and equipment that are their property, etc).
As a tenant you may be responsible for the repairs and maintenance of the internal surfaces such as floor coverings, doors and windows and any equipment and fixtures provided by the landlord for your use.
Equipment such as air-conditioners and fire sprinklers should be negotiated to be replaced by the landlord when their useful life span is over, but the day-to-day maintenance is your responsibility.
TIP: Have the premises independently inspected before entering into the lease. A condition report, including photographs, should be accepted by you and the landlord. This report can be useful if there is a dispute when the lease ends about the condition of the premises or equipment, and whether this has been caused by fair wear and tear.
If your landlord carries out works that disrupt your business (including general maintenance work or building redevelopment), you may be entitled to compensation. Read our guide on how to claim compensation for disruption caused by landlord’s works.
You may need to assign the lease (the lease is taken over by another person) if you decide to sell your business or can no longer keep operating. You will need the landlord’s permission to do this, so make sure your lease states that they cannot unreasonably withhold their consent.
Reasonable grounds for refusing the assignment may include the prospective new tenant having a poor credit rating, them being unlikely to be able to conduct the business successfully or intending to use the premises for a purpose other than the use permitted by the lease.
If you assign a lease you may still be liable if the new tenant defaults on the lease. For retail leases covered by the CT Act clauses that allow the landlord to withhold consent unless you agree to accept liability for the new tenant’s default are illegal.
However, for leases not covered by the CT Act ensure that you are released from any liability after the date of assignment.
If you sub-lease part or all of your premises, you are still liable for the lease. This may mean that you will need to pay rent if your incoming tenant fails to pay. It is important to undertake a credit check and ensure that the incoming tenant is able to meet the lease requirements.
If your sub-lease is regulated by the CT Act, you essentially assume the responsibilities of a landlord under the Act and must provide the appropriate documentation including a Disclosure Statement and Tenant Guide to the new sub-tenant.
If you are assigning a lease or sub-leasing you may be required to pay the landlord’s reasonable legal costs and other associated expenses..
You will be in default of your lease if you fail to pay your rent on time. This will allow the landlord to take action to recover the rent. In many leases the landlord will also have the right to enter the premises and lock you out without notice.
The landlord can claim the loss of rent up to the end of the lease period and costs associated with reinstating and re-letting the premises. If the premises are re-let at a lower rent the landlord can claim for this plus any other loss and legal costs associated with your defaulting.
When negotiating your lease make sure the default clauses specify that you must be given written notice of any default, and that you are given sufficient time (at least 14 days) to rectify the default before any action is taken against you.
You can also breach your lease (breaking part of the agreement) if you do not undertake certain requirements, such as failing to repair or maintain the premises. Once again, you should negotiate in your lease to have written notice and sufficient time to rectify any breaches before any action is taken against you.
A redevelopment clause may allow the landlord to terminate a lease early so they can carry out major works to renovate or redevelop the premises. In these circumstances you could find yourself without premises or relocated to alternative premises. This could severely affect your business.
If possible, you should try to negotiate to have the redevelopment and relocation clauses removed from the lease. If you can’t, make sure the lease provides compensation for loss of trade or goodwill associated with relocating your business, along with payment for relocation and other costs and losses.
You should also consider negotiating a reduction in rent if appropriate. Generally the redevelopment clause should provide sufficient compensation so that you are in substantially the same position as if the redevelopment did not occur.
For leases covered by the CT Act there are comprehensive requirements relating to the redevelopment and relocation of a tenant’s business and the early termination of a lease.
TIP: You should give serious consideration to the risks associated with redevelopment and relocation. If you are unable to negotiate adequate compensation, you should consider whether the potential risks for your business make it worth entering into the lease.
When negotiating a lease check whether there are any clauses that allow the landlord to terminate the lease early. If there are, try to negotiate to have them removed.
- Read our publications on commercial leasing.
- If your business is in WA, contact our commercial tenancy advisers to discuss the business aspects of your proposed lease.
- Hire a lawyer (specialising in the leasing of commercial property) to discuss the legal aspects of your proposed lease.
- Discuss with your accountant the financial and tax implications of your lease.
- If your business is interstate, contact an adviser in your area.