The language of commercial landlords

With ‘options to renew’ and ‘three by three leases’, it sometimes seems like commercial landlords have to speak a whole other language.

But the lingo isn’t really that hard to translate.  Lease Agreement

Getting a commercial lease agreement right from the beginning is crucial for both lessees and lessors because rent returns have the potential to make or break the success of a commercial investment portfolio and lease terms run for as long as 20 years in some instances.

So what exactly is involved when it comes to reviewing a commercial tenancy and how can landlords ensure they protect themselves and their asset whilst keeping their tenant happy?

The review

The regional director of asset services for CB Richard Ellis, Sam Cuccurullo, says commercial lease re-negotiations have a longer lead time than in the residential world.

“If a lease agreement is about to expire and we want an ongoing involvement with the tenant, we’ll start negotiations within a six to twelve-month period prior to the lease expiry,” he reveals.

“The first step with a renewal is to look at where the market’s heading over the next two to five years. If the market is poor the landlord might negotiate a lease that includes incentives

investor-enquiry-form
for the tenant and provides for market rent reviews during the new lease period, which is generally three to five years.”

Some commercial leases have what’s known as an ‘option to renew’, an inbuilt allowance for the tenancy to continue at the expiration of the initial lease agreement. More on these a little later.

If such an option is not incorporated into the agreement, Burgess Rawson director Chris Burgess says everything is on the table.

“The landlord can ask whatever he wants on renewal of the lease and it’s then a matter of negotiations with the tenant, whereas if you have an option you have to abide by the lease terms and conditions that are in existence,” Burgess explains.

“If you want to review the rent you can put that to the tenant but there’s usually a mechanism in place to say that if there’s no existing agreement the rent can be arbitrated by a valuer. Essentially, if you don’t have an option you can charge whatever rent you like but it’s up to both parties to negotiate.”

Going green

To complicate the issue of lease renewals further, the latest buzzword in property circles – sustainability – is making its way into the commercial forum.  Green-Economy

“We’re starting to see an increase in the instance of ‘green leases’,” Cuccurullo says. “There’s a big push, mainly from government tenants, to ensure that premises have a minimum rating according to industry sustainability standards.”

He explains that Green Lease Schedules (GLS) spell out that the building in question must comply with a certain efficiency rating before tenants will commit to a further term.

This includes the consideration of energy consumption levels, waste management and water treatment.

“Landlords will be forced to make any necessary compliance changes either prior to or after lease renewals and that will be documented in the new lease agreement,” says Cuccurullo.

Options to renew

Options to renew can be a minefield for commercial landlords to navigate.

They often favour the tenant, as an option gives the occupier surety that they can remain in the building upon expiration of the initial lease agreement, even though they don’t have to inform the landlord of their intentions until six months before the lease is due to terminate. Buying Commercial Property

However, Cuccurullo says that some tenants prefer not to take up options to renew as they can be detrimental when it comes to re-negotiating terms.

“Occupiers only exercise options about 50 to 60 per cent of the time because they don’t know when the triggers are in leases. Some leases could be five to seven years but they don’t have sophisticated information as to when they should trigger the option to renew.

They might also be advised not to exercise an option because they can possibly negotiate a better incentive.”

Options can include lease terms such as ‘three plus three’ – an initial three-year lease with a three-year option to renew. It’s at the tenant’s sole discretion as to whether they take up the option and if they choose to do so, their intentions must be put in writing to the landlord or managing agent at least six months prior to the expiry of the lease. Commercial-Property

With an option to renew, “the tenant is virtually agreeing to remain in the premises under the same terms as the current lease, with some clauses being amended”, explains Cuccurullo.

“Normally that involves a market rent review – which falls on the exercise of option – or they may have negotiated a 4 to 5 per cent increase on renewal.”

He says that in office and industrial premises particularly, many landlords don’t like giving options because it puts the onus completely on the tenant as to whether they stay, leaving the owner virtually in the dark and potentially affecting their future plans for the premises.

On the other hand Burgess says: “If you don’t have an option you have no good will, particularly in retail premises because the landlord can turf you out when your tenancy comes to an end.”

The basis of a continuing tenancy under an option to renew is formed at the outset of the rental agreement.

In this sense, it’s important that any option included in the lease is carefully worded to protect the interests of both parties. Rent Contract

“Having a recourse to market is very important when it comes to options,” Burgess says. “Some have built-in reviews based on CPI (Consumer Price Index) and in low inflationary times that’s usually disadvantageous to the landlord because he might be in a situation where rents are going through the roof and he’s stuck with CPI increases.”

If a market review is initiated when the option to renew comes into play, the landlord can re-negotiate a rent in line with the fair market value of the premises.

The tenant can either accept whatever the new rent will be and take up the option, or request that the new rental amount be negotiated prior to exercising their option.

If the tenant fails to advise the managing agent or landlord that they intend to exercise an option to renew at least six months preceding the expiration of the lease, it’s entirely up to the landlord as to whether the lease will be renewed and on what terms.

Rent revision

Rent reviews for commercial premises are written into the initial lease agreement. There are three methods for increasing rents – annual CPI adjustments, fixed adjustments and market reviews.

“If the market’s poor you wouldn’t do market rent reviews, rather you would perhaps look at a 3 to 5 per cent fixed annual review or a CPI increase, whatever is acceptable at the time,” Cuccurullo says. Commercial Property Value

On the other hand, if the market is performing well and looks to continue moving upward over the term of the lease, Cuccurullo says owners should include regular market reviews to achieve a better rate of return.

CPI increases are done annually and depend on the rate of inflation at the time, or the 12-month CPI adjustment.

Cuccurullo says landlords have the option of alternating the type of rent reviews to occur in lease agreements over their term.

“If the market is really hot, you should try to have a market review every two years for say a five-year term with an alternating fixed increase of 4 to 5 per cent per annum. If the market is dead on the other hand, you would only have a fixed increase all the way through the lease with no market reviews, because that could potentially push the rent down.”

Options to renew often stipulate the type of rent review that will occur when the new lease term commences. Usually this is a market review, however if no option is included a new rent will be negotiated based on comparables for similar commercial premises.

Burgess says the lease agreement “should have recourse to market every three years or so, with CPI adjustments in between”. Market Trends

“But if CPI’s really running hard you might go for a smaller fixed increase,” he adds. “Nowadays because inflation’s not as high, people are happy to have a market review every five years but you don’t want to leave it too much longer than that because conditions such as supply and demand can change dramatically.”

He adds that in the instance where commercial premises are unique and therefore difficult to review based on comparable rates, recourse to market can be difficult.

“In that situation it’s generally advisable to have some sort of fixed increase so the landlord knows where they’re heading financially,” he advises.

Editor’s note: This article was written by Bronwyn Davis and first published in Australian Property Investor Magazine in 2008 and is copyright and reproduced with their permission.

As the principles are still relevant today we’ve decided to republish it for the benefit of our many new readers.

You may also want to read: Dangling a carrot to secure a commercial tenant

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'The language of commercial landlords' have 14 comments

  1. Avatar for Property Update

    August 11, 2016 @ 9:44 am Paul Bygrave

    Hi,
    I’m about to sign a commercial lease however I notice that the lease contains a Market rent review date that corresponds with the end of the first lease term (3 years) this seems fair enough. It than states a CPI adjustment of rent as per the schedule dates, again this would seem fair enough, but it also states a Fixed Term increase annually of 4% this would seem a little rich and smells of double dipping to me. My question is; is this normal and typical of commercial leases or is it something I could reasonably expect to have removed?

    Reply

    • Avatar for Property Update

      August 11, 2016 @ 3:19 pm Michael Yardney

      Paul
      It depends on the type of property you are leasing and where it is located, but I would attempt to get future reviews (other then the market review at the end of the lease) to CPI

      Reply

  2. Avatar for Property Update

    May 5, 2016 @ 10:25 am AVI

    Hi

    I would like to know what is the most common
    Way for an annual rent increase for child care
    Centre if I’m ( being the landlord) giving a 15 year lease and then an option of 5 years
    Is CPi option to low

    Reply

    • Avatar for Property Update

      May 5, 2016 @ 9:02 pm Michael Yardney

      As the value of your property will in part be dependant on your rental, CPI increases for 15 years will disadvantage you – esp if it remains low. Landlords are now asking for a fixed % increase or CPI – whatever is the greater

      Reply

  3. Avatar for Property Update

    July 9, 2015 @ 6:39 pm John newton

    We purchased freehold a old service station passing rent was $ 57000 we then co built a new one with a major oil company on the site . Our contribution being $600000 theres $440000 of which gave a total yield of 8.5% so $51000 +$57000 = $108,000 and the rent now is $120000. That was 5 years ago and we are approaching market review,The service station in my opinion is grossly under rented even with the 3.5% annual increases ,My question is ,is there any limitations to how much the landlord can increase the rent eg if valued by a licensed valuer and and the rent was put at $ $200 000 would that be the amount the oil company would after pay .

    Reply

    • Avatar for Property Update

      July 9, 2015 @ 6:55 pm Michael Yardney

      John
      I would definitely get a specialise valuer on your side to represent your case. WHat you’re hoping could be correct, unless there are any special provisions in your lease

      Reply

  4. Avatar for Property Update

    April 15, 2015 @ 12:26 pm Nicole

    Hi, Thanks for this useful article.
    My question is surrounding the market reviews and the timeframe by which these should be completed and can be exercised. We have a lease agreement which provides for a market review at a date. Is this something that can be exercised after the market review date (retrospectively) or does the review have to be completed and communicated by the date of the review on the contract?

    Reply

    • Avatar for Property Update

      April 15, 2015 @ 12:37 pm Michael Yardney

      Nicole- that’s a good question, but a well drafted commercial lease would allow the landlord to retrospectively request a review after the due date

      Reply

  5. Avatar for Property Update

    January 5, 2014 @ 8:12 pm Chris

    Hi thanks for the article.

    Question: What documents are things are required by the valuer in at market review? Things like the lease obviously, but what about the tenant’s financial statements for running the property (FYI – we are the landlords of a motel). I ask this because the tenant’s have provided their financial statements which are clearly fabricated – eg. council rates of $9K when we found out the rates were acutally $3K / Telephone bills of $4K for a 11 bedroom motel.

    We will obviously tell the valuer this, but what to see if they rely on this and what else they will require.

    Cheers.

    Reply

    • Avatar for Property Update

      January 5, 2014 @ 10:37 pm Michael Yardney

      Chris
      A motel is valued as a commercial property and this is very different to a residential property.
      While the real estate is important another critical factor is the lease as well as the strength of the tenant and any guarantees given by them. having said that, if they are valuing the property and not the motel as a business, they don’t usually go into the details of the tenant’s day to day accounts

      Reply

  6. Avatar for Property Update

    February 14, 2013 @ 11:18 am John L.

    Hi
    We have a childcare centre which we took on the landlords new purpose built building. As usual as tenants we completely fitted out the playgrounds. We had to also had to spend many tens of thousands of dollars extra re-landscaping and excavating adding new drainage to the yards because of the water drainage problems. Obviously adding real value to the landlords investment. We also re-paint inside every year to keep it as an attractive place to run the business.

    Our lease is optioned at 10 +5 +5 yrs.
    We are now scheduled for a market rent review (end of 5th yr) We have being paying yearly rent increases at CPI or 3% whichever is greatest.

    My confusion lies with “market rental review” increase (if any, but there is a ratchet clause).
    Surely any market review rental increase over the last 5 yrs is also made up of the CPI component. So if there has been say an 8% increase in market rent value and we have being paying yearly increases of say 3.5% CPI, wouldn’t that mean that market rent review increase should be 4.5% not an additional 8% as well because that would be double dipping. My line of thinking is that there are 3 options in the rental increase. 1) just CPI 2) an agreed % yearly increase 3) Market value. Not a combination of CPI and market value increase on top of that.

    My question to you I suppose is: – Is that right ?

    I have found by googling childcare centres and rental market review a couple of centres came up stipulating that after the 3 yearly review that just one (the highest) of either a CPI value or Market Rental Review is to be used in confirming the new rental charged for the next 3 yrs.

    We are the only Childcare leasehold in our suburb, the others all freehold so are not subjected to rental increases every year. We are now operating as having the highest daily fees in our area and feel that any over the top increases would be detrimental to the business.

    I feel that a valuer would be hard pressed to value our leasehold building as it’s the only leasehold in our area but there is one other leasehold of similar age and licensed child numbers in the next suburb, the rent of the building is higher because the cost of that building was 55% more not including a fully supplied playground fit out. I would think it would be unfair for a market review to compare our rent with that of a more elaborate building when we organize a valuer to assess our market rent review.
    Regards
    John L

    Reply

    • Avatar for Property Update

      February 14, 2013 @ 11:24 am Michael Yardney

      John

      The market rent is what other comparable properties are paying at present in “the market”. In some areas despite an increase in the CPI, the market rent has gone down – due to oversupply

      That may be hard to determine if there are few if any comparable properties, but it’s a valuers job to determine the “market rent” and the have models to determine this

      Reply

  7. Avatar for Property Update

    July 17, 2012 @ 1:54 pm John Dempsey

    my shop lease is up for renewal and I would like to know who conducts a market review, the real estate agent i deal with said they recon $550per spq meter down from the $600 we are currently paying the original lease 10 years ago started at $415 per sqm can you let me know what the process for a market review is regards John Dempsey

    Reply

    • Avatar for Property Update

      July 17, 2012 @ 2:03 pm Michael Yardney

      John
      If you and the landlord do not come to an agreement on the market rental, then there will be a clause in your lease that explains who will conduct the market review. It’s often a valuer

      Reply


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