Commercial Leases (Part 1): Lease Terms, Options & Expiry

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You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

Welcome back to another episode of Explain That by Velocity Legal.

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In this series, we'll be covering leases, in particular, what happens at the end of a lease and what rights and abilities a landlord and a tenant have.

In this series, I'll be joined by Senior Associate Joel Garrett. Joel specialises in property law matters and regularly deals with leasing matters.

0:36
So firstly, Joel, welcome to the program.

Thanks, Andrew. Happy to be back for a second time.

Fantastic. Well, we did a previous series about fit-outs in leases. Today we're going to be talking about the term of the lease.

Now Joel, as you would no doubt know, a business needs premises generally.

0:55
So it's a pretty important thing to make sure they have security of tenure.

Obviously very important for premises to be in existence for most companies to be able to operate their business from.

Sometimes I think leases probably aren't taken as seriously as other contract documents.

1:11
This session will cover the importance of knowing how long the lease is going to run for and what to expect towards the end of it.

Fantastic. So in this first part of the series, we're going to be going through some of the fundamentals. What are we going to be discussing in particular, Joel?

Yeah.

1:27
So just things to look out for when you're entering into a new lease, both from the perspective of a landlord and a tenant, and the process of exercising an option for a further term.

Often when you're entering a lease, there'll be an initial term that you enter into, and then there's usually an option, which is a benefit of a tenant to be able to stay in the premises longer after that first term.

1:50
So explaining the process of exercising that option, both for a retail lease, which falls under the Retail Leases Act, a piece of legislation governing those leases, and for non-retail leases, which are leases that fall outside the operation of that legislation.

2:06
Discussing what happens to a lease if neither the landlord nor the tenant does anything. So the lease expiry date comes up and neither does anything.

What happens in that circumstance and what to expect at the expiration of a lease if there's no further terms and either party wants to end the lease.

2:26
Fantastic. So we've got four things essentially, entering the new lease, what to look out for and consider at that point, the process around exercise, what happens when you overstay or hold over, and what to expect at the expiry of a lease.

2:42
That's it, yeah.

Great. So let's dive into that first topic then.

Okay, so we've got a business owner, they're looking for a new space. There's a lease that's drawn up. What should be in the mind of, I guess let's start with a tenant.

2:59
What should be in their mind when they're presented that document?

So it can be really different depending on what stage of an established business or not. If it's a new business, you'll have different expectations or needs from a lease.

If it's a new business that you're operating, and you've never done it before, you don't know how successful it's going to be.

3:17
Obviously our business owners say they are going to have the best and highest hopes for their business, but you never know what's going to happen.

So if you're entering into a lease, you don't want to lock yourself into a five-year, 10-year lease potentially, because if things don't go as well as you need, you're going to be contractually obliged to still pay rent effectively to that landlord for that whole time, unless you can come to some kind of arrangement to surrender the lease early.

3:42
So for a new business, you're probably wanting a shorter term initially just to get your feet on the ground, your business established, and then having those additional options for further terms in the back pocket.

So if things are going well, you know that you've got security to be able to exercise those options for further terms and remain in that premises for a long time.

4:03
For an established business, less of an issue. Perhaps you're wanting to move to a larger space because your business is doing so well. Your lease has expired, you need a new place, and you're happy to have a longer initial term.

And you'll have a bit more certainty on the rent that's expected to be paid across that entire first term.

4:21
Because often if you exercise an option, there's usually a re-evaluation of rent to market rent. So it's kind of an unknown.

But if you have a longer lease term, you can negotiate fixed increases. So a longer term is more beneficial. You have more certainty about your overheads and the expenses for your businesses.

4:40
Have more confidence.

What sort of options? So it sounds like there's a balance between the length of the initial term and what options exist for a tenant.

Flexibility is good. What are those options? What do they normally look like, or how many do you see normally in practice?

4:59
Yeah, it's really flexible. There's no one rule.

It really depends on what the landlord's trying to push. A landlord often will want a longer initial term because they have more security of knowing that they can require the tenant to keep paying rent for that whole time.

5:17
But if it's a short term and only two years or something, and there are some options, the tenant might not want to exercise them and they have to start from scratch again.

Finding a tenant, the place might be empty for six months, and then they don't have that security of guaranteed rent.

So for a landlord, the longer the initial term is, the better, generally. It equates to more guaranteed rent.

5:37
And the number of options a landlord might agree to will likely depend on their intended future use of the premises.

If it's an older development, if it's an older property, they might be thinking about developing the land for some purpose or knocking it down, doing some refurbishment.

5:56
To simplify that process, they might not want to grant too many options to a new tenant because if they wanted to go ahead with the development, they might have to pay that tenant compensation or get agreement for them to get out of the lease so that they can move forward with their intended future use of developing the land.

You also run the risk of if you're a landlord and you have a tenant with a five-year lease and then three more five-year terms, if they're a bad tenant, you kind of are stuck with them.

6:21
They might pay rent on time and do all they need to do, but they just make your life difficult or you don't like them.

Not all commercial relationships work out great, but if you're giving them a lot of options, you're stuck with them.

So it's a balancing up of the landlord's needs.

6:36
What do they want with the future of the premises, and are they confident that they're going to have a good tenant?

It's a good point. I mean, that example you give with a five-year lease with three options, from a landlord's perspective, they're only getting rent for five years definitely.

6:52
But in theory, they've locked up that space possibly for 20 years.

So they can't offer it to someone else who might need more space, or develop it, or do all those things.

So it makes sense that that's not really in their interest. So I can understand why there'd be some reluctance around offering too many options.

7:12
Yeah. Also from a tenant's perspective, you can't exactly map out how your business is going to end up going. The space might end up being too big or too small for your needs.

So some things for a tenant to consider when entering into a new lease is, depending on what it is, if it's a standalone shop at a strip of shops, at a local shopping strip or something, you have less flexibility.

7:33
But if you're in a tower like in the city, you could try and look for a landlord who's willing to offer an expansion or contraction right.

An expansion right in the lease will allow a tenant to tell the landlord, look, we need to get more space. We're doing well. We want to have more space to be able to operate our business.

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And there'll be a term in the lease where they can tell the landlord this, and the landlord is obliged to offer them some more space in that building.

It might be the next door tenancy at the same level, might be another room in a level above, but it just gives a bit more flexibility to a tenant that, look, if things change or we need more space, we've got that option.

8:08
You're not stuck in this little premises.

And similarly, if things are maybe not going as well as you think, or you have no need for the additional space anymore, sometimes a lease can have a contraction right, where there'll be a set period where a tenant can exercise its contraction right.

8:25
And a portion of the lease area that you have will just be taken away and your rent will go down too.

I suppose landlords are probably more likely to agree to the expansion right than the contraction right.

Yeah, they'll be more happy to.

But sometimes, especially in the current market, I think there's a bit of a shortage.

8:42
I mean there's an excess of tenancy spaces in the city particularly.

So I think landlords are probably a bit more flexible in trying to get people in the door and offering these additional incentives and assurances that if you need to change things, we can change it for you.

8:59
That's a good point. I guess when you're entering into a lease, you've got to be pretty aware of what the market is like, what is market at that point, because it's a supply and demand economic type question.

In a hot market that's very landlord favourable, you're probably not going to get as much flexibility.

9:17
Whereas if it's more of a tenant's market, you're going to get more.

Yeah, I think since COVID, there's a lot of office space around available as well.

So expansion and contraction rights would be more commonly discussed when entering into a new lease.

Well, let's go to that second point then.

9:33
Second one you had was about the process for exercising an option.

This can change dramatically, or maybe dramatically is a bit dramatic, but under a retail lease, there's a prescribed process that needs to be followed.

So if you're operating a lease that's under the legislation, there's a requirement for a landlord to notify its tenant of the latest date to renew or exercise its option to renew the lease.

9:59
It can't be any later. So the landlord has to give this notice. It can't be any later than three months before the date that the option can be renewed or the lease can be renewed.

That changes. Each lease has a different date upon which a tenant can renew its option or can renew its lease or exercise its option.

10:17
So the landlord just needs to be aware of those timeframes.

So the landlord's got to write to the tenant, you're saying. It's saying, hey, look, you've got this option. It's going to come up.

Yeah.

And what needs to be in that notice?

Yeah.

10:33
So it needs to include the date by which the option to renew can be exercised.

The landlord will put its proposed rent for the new first 12 months of the new lease. That's presuming that there's going to be a market rent increase or market rent review occurring at the time of the exercise of the option.

10:53
The availability of a tenant to request an early rent review, which I'll discuss a bit later.

The availability of a cooling-off period.

Yep.

And any changes to the most recent disclosure statement that was provided by the landlord to the tenant, obviously not including the proposed rent, which they have to specify separately anyway.

11:17
Yep. All right. So the tenant's got this notice, it sets all these things out, which is, I guess, addressing information imbalances or preventing people missing dates.

Yeah, I guess.

So the two questions, what happens when the landlord hasn't provided the notice? And I guess, what if the tenant doesn't agree with those things stated in the notice, like the rent?

11:32
Yeah. So if the landlord fails to give the notice, that lease is just going to continue indefinitely.

So the purpose of the legislation, the Retail Leases Act, is to give tenants more protections. It's definitely tenant-favourable legislation.

And the purpose of this specific requirement for a landlord is to make sure that a tenant can't be surprised that they've forgotten.

11:49
They might have forgotten that the lease expires by a certain date, and when that date passes, the landlord can't just come in, knock on the door and kick them out.

They have this positive obligation to give this notice.

And if they don't give the notice, then the lease just continues indefinitely until it's done.

12:07
And then the lease will be extended by the minimum timeframe that they could have exercised the option previously.

So if you're a month late in giving that notice, that means the lease is extended by one month, then the tenant still has all its rights to exercise this option.

It's definitely more beneficial for a landlord to do that notice as soon as possible because if the lease is extended, it's extended on the same terms.

12:23
So they might be missing out on an ability to increase the rent.

So it's really important for a landlord to be on top of all of these dates.

Be aware of those dates, yeah. You don't want to miss out on getting more rent if it's possible.

And then in terms of what happens when the landlord proposes the new rent, let's say there's a market rent review and the tenant doesn't agree, what happens in that situation?

12:45
So from giving that notice to the tenant, the tenant has 28 days to think about the proposed rent.

If they're not happy with it, they can initiate what's called an early rent review process, and basically it's an opportunity for the tenant to write back to the landlord saying, hello, sorry, I don't agree with your proposed rent.

13:05
They might have gone off and got an appraisal of the rent themselves and think there's a bit of a discrepancy between what's been put forward and what's actual market.

And they can go to the landlord, give their own counter-proposal for market rent.

Hopefully the parties at that point will be able to come to an agreement on what the market rent should be.

13:25
But if they can't, then the parties are required to try and jointly appoint a valuer to do a specialist market rent determination.

And then if the parties are still at ends and they can't even agree on a joint valuer themselves, either the landlord or the tenant can make an application to the Victorian Small Business Commission, which has powers under the Retail Leases Act to appoint a specialist retail valuer themselves.

13:53
Those costs would be shared between the parties, and then that valuer would do their determination, and that would be binding on the parties as to what the market rent will be.

So it's a bit of a circuit breaker to determine rents in retail leases.

Yeah, it's a forced dispute resolution mechanism because if you've got a basic lease, these things wouldn't be considered greatly.

14:14
And I think it prevents, again, the landlord from being able to dictate what they think the rent should be just because they're the owner. It needs to actually be a fair and reasonable market rent.

And then okay, so we've talked about retail leases and the process there. What about a non-retail lease?

Well, that's completely different.

14:32
A landlord can basically dictate anything that they want as part of the lease negotiations.

So a non-retail lease is not subject to any legislative requirements.

Basically, it's important for, it's not something that a tenant will often think about when they're negotiating a new lease, what to do in five years' time.

14:54
But it is important because it can make a really big difference as to what requirements are needed to exercise that option, the ability for the valuer to have regard to different things that they otherwise wouldn't be allowed to have regard to if it was a retail lease.

Under the legislation, often a landlord will put the positive obligation on the tenant to notify the landlord that it has an option that it wants to exercise, and there'll be a timeframe on that.

15:19
And if a tenant misses it, there's potential that they will just forfeit their ability to exercise that option.

And then once the expiry of the lease comes around, they have to get out.

A retail lease is really important, the legislation is really important to protect those tenants in certain circumstances.

15:39
But if you're not within that legislation, you really need to be on top of your timeframes as a tenant to make sure that you're not missing out on being able to exercise those options and secure your tenancy.

And negotiate those terms upfront because you're not going to have any protection from, I mean other than possibly unfair contracts, general consumer law protection, you're not going to have anything specific like the Retail Leases Act.

16:01
Yeah. Well, thankfully, I think if it's a building, a large building in the city, a lot of it would be non-retail because if you're above, it's a funny little regulation as part of the Retail Leases Act, if you're above the third storey, you can't be a retail lease for the purposes of the Act.

16:18
So yeah, you want to make sure that whatever standard lease you're getting from a landlord, in that scenario, is reviewed.

And Joel, one question, it might be delving off a little bit. I think that I remember reading some things about this.

You could have a situation where there's conditions to be a retail lease.

16:36
And I think one of them is, you know, the rent being over $1,000,000, for example.

And there's discussion about can you go in and out of the retail lease exactly.

Let's say under the original term it was below that threshold, and now in the new option it might get above.

16:52
Can you go in and out, or is it sort of once, if the original term was a retail lease, does that mean it's always a retail lease and sort of vice versa?

Once you're in, you can't get out.

So for example, if you're right, if it was like $990,000 per year and then the next year a rental increase occurred and it took you over the $1,000,000 threshold, that doesn't suddenly change the characterisation of a retail lease to a non-retail lease.

17:19
Moving on to situations where when nothing happens and no option has been exercised, what happens in those situations?

So the lease will just continue. It'll be on what's called an overholding period or periodic tenancy.

A couple of different ways to describe it, but same thing.

17:35
Generally, that just ends up being a month-to-month lease.

So the landlord will continue getting rent. Depending on the terms of the lease, rent might stay the same, or sometimes there's provisions dealing specifically with overholding periods and there'll be an agreed rental increase for that period.

17:53
But effectively the lease just continues.

But it's not a secure tenancy, particularly from a tenant's point of view. They can be booted out basically at any time.

I guess it's not secure for either party really.

Well, yeah, if it's a retail lease, a landlord is obliged to give at least six months' notice to its tenant if it's not intending on offering it a new term.

18:17
So that's a bit of comfort, like the tenant has at least six months to deal with that situation.

But on the other hand, you're right, it's not good for a landlord because a tenant can basically terminate at any time after the expiry.

I believe they have to give it one month's notice.

But yeah, it's definitely favourable towards a tenant.

18:34
They've got more time to deal with that situation than a landlord.

And is overholding particularly common? I guess you might see it in a case of a really old shopping centre or something where it's going to be redeveloped and they don't want to offer a new term.

But is it common?

Not really. As we started at the beginning of this, a lease is so important to a business's success.

18:52
If you have a completely arm's length, like you don't know the landlord, that's just a normal lease, normal negotiations, most tenants are pretty aware of when their leases are expiring.

And if they're not, they really should be. That's really important.

19:07
So I don't think it's all that common.

I think the most common times you'll see it is if it's like a family friend you're leasing something from, and it's just an ad hoc friendly lease and there's no real worries about being kicked out because you've got an understanding with that person.

19:24
But for an arm's length lease, most people are aware, and then overholding won't carry on for too long.

Well, final point then, expiry of leases. What happens? What should people expect if they don't work it out? They don't. There's no more options, and the landlord says, you know, lease is over.

19:43
Get out.

If there's no overholding period and we know that the expiry of the lease is coming up, both parties really need to understand what needs to happen and what their obligations are as a tenant.

There's likely, there's almost definitely going to be some reinstatement or make-good obligations.

It could be as simple as just removing all your property, removing all your fixtures and fittings and repairing any holes in the wall or holes in the ceiling, floor, whatever.

20:07
It can be as simple as that and just putting it back into the same condition, subject to fair wear and tear, that you entered it in.

But there can be some more stringent obligations that a landlord can place on a tenant. That could be repainting and refinishing all the surfaces, walls, ceilings, cabinets, all that kind of thing, requiring a professional deep cleaner.

20:28
The premises, if you've taken over an empty space and you've put in some semi-permanent walls or reconfigured the space to how you manage your business, the landlord might require that you uninstall all of that and bring it back to its base build condition.

20:45
So these are the kinds of things that you need to be aware of when you're entering into a lease as well, because the cost of some of this stuff can be pretty significant.

And it's a cost that you might not really want to deal with if your business is shutting down or you're leaving a premises.

21:01
You probably haven't.

Those make-good costs could be quite a lot if they've installed significant...

Particularly for warehouses and things like that, like they'll have boreholes in concrete ceilings or the ground, and to repair those to a good standard is not cheap.

So I think you really need to be aware of it and have in the back of your mind when you're approaching the end of your lease because it's not a cheap exercise to get all that done.

21:24
And if you don't do it, then you risk losing your security deposit.

So most leases, well every lease, will have a security deposit required to be paid by a tenant that's usually three months' rent or something like that.

You want to get that back obviously when you finish your lease because that's a lot of money.

21:42
But if you don't comply with all your obligations under the lease, which includes those reinstatement or make-good obligations, you risk losing that to the extent of the cost of whatever it took for the landlord to comply with those obligations on your behalf because you failed to do so.

So it's really important to be aware of what you need to do, likely cost of that, just to make sure you can also get your security deposit back.

22:04
Yeah. And I suppose when you're negotiating the lease in the first place, it's good to be aware of that.

What's the exit? What's the exit strategy from this?

And then that goes into having the options because the longer you can be in there, the longer you could sort of amortise those costs essentially, of making good one day.

22:21
Yeah, it's something for landlords to think of too.

If you know that the tenant's going to be renovating that place substantially and making it a very unique situation that's not going to be easily tenantable once that person is done, make-good costs might be quite extensive to bring it back to base build.

22:37
So you want to be aware of those potential costs and have an appropriate security deposit in place to cover the cost of doing that if the tenant just disappears and vacates that premises without doing it as well.

Absolutely. Well, that's Part 1.

We've been talking about terms, options and the expiry of leases.

22:56
We covered four things, things to consider at the entry of a new lease, the process for exercise, overholding periods and what to expect at the expiry of the lease.

In Part 2, we'll be going through a case study involving the renewal of a lease.

23:12
It's a retail lease.

Thank you again, Joel, for being part of this part. I look forward to Parts 2 and 3 of this series.

Thanks, Andrew.