Commercial Leases (Part 2): Case Study on Exercising an Option

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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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This is Part 2 of a three-part series concerning terms, options and the expiration of leases.

I'm with Joel Garrett.

Welcome back to the show, Joel.

Thanks, Andrew.

In this part of the series, we'll be delving into a case study which will flesh out some of the principles we talked about in Part 1.

0:33
Joel, what have you got for us?

So I thought it would be useful just to sort of run through a scenario where a retail lease is approaching expiry of its lease term and we're acting as a tenant who is seeking to exercise its option for a further term.

Great. So retail lease, it's regulated, as we talked about in the first part. They've been running their business, getting towards the end of the lease.

0:56
They need some advice, you know, thinking about what they do.

What would you tell them? What's the steps involved?

So firstly, obviously I'd check if it was a retail lease or a non-retail lease.

So this one's a retail one, and first thing I'd tell them is that you're safe. You can't be kicked out even if the lease gets to the end.

1:13
What needs to happen is a landlord needs to give the tenant a specific notice, which is under section 28 of the Retail Leases Act.

I ran through what needs to be on there. But quickly again, the landlord needs to write to them, give the date by which the option to renew the lease can be exercised, the rent, their proposed rent for the first 12 months of the renewed lease.

1:33
And that will be subject to if there's a fixed increase or a proposed market rent review. Often it's a market review.

The tenant's availability for the early rent review of the proposed rent that the landlord's giving, the availability of a cooling-off period for if it exercises its option, it can sort of retract that, and give the tenant any changes to its most recent disclosure statement.

1:56
A few questions. Just with that early rent review and the cooling-off period, is that something that depends on what's in the initial lease or is that like a flexible point at that point in time about the ability to have a cooling-off period and the early rent review?

2:11
Those are legislative rights that a tenant has.

So yeah, the Retail Leases Act seeks to protect tenants as much as possible. If they've agreed to a specific rent or something and they decide two weeks later maybe this isn't going to work out for me or this space is no longer suitable, they can sort of pull the pin and withdraw their exercise.

2:32
Yeah, gotcha. Yep.

So it's notification of their rights under the Act, essentially.

Yep, because a lot of people don't. Yeah, most tenants wouldn't know what their rights under legislation are.

So that's why the notice exists, to just make sure that everyone knows what they can and can't do.

I think you mentioned in the previous part if that notice wasn't issued, the lease sort of carries on until such time as they do the notice, and then all the dates are extended out as well at that point.

2:59
Yeah. So it needs to be issued at least three months before the latest date that the option can be exercised.

If the landlord is two months behind that schedule, then the lease will just extend by two months on the same terms and conditions as the initial term.

3:16
So the tenant just has security that if the landlord doesn't comply with its obligations and provide that notice, it has the benefit of that lease just indefinitely until that notice is provided by the landlord.

And Joel, you've mentioned it has to be done at least three months before.

3:31
Is there any, like is there a window or is it just at least three months before?

At least three months before.

So most leases generally say the window to exercise its option will be between three to six months before the expiry.

So a notice by the landlord will generally be given in that three to six month window.

3:51
That's a negotiable point. It can be six to nine, nine to 12 months.

I think from a tenant's perspective, it's better to have that exercise closer to the expiry date.

Things can change a lot for a business in six months.

So if you're required to exercise your option nine months or even 12 months before the expiry of the lease, you're sort of locking yourself into something way in advance than what is really beneficial for you.

4:15
So the closer it is, if you're negotiating a new lease, you want that last date of exercise of your option to be as close to the expiry of the lease as possible.

Yeah, makes sense.

With the rent point, I know in your notes you've got talking about, you know, market rents, and you did mention that there can be fixed increases.

4:34
What options do you normally see? How common is market versus fixed increases in the rent under the options?

I would say 95% of leases probably have a market rent review at the exercise of a further option.

There'd likely be fixed reviews or CPI increases annually on the anniversary of the lease date.

4:55
But when you're exercising an option, a landlord by nature, property prices go up, rent prices go up.

That might go up faster than your agreed fixed increases throughout the term.

So a market review is usually a good opportunity for a landlord to ensure that they're getting the maximum or appropriate amount of rent for the next however many years that further term would be.

5:19
Makes sense.

All right, so then moving on to the point about that notice is issued or landlord's thinking about that notice, how do they determine what is market?

Yeah, there's no real prescribed requirements for that proposed rent.

Often landlords might just keep it simple and if a 4% increase is being applied throughout the term, they might just apply a 4% increase again and just propose that.

5:43
So when it says their proposed market rent, it doesn't necessarily require them to come to a market rent analysis.

It's basically just what they think is an appropriate rent for the next further term or starting rent for the next further term.

If the landlord thought the rent was way lower than it should be, I'd recommend getting an appraisal or valuation done just to present that to the tenant as well, just so you have some sort of substantiating reason for demanding higher rent.

6:13
But there's no real necessary or required process for a landlord to go through.

And then in terms of the tenant's rights, once that's proposed, what do they look like?

Yeah. So once that landlord, once that notice has been sent by the landlord, the tenant has 28 days to consider its options.

6:31
If they don't agree with the market rent in that 28-day window, they need to write to the landlord stating that it's not agreed and requesting what's called an early market rent review.

In that correspondence, the tenant would probably propose their own rent that they think is a more appropriate reflection of what market rent is.

6:50
Hopefully at that point the parties can just come together, come to an agreement or a compromised market rent and move on.

But it's not uncommon for that issue to escalate to a full-blown rent review dispute.

If that does happen, the parties are encouraged to try and jointly appoint an independent valuer to go and attend the premises, do an inspection and complete a revaluation report on what they believe the market rent to be, and that will bind the parties to the rent for the further term.

7:25
But if the parties are so far apart they can't even agree on a joint independent valuer, then either party can submit an application to the Victorian Small Business Commission to appoint a valuer on the parties' behalf.

I guess it's really in their interest to try to resolve it, depending on how far away the parties are, of course, from the figures.

7:46
Yeah, it's definitely beneficial depending on what's at stake.

If it's a small premises and you're talking about the difference of a couple of thousand dollars per year, the cost of appointing a valuer is going to be more than that anyway.

So you kind of need to weigh up, is it worth having the battle just to have sort of a moral victory, or are you just going to suck it up, take a proposed increase rather than pay a valuer who might even come back and have an even higher amount, or it might be the same and then you've spent money on nothing.

8:15
It really depends on the size of your lease, how much is at stake and then the costs.

If you want to, a tenant or a landlord can apply to the VSBC themselves, but often a lawyer will get involved to help with that process.

And then there's those additional costs as well.

So it's in everyone's best interest to try and be amicable.

8:33
Whether it's the parties agreeing on a mutually appointed valuer or the VSBC doing it on their behalf, at the end of the day, there is going to be a valuer that comes up with the determination of what the rent will be.

Yeah, the VSBC process can take a bit of time, so there's often a delay in getting them to action these requests.

8:56
It can take a month or something just to appoint the valuer, and that just drags out this whole process. It's painful for both the landlord and the tenant.

That raises a good question.

I mean, if time's moving as this stuff is done, how does that affect tenants' rights to renew?

9:12
Do they need to, like, are they moved as well or do they need to lock it in and you have the argy-bargy over what the figure is?

Yeah, that's a good question.

They'll keep paying rent at the old amount during this whole process, and it's kind of just frozen in time until this determination is completed.

9:31
The valuer is under legislation required to finalise its determination within 45 days of appointment, which is a pretty long time because just think about it, the landlord issues its notice, the tenant has 28 days to object to that.

So that's a whole month gone.

9:48
They might spend another few weeks debating over a valuer. That's nearly two months, and then this valuer has another month and a half to get its determination through.

So it's just a constant. I did one of these disputes a couple of years ago and the second year of the further term had already started by the time we determined what the rent for that would be.

10:09
So it's painful if you can't agree on the market rent.

But once the determination has been provided by the valuer, the tenant then has 14 days to decide if they want to exercise that option at the new market rent that's been determined by that valuer.

10:27
Or if they don't want to, then the lease is extended by a further three months after those 14 days, and that's when the new end date of the lease will be.

So then they'll start preparing for their make-good and reinstatement obligations.

Okay. So if you're in a retail lease, essentially you don't have to commit to the new term until that process is actually done, of course.

10:51
And then you can decide whether to commit or not, although sometimes, as you said in your example, you might have overheld for quite a while at that point.

It can always be a tool. Like if the tenant wants to stay there for a bit and just sort of tidy up its business or it's looking for another premises, it could potentially use this process to just keep there for a while.

11:12
In the background, they might not want to really proceed or stay on at that place.

So it's a bit of a stalling mechanism.

Yeah. I haven't seen that actually happen, but it could.

And then once it's all done, the parties agreed to exercise, that would be done through a formal sort of contract or deed?

11:34
Yeah. Well, I probably should also mention that these determinations, while they're binding on the parties, there are ways that they can be set aside as well.

I think I'll discuss that a bit more in the next series, but while it's binding, they use the word in the legislation, they can be set aside if there's been some manifest errors made by the valuer coming to a conclusion.

11:58
So that's kind of the third option.

You can accept the determination, take your renewal, accept the determination, say no thanks and you get out in three months.

Or you can reject it and think about setting it aside.

But if finalising the new further term, we'd always recommend entering into a deed of renewal of lease just to formalise that process.

12:21
Obviously, if you write to the landlord, exercise your option and agree to that further term, you've made a binding contract in the extension of the lease.

But just for record-keeping purposes and just making sure that there's no misunderstanding on what terms that renewal has been agreed, we really highly recommend entering into a deed of renewal just to formalise that.

12:40
And then the other terms, if anything's changing at that point.

It's also a good opportunity. So if you've got a lease and this is sort of the final option under that lease, if you have intentions to want to stay on that premises beyond that next three, five-year term, whatever it is that you're exercising your option for, I always recommend clients to use the renewal process as an opportunity to negotiate an additional further term.

13:08
It just gives a bit more bit of comfort.

Yeah, add an extra one on.

Yeah. Without that, the landlord has way more leverage to demand different things.

If they want more rent or more maintenance obligations or something, if they are negotiating a new lease, they have a lot more scope to be able to demand those things.

13:25
But if you have a further term, the lease will just continue on the same terms and conditions as the existing term was.

That makes sense.

Well, that's a good analysis of a case study involving the renewal process for a retail lease.

13:43
That's been Part 2 of this series. In Part 3, we'll be talking about some specific issues within this context of terms, expiry of leases and negotiating those things.

Thanks once again, Joel, for being part of this part. I look forward to Part 3 of this series.

13:59
Thanks, Andrew.