Sound Leases - A key element to creating value in your business
There comes a time when a business owner has to negotiate a lease. And you only get one chance to get this right, because once it’s signed, “That’s it!”
Typically. in the course of your business activities you might have to; negotiate a new lease, assign a lease to a buyer of the business, or take-on an assignment of a lease when purchasing a business.
We have all heard the horror stories, however, most can be avoided with clear thinking and good legal and commercial advice.
So, why would you want a lease? A lease gives you the right to carry on your business in a location and a legal interest in the property for the term of the lease. It gives you the right to trade and most importantly- security.
Profitability is a function of your skill as a business owner and marketer and your accumulated customer base that drives your turnover. When it comes to buying or selling a business, continued access to these established customers is a critical factor in the valuation. It’s a large part of the difference between the cost of starting a business from scratch and the buying price of an established business.
When buying, selling or renewing, the terms of your lease will determine your right and cost of access to these valuable customers. A secure lease, reasonable rent and outgoings will be generally regarded as a valuable business asset. A good lease creates a real value when selling retail businesses. And conversely, a poor lease can devalue what is otherwise a good business. It is important that you read the lease documents carefully and ensure you understand what each clause meant to you and your businesses.
Don’t leave it to someone else. Lease terms vary widely as they are regulated by state and local law – assume nothing, read everything. Buying a leasehold business or starting up a leasehold business is a big financial decision. Legal advice is very important but ensure your solicitor deals with retail and commercial leases on a regular basis. After all, you don’t ask your GP for advice on your toothache, you ask your dentist.
Reviewing a lease
In my experience, when reviewing leases attention should be given to those areas that affect.
Security of Tenure
Ongoing liability of a Business Seller
Base rent payable under the lease: The amount payable annually is generally fixed, so you at least know how much you will pay for the particular year in question.
Basis for rent adjustments: Rent is commonly increased in line with the CPI each year. Fixed percentage of increases such as 5% to 7% are common in shopping centres. Increases compound each year, so keep that in mind.
Turnover Rent: In some leases there are percentage rental clauses. These clauses usually state the minimum weekly turnover. Above this value, the rent is calculated on a percentage of turnover rather than base rental. It is rare to see this enforced, as the threshold value is usually quite high.
Rent Reviews: It is common to have a rent review at the end of each term of the lease. For example, if you have a three year lease with a three year option, at the end of the first three years the rent can be adjusted to match the rate that is paid by the other retailers in the area. Make sure you know the market rates and are prepared to pay market rent if you have to.
Outgoing/charges: Make sure you know what and how much you have to pay and what they cover. They may cover body corporate fees building insurances, etc.
Electricity Charges: Ask whether your electricity consumption will be charged by the landlord or whether you will have your own account directly with the supplier.
Repairs and Maintenance contributions: Establish your obligations as a tenant.
Break down of Landlord’s equipment: For example, if the landlord owns the compressor that runs your cold room it is reasonable that you are required, to service it. Do you have to put a service agreement in place with a service company to service the landlord’s equipment? What happens if it blows up who pays? - Read your lease.
Cleaning contributions: Are there any required? Who pays for what?
Re-fit clauses: Is there a re-fit clause in the lease? If so when will it need to be done, who can complete such works and who will approve the works? Ask how much is the average spent in the centre on re-fit. You may be surprised. (I currently have a client who is paying $200,000 that is more than two years rent and he has to do it to get a new lease).
Security of Tenure:
Term of your lease: If you are sure that the business will remain profitable for many years the objective is to have a long lease that will increase the net worth of the business from a resale perspective. Banks look favourably at long leases. A short term lease would only be considered if you weren’t sure that the business was going to survive and you could exit the lease at the end of the first term and cut your losses.
The Period remaining of that term: You will need to look at the end date of the term so you know how long is left on the lease.
Whether the lease contains any tenants options to renew: Sadly, few new leases in major business districts contain tenants options periods. This trend appears to have occurred to meet the landlords’ interests.
A lease without tenants options allows the landlord to negotiate from a position of strength, especially if you are at the end of your lease. You either sign a new lease on the landlord’s terms or you move your business. The cost to move your business, reinstate the landlords property back to its original condition (a clean shell in most cases), and to set up somewhere else is expensive and can result in loss of customers and new business risks.
I had a call from Steve. He wanted to sell his business. Steve had bought the retail business two years earlier for $750,000+stock. At the time the business had two years remaining on a five-year lease.
Steve’s purchase contract was subject to a lease extension of an additional five years, but while in a meeting at the time of purchase, the centre manager disclosed that they would not be in a position to renew the lease until it expired in two years time.
Steve really wanted the business and asked if the centre manager could give them some sort of assurance that a new lease would be offered. The manager of the centre delivered a letter stating that if the rent was paid on time and that the business performed inside the requirements of the lease that they would offer a new lease. (This is often known as a Comfort Letter). On the strength of this letter, Steve bought the business.
When Steve called me (wanting to sell the business) he had a new lease offer from centre management. It had a five-year term, rent had been increased by 20% and a demolition clause had been inserted so he would have to vacate with six months notice at any time in the term.
Steve asked me what his business would be worth. It was difficult to tell him, that his business was unsellable due the proposed lease agreement. The business was now a liability as opposed to an asset.
The moral of the story here is that a good secure lease increases the value of your business.
Demolition clauses: Ask whether the lease contains a demolition clause. If a lease provides for demolition the landlord generally must give written notice to the tenant advising that the landlord has elected to terminate the lease. The period of the notice will differ from jurisdiction to jurisdiction and according to the lease terms. If a lease contains a demolition clause, you need to carefully consider the impact such a clause would have on you and your business if the landlord exercised his or her rights under it and whether or not you are entitled to claim compensation from the landlord.
Relocation clauses: A relocation clause allows the landlord to relocate a tenant to different premises. Relocation clauses are, in my experience, common in retail shopping centre leases. If the landlord wishes to relocate the tenant, the lease will provide for the landlord to give the tenant notice about the relocations. The minimum period of the notice will differ between jurisdictions. The lease will specify the actual period and compensation if any. Relocation costs can be significant and include removal of fixtures and fittings, replacing fixtures and fittings, legal costs, etc.
Lessors right to terminate: The landlord rights to terminate are usually set out in some detail in your lease agreement. Common reasons are a breach by the tenant such as not paying rent, outgoings, or trading unlawfully.
Lessees right to terminate: The tenant’s right to terminate is largely dependent on the terms of each individual lease but generally speaking, the right of a tenant to terminate will be very limited. It may be limited to where the property can no longer be occupied because of fire or flood.
Council approval: Enquiries with a town planner, local council, or safe foods authority should be made to ensure that your intended use of the property is and will be lawful. I recently met a business owner who had bought a business that was shut down by council three months after he paid for it because the property was in an area that didn’t have the correct zoning.
Liability: It is also important to establish the ongoing liability of the previous business owner or tenant regarding the lease. It is common practice for leases to contain a covenant that maintains the original Lessee’s liability for performance after a business is sold for the duration of the initial lease term, some state governments have enforced new legislation that helps a new tenant, best to ask your solicitor to be sure. It is also prudent to establish where possible the history of the lessor’s performance as a landlord.