Commercial lease pitfalls: four key issues you need to understand

Commercial lease pitfalls: four key issues you need to understand

The pandemic battered economies around the world in 2020, and New Zealand was no exception. Many businesses downsized or even closed, and shops in many commercial areas once again displayed‘For lease’signs.

Yet a crisis can spell danger for some and opportunity for others. If you are considering letting or renting commercial premises, make sure you fully understand the following before signing:

• What exactly is a lease?
• What hidden issues lie within lease negotiations?
• From a legal perspective, can you withhold rent?
• How can you make full use of government relief schemes during the pandemic?

What do we need to discuss when we talk about leases？

Starting a business and renting premises is exciting, but before signing, make sure you fully understand the lease itself. In New Zealand, most leases use the standard Auckland District Law Society (ADLS) form. Generally, signing a lease involves two steps:

• First, sign an Agreement to Lease. This agreement contains the basic commercial terms, such as rent, the lease term, renewal rights and rights to increase rent, and runs to 8 pages.
• Next, sign a Deed of Lease. The deed must contain core commercial terms and additional clauses that exactly match the Agreement to Lease, but sets out both parties’ responsibilities and day-to-day requirements in greater detail than the agreement. Note that clause 1 of the standard Agreement to Lease provides that, once both parties have signed the agreement, the terms of the deed bind both landlord and tenant, even if the Deed of Lease has not yet been signed.

It is particularly important to stress that many tenants think they are only signing an expression of intent when they sign an Agreement to Lease, and therefore do not need a lawyer. This is a serious misconception. We recommend consulting a lawyer before signing an Agreement to Lease, or even when you first begin discussing the lease’s terms with the other party. If you wait until the agreement has been signed and you are preparing to sign the deed, it becomes difficult for a lawyer to negotiate lease terms on your behalf.

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What should you consider during lease negotiations?

Think lease negotiations are only about the rent? Then the lease you sign is bound to be full of pitfalls. Negotiating carefully, conducting due diligence, clarifying the relevant terms and securing the best possible price are the foundations of a reasonable lease.

So what do you need to understand and consider during lease negotiations? Here are some points for reference:

1. Basic lease information

Are the lease’s core commercial details complete and consistent with your understanding?

      A sound lease must first ensure both parties clearly understand the basic details, including:

• The names of the landlord and tenant, and the guarantor’s details;
• The address of the premises, a description of the leased area, rent, car park numbers, floor plans and similar details;
• Rent and other outgoings payable by the tenant, rights to increase rent and how increases are calculated;
• The lease term, renewal intervals and total possible lease duration;
• The permitted use of the premises and other relevant details.

 These details may seem simple, but they form the foundation of the contract and are among the areas most prone to ambiguity and problems:

We once had a hospitality client whose lease did not clearly describe the leased area. They later had to pay an additional amount to rent an outdoor area that had not been included in the original description. Car parking disputes are also common. We recommend clearly describing all parking arrangements, whether the spaces are allocated or shared with other tenants in the building.

1. Lease due diligence

If you are a tenant, make sure you do your homework before signing. For example:

• Can you operate your intended business from the premises? Do you need resource consent or building consent from the relevant authority? If you want to open a liquor store, for example, you should investigate liquor licensing requirements beforehand.
• Will the landlord provide a cash contribution towards your fit-out (a landlord’s fitout contribution)? If so, when will it be paid, what conditions apply, and when will it be made available? What are the tax implications for the tenant receiving these contributions?
• If the building is older, does it meet earthquake requirements and is it structurally sound? Have you thoroughly inspected the premises’ structural condition and surrounding environment?
• Do you understand the competitive environment in the area? If many nearby shops have suddenly become available for lease, is there a particular reason?

There are too many due diligence matters to list individually. Consider every potentially relevant factor in light of the particular premises. Also, if your decision to lease depends on certain prerequisites being met—for example, obtaining a liquor licence for a proposed liquor store—these should be included in the contract as special conditions.

If you are a landlord, we also recommend doing your homework before signing. For example:

• Check the tenant’s assets and liabilities. If the tenant is a company, you can request financial statements and evidence of available funds to demonstrate its ability to pay the rent.
• Establish which routine maintenance costs can be passed on to the tenant.
• Specify in the lease any tenant activities requiring the landlord’s approval, such as whether fit-out plans need approval.
• If you own several properties in the same building, check your existing leases with other tenants for restrictive clauses, such as non-competition clauses, which may prevent you from leasing to certain types of tenants.
• If the premises are subject to property management rules, provide these to prospective tenants, as some rules restrict the uses for which premises can be leased.

1. Lease terms and renewals

The length of a lease is a commercial decision that the landlord and tenant need to agree on.

The initial term usually ranges from 2 to 8 years. Some leases include renewal rights. For example, an initial 5-year term may allow the tenant to choose to renew for 3 years at a time, with two renewals available. The maximum lease duration would therefore be 5 + 3 + 3 = 11 years.

First-time tenants should note that once a lease term begins, their obligations continue until that term expires. For example, if the initial term is 5 years and the tenant wants to leave after 4 years, the landlord can require them to continue paying rent until the 5-year term ends. The same applies during a renewal term.

The right to decide whether to renew rests with the tenant. This means that throughout the maximum 11-year lease period, the landlord cannot take back the premises and refuse to lease them if the tenant wishes to stay and has not breached the lease.

1. Redevelopment clauses

Given the lease term and renewal issues discussed above, landlords should bear this in mind: if your premises have development potential, or you intend to develop and sell them in future, we strongly recommend including a redevelopment clause when negotiating the lease.

A redevelopment clause gives the landlord the ability to take back the premises for alterations or development when the time is right, without having to pay compensation for breach of contract. Naturally, this presents a relatively high risk for the tenant, as the landlord can cancel the lease at any time, increasing uncertainty.

These negotiations can therefore be handled by the parties’ lawyers, who can help identify a reasonable point at which the redevelopment clause may be invoked—for example, allowing the right to be exercised only after the initial term ends.

1. Types of lease security and how they differ

We increasingly see landlords requiring tenants to provide various forms of security when signing a lease. The three common types are personal guarantees, bank guarantees and cash deposits.

• If the lease is signed in a company’s name, landlords generally require the company’s legal representative or a shareholder with sufficient assets to provide a personal guarantee. This means that if the company fails to fulfil its obligations as tenant—for example, it falls behind on rent and cannot repay it—the landlord can require the guarantor to meet their guarantee obligations and repay the company’s debt. Before accepting a personal guarantee, the landlord should also investigate the guarantor’s personal assets. Do they hold actual assets to support the guarantee? Where there are 2 or more guarantors, the landlord can choose to pursue them jointly or pursue particular individuals. Note that liability under a personal guarantee is unlimited: the guarantor’s liability matches the tenant company’s liability under the lease.

• Another common form of security is a bank guarantee, also generally called a bank deposit. The secured amount may equal several months’ rent, commonly 3 to 6 months, depending on the landlord’s requirements. The tenant must apply to a local bank, and generally provide collateral or cash before the bank issues the guarantee document. Once the guarantee is approved, if the tenant falls behind on rent, the landlord can require the guaranteeing bank to fulfil its obligations and repay the arrears.

• Often, a tenant company is newly established and a bank cannot provide a guarantee. In these cases, the landlord will generally accept a cash deposit of equivalent value. The deposit is usually held in a lawyer’s trust account and returned when the lease expires, with relevant provisions included in the lease.

When negotiating a lease, landlords should carefully consider how effective the security will be in practice. Do you understand the guarantor’s personal asset position? Are their major assets held personally or in a trust? Will recovery be straightforward if a problem arises? Tenants providing a personal guarantee for a company should exercise great care and clearly understand whom they are guaranteeing and what obligations they are taking on.

Can tenants end a lease? What are the consequences of rent arrears?

Recently, many industries have been severely affected by the COVID-19 pandemic, and some shops even face closure. This has led some people to consider whether they can end their lease with the landlord, or defer rent payments until their cash flow improves. You therefore need to understand the legal responsibilities associated with rent arrears.

A Landlords can cancel a lease for unpaid rent, putting the tenant’s business at risk of interruption

For tenants: under the lease, the tenant must pay the agreed rent on time in accordance with its terms. Tenants cannot refuse to pay rent。

 For landlords: New Zealand’s Property Law Act 2007 requires a landlord to give the tenant written notice before cancelling a lease where rent arrears constitute a breach.

Section 245 of the Property Law Act provides that a landlord may cancel a lease when all three of the following conditions are met: 1) the landlord gives the tenant written legally compliant notice of cancellation; 2) the tenant still fails to pay the rent arrears within the specified remedy period; 3) the rent has been overdue for more than 10 working days.

Several points deserve particular attention:

• Because of the COVID-19 pandemic, the law has temporarily extended the original 10-working-day period to 30 working days.
• Written cancellation notices must meet specific requirements and follow a particular format, and must be drafted by a lawyer.
• Giving notice and allowing time to remedy the breach can happen concurrently. Contrary to a common misconception, landlords do not have to wait until rent has been overdue for more than 30 working days before issuing written notice. We advise landlords to seek legal advice immediately if a tenant falls behind on rent or repeatedly pays late.

B Landlords can pursue losses through legal action, potentially leading to the tenant’s bankruptcy

As discussed earlier, even if tenants leave the premises before the lease term expires, they remain legally liable for rent until expiry and related costs, such as the landlord’s costs of reletting the premises.

If the tenant fails to meet their obligations, the landlord can pursue the guarantor or call on the bank guarantee. If the bank guarantee does not cover the losses, the landlord can still pursue the tenant or guarantor for the balance.

A landlord can also issue a written statutory demand to a tenant with rent arrears. If the tenant still fails to pay within the specified period, the landlord can commence proceedings seeking a court judgment. Outcomes may include recovery of the rent owed or requiring the tenant to enter bankruptcy proceedings. Requiring a financially sound guarantor or a deposit when signing the lease can help reduce the landlord’s losses.

However, note that if the tenant’s goods remain on the premises, the landlord cannot sell them to offset unpaid rent.

If the landlord changes the locks, the tenant’s goods must be stored somewhere safe.

We recommend that both parties address rent arrears proactively and promptly.

Do not wait until the problem becomes serious or the amount owed grows before dealing with it. Court proceedings are usually a last resort for both parties, given the legal costs and the time and effort involved in lengthy proceedings.

Of course, if communication cannot resolve the dispute, going to court can at least provide an impartial judgment.

Has the New Zealand Government introduced policies to address the pandemic’s impact?

During the pandemic, landlords and tenants each have their own positions and financial burdens to bear. Tenants lose their income when their businesses cannot open, while landlords without rental income lose the ability to repay their loans.

So has the Government introduced measures to help landlords and tenants through these difficulties?

Many people do not realise that clause 27.5 of New Zealand’s standard ADLS contract, the 2012 edition, provides that where an emergency, such as the COVID-19 pandemic, prevents tenants from accessing their premises to fully conduct business, they need pay only a fair proportion of the rent.

However, because the clause does not define a ‘fair proportion’, some tenants and landlords have been unable to reach agreement.

Beyond fair-proportion rent, the New Zealand Government’s pandemic response policies fall into two main areas:

• On 16 May, the Government first introduced temporary legal changes, principally extending the lease cancellation notice period from 10 to 30 working days, to give tenants more time to repay rent arrears or negotiate with their landlords.
• On 4 June, the Government introduced an amendment bill to the Property Law Act 2007 to support small landlords and local businesses through these difficulties. The bill stated that, where a tenant’s business was affected by the COVID-19 pandemic, the landlord and tenant must negotiate and agree on a fair proportion of rent. If they could not agree, they would need to use the designated arbitration process. The New Zealand Government would provide a legal assistance subsidy of NZ$6000 per case, covering approximately 75% of arbitration costs. Total funding available nationwide was NZ$40,000,000. However, parties engaging lawyers would still have to pay their own legal fees.

Currently, only businesses meeting the eligibility criteria can receive government arbitration support. The criteria are: the business has 20 or fewer full-time staff at each leased site; it operates in New Zealand; and it has not already reached a rent reduction agreement with its landlord.

For more information about the commercial lease arbitration subsidy, visit https://www.justice.govt.nz/about/news-and-media/covid-19-news/guidance-for-commercial-property-settlements/

We strongly recommend that both parties consider matters thoroughly when signing a commercial lease, reducing commercial and legal risks from the outset and avoiding unnecessary litigation later.

As lawyers, we believe that whether our clients are landlords or tenants, each has commercial interests to protect and pursue. At the same time, each should clearly understand their legal responsibilities.

In the current economic difficulties, our approach to lease disputes is for both parties to understand their legal responsibilities and find a practical solution with their long-term business relationship in mind.

About the authors:

Joy Yuan is a lawyer admitted to the High Court of New Zealand and a principal at Turner Hopkins. She holds degrees in law and management, and an MBA specialising in entrepreneurship from Babson College in Boston. Her expertise covers commercial law, including company structuring, shareholder agreements and establishing trusts, as well as property law, including subdivisions and property transactions.

Elaine Li is a legal executive in Turner Hopkins’ commercial property team. Her work includes commercial lending, business sales and purchases, shareholding changes, commercial leases, residential, apartment and commercial property sales and purchases, subdivisions, and changes to easements and title registrations. She also assists the firm’s partners with employment matters and commercial disputes.