Signing a Commercial Lease in NSW: Five Clauses That Catch Tenants Out

Introduction

Most tenants sign a commercial lease and only read it carefully when something goes wrong. By then the worst clauses have already taken effect and there is little that can be done. Here are the five clauses that most often surprise tenants after they sign and what to do about them before you do.

Why Commercial Leases Need More Attention Than You Think

A commercial lease is typically the second largest financial commitment a small business makes, after employing people. It often locks the business in for three, five, or ten years, with a personal guarantee behind it that can follow the directors home if the business fails.

Yet commercial leases are regularly signed with less scrutiny than the average residential tenancy agreement. Landlords present a heads of agreement, solicitors push for signing before an opportunity is lost, and the detail of the actual lease gets glossed over.

Five clauses account for the majority of the problems we see after the fact. Knowing how they work before you sign is the difference between a productive tenancy and a commercial disaster.

Trap One — Make Good Clauses

The make good obligation is the single biggest surprise at the end of a commercial lease. It is the clause that requires the tenant to return the premises to their original condition at lease end. Depending on how it is drafted, that obligation can range from repainting the walls to demolishing a fit-out and restoring the shell to its original structural state.

Make good costs can easily run into the tens of thousands of dollars. For larger premises they regularly exceed one hundred thousand. Tenants who have never thought about the clause often sign contracts where the landlord can insist on a complete strip out even if they would rather leave the fit-out in place for the next tenant.

What to negotiate. Define the original condition clearly. Attach photographs or a condition report as an annexure to the lease. Agree that certain fit-out items can be left in place if the landlord does not object. Consider a capped make good amount rather than an open-ended obligation. If significant works are expected at the start of the lease, negotiate a make good bond or a rent reduction to compensate for the eventual cost.

Trap Two — Outgoings and Variable Costs

The rent number on the front page of a commercial lease is rarely the full cost of occupancy. Most commercial leases pass through a range of building expenses to the tenant. These are called outgoings, and they typically include:

• Council rates
• Water rates
• Land tax
• Building insurance
• Strata levies
• Air conditioning maintenance
• Cleaning and security
• Management fees

Individually these items can seem modest. Together they often add 20 to 40 percent to the headline rent. And unlike the rent, they are not fixed. Council rates rise. Insurance premiums jump. Strata levies can spike if a major repair is required.

Retail leases have some protection under the Retail Leases Act 1994 (NSW), including a requirement for annual written estimates of outgoings and limits on certain types of costs that can be passed through. Non-retail commercial leases have no equivalent statutory cap.

What to negotiate. Insist on a full schedule of current and forecast outgoings before signing. Exclude capital expenditure from the outgoings the tenant has to contribute to. Cap the annual increase in outgoings or exclude specific large items. If the premises are within a strata scheme, ask for recent strata reports so you understand the state of the common property and any planned major works.

Trap Three — Personal Guarantees

Most commercial leases granted to a company require one or more directors to provide a personal guarantee. The guarantee means that if the company defaults, the landlord can pursue the individual directors for the outstanding obligations, including unpaid rent, outgoings, make good costs, and damages for early termination.

This is where a lease failure can become a personal disaster. If a business goes under two years into a five-year lease, the remaining three years of rent plus make good plus outgoings can amount to hundreds of thousands of dollars. A personal guarantee transfers that liability from the company to the director personally, and the director's home is often the asset the landlord pursues.

Many directors do not realise this until the guarantee is called on. Directors of family companies have found themselves personally bankrupt over a business failure they thought was ring-fenced behind the company structure.

What to negotiate. Cap the guarantee at a defined dollar amount or a defined time period. Limit it to rent and outgoings only, rather than the full suite of damages the landlord could otherwise claim. Ask for a release of the guarantee once the tenant has demonstrated a strong payment history. Consider a bank guarantee or larger security deposit as an alternative to a personal guarantee. Never sign a guarantee without understanding the maximum exposure it creates.

Trap Four — Assignment and Sub-Letting Restrictions

Businesses change. The tenant that signs a lease in year one may not be the tenant that wants to occupy the premises in year four. The clauses that govern assignment (transferring the lease to someone else) and sub-letting (letting part of the premises to another party) determine whether that flexibility exists.

The standard position in most commercial leases is that assignment and sub-letting require the landlord's consent. The question is what conditions can be attached to that consent and whether it can be refused.

Restrictive assignment clauses become a real problem when the tenant wants to sell the business. A purchaser will typically want to take over the lease as part of the sale. If the landlord refuses consent or imposes onerous conditions, the sale can collapse or the sale price can drop significantly. In some cases the tenant ends up unable to exit the lease at all, despite having a willing buyer.

What to negotiate. Ensure the lease says consent to assignment cannot be unreasonably withheld. Define the criteria the landlord can take into account. Exclude certain grounds of refusal, such as the proposed assignee operating a different but still reputable business. If sub-letting is commercially important, negotiate specific carve-outs for common scenarios such as sub-letting to related entities.

Trap Five — The Retail Leases Act 1994 Disclosure Statement

The Retail Leases Act 1994 (NSW) applies to most leases of retail premises, which the Act defines by reference to specific business categories rather than by the look of the premises. Many tenants and some landlords do not realise their lease falls within the Act. When it does, a failure to comply with its requirements can have significant consequences.

One of the most important requirements is the disclosure statement. The landlord must provide a written disclosure statement to the tenant at least seven days before the lease is entered into. The disclosure statement must contain specific information about the premises, the rent, the outgoings, and the building.

If the landlord fails to provide a disclosure statement, or provides one that is materially inaccurate or incomplete, the tenant may be entitled to terminate the lease or seek compensation. The Act also voids certain clauses that purport to shift particular costs onto the tenant, and limits the outgoings that can be passed through.

What to verify. Check whether the Retail Leases Act applies to your lease. If it does, make sure you have received a disclosure statement in the proper form and at the right time. Compare the disclosure statement to the actual lease for inconsistencies. If the disclosure statement is late, inaccurate, or missing, get legal advice before signing anything further.

Options to Renew and What They Really Mean

Many leases include an option to renew. On paper this gives the tenant the right to extend the lease for a further term, usually on the same conditions with the rent adjusted to market.

In practice, options to renew have traps of their own. The option must usually be exercised within a specific window, and missing the window by even a few days can extinguish the right. The rent on renewal may be subject to a market review that produces a significant increase. Some leases contain clauses that entitle the landlord to refuse renewal if the tenant has been in breach, even for minor historical matters.

Diarise the exercise window the day you sign the lease. Start thinking about the renewal at least twelve months before the option date. Get advice on any market rent review before it is conducted, not after.

Rent Reviews and How They Can Compound

Commercial leases typically include rent reviews during the term. These can be fixed percentage increases, CPI-linked, market reviews, or a combination of these.

Over a five or ten year lease, the cumulative effect of annual increases can be substantial. A fixed four percent annual increase compounds to roughly forty-eight percent over ten years. Market reviews can produce sudden jumps that test a business's ability to absorb them.

Understand the review mechanism before signing. Model the cost of the lease over its full term, not just the first year. If the review is CPI-linked, check whether there is a cap or a floor. If market-linked, understand the process for challenging a review you consider unreasonable.

What to Negotiate Before You Sign

Every clause in a commercial lease is negotiable in theory. In practice, the tenant's negotiating leverage depends on how much the landlord wants the deal and how many alternative tenants are available.

The items most often negotiable, ranked by how often landlords give ground:

• Rent-free period at the start of the lease
• Contribution to fit-out costs
• Cap on annual outgoings increases
• Capped or defined make good obligations
• Personal guarantee cap or time limit
• Clearer assignment consent criteria
• Rent abatement provisions for disruption or inability to trade

You will not get everything. You may not get any of it if the premises are in high demand. But you will not get any of it if you do not ask.

Red Flags That Should Make You Pause

Pressure to sign quickly. A landlord who refuses to allow time for legal review is a landlord who knows the lease has problems.

Open-ended make good obligations. Anything that requires the tenant to return the premises to the landlord's satisfaction without defined standards is effectively a commercial blank cheque.

Unlimited personal guarantees. A guarantee without a dollar cap or time limit can follow directors indefinitely, well past the end of the lease itself.

Vague outgoings definitions. If you cannot tell from the lease what you will be charged for, assume you will be charged for more than you expect.

Unusual termination rights in the landlord's favour. Some leases allow the landlord to terminate for demolition or redevelopment with limited notice. For a business relying on a specific location, this can be fatal.

What Happens If You Sign Without Advice

Tenants who sign without legal advice routinely discover the problems at the worst possible moment. The usual sequence is something like this.

The business does well and outgrows the premises, but the lease has four years to run and the assignment clause is restrictive. Or the business struggles and tries to exit, but the personal guarantee means the director is still on the hook for the remaining term. Or the lease comes to an end and the landlord demands a full strip out that costs more than the last year's profit.

The lease cannot be renegotiated once it is signed. The time to address every one of these issues is before the contract is executed.

The Bottom Line

Commercial leases are dense documents drafted by lawyers on behalf of landlords. They are not neutral. Tenants who sign them without equivalent legal representation are accepting risks they have not been able to evaluate.

The five clauses covered here are the ones that most often cause problems. There are others. The cost of legal review before signing is usually a small fraction of the cost of fixing a problem after the fact, and in many cases it is the difference between a business that thrives at its premises and one that ends up locked into terms it cannot live with.

If you are looking at a new lease, or renewing an existing one, the single best decision you can make is to get the document reviewed before you sign.

Need Expert Guidance

Salbridge Lawyers reviews and negotiates commercial and retail leases for tenants across Sydney and New South Wales. We work with you before you sign to identify and fix the clauses that create the biggest commercial risks.

Contact us at info@salbridgelawyers.com.au or call 02 9033 0495.

This article provides general information only. Every situation is different — seek specific advice for your circumstances.