Heads of Terms for the Grant of a Commercial Lease

Guidance notes for Commercial Lease Heads of Terms

This product constitutes an easily adaptable set of heads of terms pertaining to the grant of a lease in respect of commercial property and will therefore not be suitable for use in relation to a residential property lease.

The purpose of heads of terms is to outline the main commercial aspects of a proposed transaction, in this case the grant of a lease over commercial property. The document outlines points that are essential to the deal or which may be particular to the property being leased.

Given that heads of terms deal with commercial issues, they are often drafted in an even-handed manner and therefore are not worded so as to favour one party or the other. Their purpose is simply to reflect the main elements of the prospective deal. With that said, our product has been drafted on the assumption that the heads of terms will be produced by, or on behalf of, the landlord (as is traditionally the case with the grant of a lease in relation to commercial property).

It is further assumed that the lease will be a headlease (i.e. a lease directly between the landlord and tenant) as opposed to a sublease (i.e. a lease between a tenant and a subtenant). If this is not the case, the heads of terms should refer to the superior landlord’s consent.

The product has been drafted also on the assumption that the landlord and tenant are both companies. The template can be easily adapted to fit the scenario where the landlord/tenant are individuals.

For the avoidance of doubt, this product does not comply with the Code for Leasing Business Premises in England and Wales 2007 (“Lease Code 2007”) and should not be used where the parties intend that the lease should be code-compliant. We would always recommend that you seek professional advice when drafting heads of terms that need to be compliant with the Lease Code 2007.

The exact terms governing a deal will vary from transaction to transaction and so there is not a “one size fits all” in terms of what a heads of terms for the grant of a commercial lease will look like. Our product contains the most material terms that are usually included in heads of terms pertaining to the grant of a commercial lease but will need to be adapted to meet the particularities of any given transaction.

Heads of Terms breakdown

Our product has been drafted on a “subject to contract” basis and the disclaimer at page three makes clear that the heads of terms are not intended to be legally binding and acknowledges that they are not exhaustive.

At page two, the address of the commercial property should be inserted under the ‘Demise’ section (as well as on the cover page).

There is further space for the parties to enter in the landlord and tenant’s details along with the landlord’s solicitor’s details and, if applicable, the details of the landlord’s agent. Centralising this information in the heads of terms ensures that any party involved in the transaction can consult this document and find names and contact information for the main parties should they need to contact them for any reason.

If the landlord does not have an agent acting on its behalf, this section can be removed and a section can be added providing the tenant’s solicitor’s details if necessary/applicable.

Lease Term

This section of the heads of terms makes clear that the lease is a “full repairing and insuring lease”. This means that the tenant will assume responsibility for the costs of repairing and insuring the property being leased from the landlord.

A lease is the grant of a right to the exclusive possession of a specific piece of land for a determinable period of time. This period is commonly referred to as the “term”. Under this section you should insert how long the term of the lease is going to be.

You will notice that the second sentence of this section which reads: “The lease is to be drafted outside of the security provisions of the Landlord and Tenant Act 1954” is contained in square brackets. This is because the landlord may agree to grant the tenant security of tenure or they may not. If the landlord does not wish for the tenant to have security of tenure, then the lease must record this and it is important that the heads of terms make this explicit. This is known as “contracting out” of the security of tenure provisions contained within the Landlord and Tenant Act 1954 (“LTA 1954”).

This is a complex area of law and therefore it will not be explained at length in these guidance notes. Very generally, the security of tenure provisions contained within the LTA 1954 grant the tenant a statutory right to renew its tenancy at the end of the contractual term, with the landlord only being able to oppose the renewal on certain limited grounds. The effect of “contracting out” is as follows:

• The tenant has no right to remain in the property at the end of the lease;
• The tenant must leave the property at the end of the lease unless the landlord chooses to offer a new lease;
• The tenant has no right to compensation from the landlord on leaving the property at the end of the lease; and
• The tenant has no right to ask the court to fix the rent or the terms of the lease if the landlord chooses to offer another lease.

It will therefore be a matter of negotiation between the parties whether or not the security of tenure provisions contained within the LTA 1954 will apply to the lease being granted. Often, the landlord will insist that the parties contract out of the security of tenure provisions in the LTA 1954.

Term Commencement Date

We have included generic wording in this section but the parties may wish to insert a specific date from which the term of the lease will commence.

Rent

In this section, the amount of rent due and payable by the tenant to the landlord per annum under the lease should be stated.

It is also made clear that the rent will be payable on a monthly in advance basis, as is often the case.

If there is to be a rent-free period (i.e. a period of time, usually at the start of the term of a new lease, when no rent is payable) then basic details relating to that period should be elucidated in this section. If there is to be no rent-free period then you can include our wording which is contained within the square brackets.

A rent-free period is often agreed as a concession to the fact that a tenant will rarely be able to gain occupation of premises and immediately begin to operate from them. Therefore, a common reason for granting the tenant a rent-free period is to allow it time to fit out the premises for its use. A landlord may be willing to give a rent-free period for other reasons, such as to:

• Attract a particular tenant;
• Act as inducement in a poor market; and/or
• Encourage tenants to take premises that are proving difficult to let.

Broadly, whether or not the landlord will give the tenant a rent-free period will depend upon the state of the market at the time the lease is granted, the nature of the premises and the identity of the tenant.

As an alternative to a rent-free period, the parties may agree a period of reduced rent at the beginning of the commencement of the term.

Rent Commencement Date

In this section you should insert the date from which the tenant will be obliged to pay the rent amount to the landlord.

Rent Reviews

This section includes generic wording and makes provision for an upward only rent review beginning a certain number of years after the commencement of the term. You should always seek professional advice in respect of how a rent review provision should be worded and how the review should be structured.

An upwards only rent review will never result in the rent payable under the lease reducing (which is advantageous from the landlord’s perspective but disadvantageous from the tenant’s).

Rent Deposit

A rent deposit is a sum of money provided by the tenant to the landlord as security for the payment of the rent and performance of the tenant’s obligations under the lease. Often the parties will enter into a separate rent deposit deed which explains how the landlord secures the tenant’s deposit. This means that the deposit remains the property of the tenant, but if the tenant defaults on the lease (e.g. does not pay the rent) then the landlord can take money out of the deposit.

The rent deposit deed will detail any other circumstances in which the landlord can draw against the deposit and the conditions that must be satisfied in order for the deposit to be repaid to the tenant.

In this section you should insert the number of months rent deposit that will be payable by the tenant to the landlord. As a rule of thumb, rent deposits are generally equivalent to between six and twelve months’ rent due under the lease, but you can often see rent deposits equivalent to as low as three months’ rent due under the lease.

Option to Determine

This section is also known as a “break clause”. A break clause/option to determine can be included in a fixed term lease so as to allow either the landlord or the tenant (or both parties) to terminate the lease early (i.e. before expiry of the term). The right to break/determine may arise on one or more specified dates or it may be exercisable at any time during the term on a rolling basis (how exactly it is to be structured is a matter of negotiation between the parties).

In this section of the heads of terms you can choose to either set a specific date (or dates) at which the lease can be broken/determined by either party or you could make clear that the break clause/option to determine can be exercised by either party at any point during the term (i.e. on a rolling basis).

Repair

This section confirms that the lease is to be drafted on full repairing and insuring terms. This means that the tenant will assume responsibility for the costs of repairing and insuring the property being leased from the landlord.

Service Charge

This section confirms that there is an annual service charge in respect of the general upkeep and maintenance of the building and the common parts of the estate. The service charge will be payable by the tenant.

Inclusion of this section is usually only necessary where the property forms part of a building or is a unit on an estate.

Business Rates & Utilities

Sometimes the ‘Rent’ section of a heads of terms pertaining to the grant of a lease makes clear that the rent will be ‘exclusive of VAT, rates, service charges, insurance premiums and all other outgoings’. The rent section can then make explicitly clear that, in addition to the rent, the tenant must also pay VAT, rates, service charges, insurance premiums and all other outgoings.

Instead of taking this approach, our template deals with payment of any applicable service charges, business rates and utilities in separate sections.

This section of the heads of terms confirms that the tenant will be liable to meet such costs in respect of the premises.

Insurance

This section provides that the landlord will insure the building and that the tenant will be obligated to reimburse the landlord the cost of insuring the building. Importantly, the section also makes clear that the tenant will be responsible for insuring their own contents within the property (so as to eliminate the possibility of the tenant arguing that this was the landlord’s responsibility).

User

The Town and Country Planning (Use Classes) Order 1987 (as amended) (“Use Classes Order”) is a statutory instrument that sets out the various use classes of commercial property. The Use Classes Order also sets out the permitted changes of use which are allowed and in respect of which planning permission does not need to be obtained.

In this section of the heads of terms it should be confirmed how the tenant will use the property and which class type the property is registered under.

For example, if the tenant intends to use the property for industrial use, this section of the heads of terms would read as follows:

“Industrial use, falling within class B1 as described in the Town and Country Planning Act (Use Classes) Order 1987 (as amended)”.

Alterations

The type of alterations that the landlord will permit may often depend on the nature of the property, the extent of control that the landlord wishes to exercise and in particular whether the lease is of the whole or part of a building. The landlord’s ability to restrict the tenant’s rights to carry out alterations is, to a degree, governed by statute via the Landlord and Tenant Act 1927. For example, the ability to put up signs at the property (i.e. on the outside of the property) may be commercially very important for the tenant.

Most leases include provisions restricting alterations to the property. This is because the landlord’s main concern will be to protect the reversionary value of the property. A way that landlords often seek to do this is by preventing tenants making permanent alterations to the leased property that would make the premises difficult to let (or lower its letting value) after the end of the term.

The tenant’s main concern is the ability to have the property configured to its needs. Fitting-out works will often have to be carried out. The tenant will also want sufficient flexibility to adapt the premises in the future, either for itself or for any potential assignee or subtenant (provided the landlord and tenant have agreed that the tenant can assign/sublet the property).

A common restriction is that alterations to the exterior and/or structure of the property are prohibited but non-structural alterations to the interior are allowed, with the landlord’s consent not to be unreasonably withheld. This is the basis on which this section of our heads of terms template has been drafted. Again, this is a complex area of law and so professional advice should always be sought.

Landlord/Tenant Works

If the landlord is planning on carrying out works before the grant of the lease, details relating to such works should be detailed within this section of the heads of terms. If the landlord is not planning to carry out any works before granting the lease to the tenant, then the wording in this section which states “The Landlord will let the demise in the state and condition it is in at the time of completion” will suffice for these purposes.

The heads of terms should also specify whether the tenant intends to carry out any fitting-out works and if so, the nature and extent of such works. If the tenant does intend to complete fitting-out works before occupying the property, a licence for alterations may need to be entered into at the same time as the lease.

In order for the tenant to commence fit-out works, they must first obtain the landlord’s written consent. This section of our template provides that the tenant must also supply the landlord with copies of any drawings, specifications or other relevant information pertaining to the proposed works as soon as possible (so that the landlord can assess the nature and extent of the proposed works).

This section also makes clear that the tenant will be responsible for the cost of any fit-out works.

VAT

This section confirms that the building is not currently elected for VAT.

As a general rule, the sale or lease of a commercial property is exempt from VAT, which means that neither a purchaser nor a tenant would have to pay VAT. This is advantageous from a tenant’s perspective, but not so from a landlord’s viewpoint given that this means they would be unable to recover any VAT incurred on related costs.

There are exceptions to the general rule – for example, where the property involved is ‘new’ (i.e. less than three years old) then VAT at the standard rate (i.e. 20%) will apply.

Commercial property owners/landlords can elect to charge VAT at the standard rate when selling or leasing their property. If they exercise this option, they must charge VAT on all supplies they make relating to that property – but they are also then able to recover VAT charged to them on any costs related to the property. If a landlord wishes to elect to charge VAT, there are certain procedures and restrictions that must be followed and complied with. A landlord may decide to charge VAT where a property has recently been refurbished or renovated, and the landlord is looking to recover the VAT costs associated with such work.

Costs

This section confirms that each party is responsible for their own legal fees incurred as part of the proposed transaction.

If the parties have agreed that one party is to pay the other side’s costs if for some reason the proposed transaction does not proceed to completion, then a separate binding break fee agreement will be needed, given that the heads of terms are not legally binding.

Conditions

Condition one states that the heads of terms are “subject to contract”, which simply means that the heads of terms are not legally binding.

Condition two is included so as to protect the landlord given that the landlord may require the prospective tenant to provide references from previous landlords and accounting information (where the tenant is a company) so the landlord can satisfy itself that the tenant is financially stable enough to pay the rent for the duration of the term.

Condition three is present to protect the tenant, given that prospective tenants must always ensure that their landlord’s lender is aware of the lease, and has consented to it, regardless of the length of the term. This is vitally important given that where lender’s consent was not obtained to the grant of the lease but should have been, the lease will be void against the lender. The lender will consequently be able to sell the property to a third party who will not be bound by the lease and may require the tenant to vacate the property.

Even if the landlord does not default on the charge, if it has not obtained consent when it should have, that may be enough to trigger enforcement action by the lender.