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Smooth Exit?

20 May 2009

Costly and time-consuming legal wrangles about ’wear and tear’ at the termination of a lease or a break point can be avoided, says Greg Kemp, by understanding your obligations as a tenant on exit when you take on the lease.

WITH MANY ORGANISATIONS REVIEWING THEIR commercial workspace requirements in light of the current economic downturn, it’s all too easy to overlook the potential economic impact of dilapidations claims which can often arise on termination of a lease or where a ‘break point’ clause is exercised. ‘Dilapidations’ is a legal term which concerns the tenant’s obligations under the terms of the lease to maintain the property and associated assets, returning it in its original condition on surrender of the lease. This includes not only repairing and decoration of the premises but the operating condition of any installed building systems. It is of particular significance where a full repairing and insuring lease is in place,
which is increasingly the norm for commercial property rental.

When taking over a property or acquiring space in a building, the overriding emphasis tends to be on ensuring the landlord has met their liabilities in providing a modern building environment to the required standards. The conditions surrounding dilapidations on exit are often seen as an insignificant element of any agreement or so far removed as to be way down the list of business priorities.

However, with leases for commercial buildings of anywhere up to 10-15 years not uncommon, a lot can happen to the building fabric and internal systems during the average tenancy period. General ‘wear and tear’ notwithstanding, companies will inevitably also carry out some alterations to accommodate changes in their business and staff turnover, whatever the flexibility built-in to the original accommodation.

Obligations
Understanding your obligations as a tenant is therefore critical. The legal situation surrounding dilapidations claims is intensely complex and there are potentially serious financial consequences where non-compliance is deemed to have occurred, either through inadequate maintenance or alterations carried out. Under a process known as ‘rectification’, tenants may be obliged to reinstate against any one of a schedule of items as detailed in the original lease or to reach appropriate financial settlement with the landlord. Such claims vary enormously in value dependant on the circumstances but can range from a few thousand pounds to several millions and may significantly delay relocation plans until the issues concerned are deemed by the courts to have been satisfactorily resolved.

By taking the appropriate steps when entering into or renegotiating a lease, it is possible for the tenant to minimise greatly their liabilities on exit. Carrying out a condition survey is essential in negotiations to ensure a fair and realistic schedule of dilapidations with no grey areas which may lead to later misunderstandings. It also serves as a permanent benchmark against which to monitor the ongoing condition of scheduled items and subsequent alterations.

Many landlords and tenants make the mistake of focusing primarily on the ‘bricks and mortar’ element when carrying out condition surveys. However, the condition of building systems should not be overlooked when taking on new obligations: disputes relating to M&E services typically account for 40% of the total value of dilapidations claims.

M&E services
M&E installations are particularly important in the context of long building leases as they often have a shorter life expectancy than the building fabric, resulting in a high probability of issues arising sooner rather than later. The situation is complicated by the fact that, unlike the building fabric, potential problems may remain undetected in a normal visual inspection. Where systems failures occur in use due to a preexisting
condition and repair obligations include the liability to renew, companies may be called upon to replace systems in order to restore them to their ‘original’ operating specifications. If an exact replacement is impossible to source due to, for example, product obsolescence or the supplier has ceased trading, tenants may find themselves funding what is in effect an improvement for incoming tenants!

Equally, increasing legislation regarding the energy performance of building systems places emphasis on the need on taking over a building, for tenants to understand the condition of such systems. Without clarification, failure to comply with the necessary emissions standards could fall to them under a ‘repairing’ lease.

In addition to the all-important condition survey, there are a number of considerations which should be borne in mind during occupancy.
● Regular maintenance inspections: The importance of implementing a planned maintenance regime for building systems to avoid reactive repair costs and the effects of breakdowns is well documented. In the context of the tenant’s legal obligations relating to plant and equipment condition, periodic independent
auditing provides additional protection againstlater claims through detailed documentation which can be used as hard evidence. Where M&E services are outsourced, the liability remains on the tenant, so it is especially important to understand what checking and reporting procedures are in place.
● Managing change: Changes in the configuration of office spaces or floor layouts and staff changes may also mean alterations are required to building services. For example, the addition of kitchenettes involving drainage and power installations, supplementary air conditioning, server/datacoms room expansion
and new telecoms systems or re-routing. Condition surveys undertaken at the outset will provide a guide in monitoring planned changes against the original agreement and determining where additional permissions or formal licence application may be required prior to commencing a schedule of works. Such
permissions, where obtained, should be carefully recorded. In addition, expert engineering assistance should be sought where such changes could affect the terms of the lease, as detailed certification may need to be produced on surrender.

In an increasingly competitive market, break clauses have become a way for landlords to offer space on more flexible terms. A break clause, typically at the 3-5 year stage, allows either side to terminate the lease early. Companies currently subject to reverses in trading conditions who are nearing a break point may well be considering their options at this time. On surrender of the lease, any agreed schedule of dilapidations will immediately come into effect.

Equally, property companies seeking to reduce their portfolio due to rising costs or local conditions are also free to terminate a contract at this point and will be keen to ensure the property is made available in a saleable condition to enable rapid disposal.

Many companies either fail to allow for reinstatement costs or make seriously inadequate provision for this element in considering a move. Commissioning an independent ‘dilapidations’ audit well ahead of lease breaks can avoid significant unexpected cost being incurred at crunch point, when companies can least afford it. Planning ahead enables companies to exercise the right to terminate without redress to the courts, which are notoriously rigorous in relation to claims arising at this point and/or can significantly reduce the final settlement payments agreed for any claims arising.

Where significant improvements can be proven to have been made to building systems backed by the evidence of surveys, tenants may be able to negotiate reverse premiums on exit.

Break clauses are often linked to rent review periods, offering opportunities to realise the added value created in the form of rent savings or a freeze on increases, with 2009 in particular predicted to be a good year for securing attractive deals that may not be available in the longer term.

Many companies are now faced with excess capacity due to the general business downturn. Where a company’s circumstances make a change necessary, landlords wishing to avoid void rent periods while
properties stand empty in a depressed market may be sympathetic to allowing the company to reassign space within buildings to other organisations. Where leases do not cover this contingency and a break point is imminent, landlords may still permit a variation in the agreement rather than risk losing valuable existing tenants. It is particularly important in these cases to clarify the extent of the obligations of sub-tenants in relation to dilapidations and alterations, since the principal tenant will often continue to be liable for disrepair even if they are not responsible for its cause.

In an ideal world, professional M&E advice would have been sought at the outset when negotiating the lease, with a full Condition Survey providing the basis for future discussions concerning any element on or ahead of lease expiry.

Equally, it is important to seek external professional advice when a Schedule of Dilapidations is served by the landlord. In occupancy, this can take the form of an interim schedule – served during the currency of the
lease - or a terminal schedule, which can be served at any time up to the last three years of the term setting out the required remedial works in respect of the alleged disrepair. A schedule served at or after the end of the lease is a final schedule of dilapidations and, since no remedial works can be undertaken, will be in the form of a claim for damages in respect of the alleged breach(es) of covenant. It is important to note that such claims will not only include the cost of remedial works but also rent and service charges for the period during which the property cannot be occupied as a result of the dilapidations.

Through independent auditing and representation, professional engineering expertise can ensure costs are justified and reasonable, potentially avoiding or mitigating unnecessary costs.
● Greg Kemp Divisional Director Facilities Management Group Hilson Moran


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