Heads of Terms drafting tips: repair & service charge provisions in office leases

The "repair" issue

In any negotiation of Heads of Terms for office space the landlord and the tenant will have different “repair” objectives, as summarised below. There are two places in a HOT where the “repair” obligation is generally relevant – repair of the premises is the obvious area but indirectly the tenant can also be liable for repairs to the building, under the “service charge” heading. Potentially, this could be a much more onerous liability:

THE PREMISES BEING LEASED:

• The space itself – i.e. the tenant’s covenant to repair “the demised premises”. Generally, in a lease of a typical office building the premises will be defined so as to include everything from the top of the slab below to the underside of the slab above – so will include flooring, ceilings, M&E plant etc. Pretty much everything.
• What does the landlord want? – to ensure that the tenant repairs the space which is being demised – all of the above items.
• What does the tenant want? – to ensure that its liability to maintain the space is “fair”, reflects the existing condition of the space and does not impose an onerous or unfair obligation on the tenant.

SERVICE CHARGE:

• The fabric of the building – structure/exterior/roof and common parts.
• What does the landlord want? – to ensure that the tenant contributes towards the maintenance of the structure, exterior, roof and common parts via the service charge and so that all monies which the landlord expends on maintenance can be recovered from the tenants in the building, without the landlord having to contribute from its own resources.
• What does the tenant want? – to ensure that the sum the tenant pays by way of service charge is in line with estimates provided by the landlord and that there are no hidden or large items of service charge expenditure charged in the future – i.e. no “nasty surprises” and in particular (for newer buildings) no costs which are incurred by the landlord to remedy defective workmanship or design in the construction of the building.

What should the Heads of Terms cover?

REPAIR COVENANT – THE PREMISES BEING LEASED:

Acceptable to a tenant

Heads of Terms will often specify that the tenant is under a full repair liability [i.e. an obligation to put and keep the space in good repair and condition]. If the tenant is taking new office space in a Cat A or CAT B “turn-key” condition then a full repair liability should be acceptable to the tenant because the space is in a “new” condition and therefore in good repair at Day 1. Likewise, if the tenant is taking a shell, a full repair liability should be acceptable because there is nothing in the space at Day 1.

Not acceptable to a tenant

A full repair liability is frequently accompanied by a provision which says that the space is handed over “in its current condition”. The tenant may be taking office space which has already been fitted out by a previous tenant. For example, the tenant may be using many of the previous tenant’s fittings, with just some cosmetic changes. A full repair liability means that the tenant is liable to carry out whatever additional works are required to put the space in “good repair and condition”. This may involve electrical works; M&E works; flooring/ceiling replacement etc. In that case, before accepting a full repair liability the tenant should:

• arrange for survey to be carried out to identify and cost any items of disrepair.
• attempt to qualify the full repair liability – e.g. by excluding any existing items of disrepair [as noted in the survey report] or by reference to a schedule of condition.

It may of course be the case that the tenant is getting an additional rent free or financial inducement to compensate the tenant for the obligation to put the premises in good repair. That may be acceptable to the tenant, but the tenant should still arrange a survey to identify the works that need to be carried out and their cost.

SERVICE CHARGE PROVISIONS – LIABILITY OF TENANT FOR BUILDING REPAIRS

There is a limit to what the tenant can do to mitigate any future liability under this heading. The HOT will often contain an estimate per square foot – and no more. However, the potential liability to the tenant under this heading could be substantial and we would suggest that the following should be considered:

New office buildings (i.e. less than 12 years old)

Warranties

When any office building is constructed, the landlord or developer at that time will invariably have obtained a wide range of construction warranties from the main contractor, sub-contractors, design team, professional team [architect/M&E engineer/structural engineer etc.] for the benefit of the landlord/developer. A warranty is effectively a “covenant” from the company giving the warranty. From the main contractor or sub-contractors it will say that the building has been constructed in a good and workmanlike manner etc… From the professional team, it will say that they have provided the service with the requisite degree of skill etc… The aim of the warranty is to give the landlord recourse against the company giving the warranty if defects appear in the fabric of the building etc.. within the warranty period (normally 12 years from practical completion) as a result of a breach of that warranty. Sometimes, the landlord will be able to require those contractors and professional team to also give warranties to a tenant.

If the tenant is the “first occupier” then it should enquire of the landlord if any warranties are available for the benefit of the tenant.

How do warranties help a tenant?

If defects appear in the fabric/structure of the building then the landlord will generally look to include the cost of repairing those defects in the service charge and a proportion of that cost will be passed to the tenant. If the tenant has the benefit of warranties then the tenant may be able to recover that cost from the company which gave the warranty. However, having the benefit of warranties does not give a tenant 100% protection – the claim under the warranty may be fraught with difficulty. For example, the tenant will need to prove that the company is in breach of the warranty, legal action may be required to enforce the warranty or the company may no longer be in business. The defect may be such that it is not clear who is responsible for that defect. Also, warranties are likely only to be available for the “first lettings” in the scheme – so if a tenant is taking a new lease say in Year 5 [eg as the second tenant] then it is unlikely that the landlord will be able to procure warranties.

Other options available to the tenant:

• A comprehensive survey of the centre/building is obviously not an option. However, a simple walk around the centre/building should reveal in very broad terms if the centre/building has been properly managed and maintained etc..
• Speak to other tenants in the centre/building. What is their experience as to the way in which the centre/building is run?
• As part of legal due diligence, examine the service charge pattern over the last three years. Does it show a steady increase in expenditure – i.e. rather than a large jump in one year.
• Do the managing agents have a good reputation in the market?
• Is the building service charge managed properly?
• Is there a sinking or reserve fund to cover any large items?
• Obtain confirmation from the landlord as to the service charge projected expenditure/planned maintenance programme over the next three years.
• A service charge cap.

Given the problems a tenant may face in recovering monies under any warranty, an alternative is to seek to exclude from the service charge provisions in the lease the cost of repairing any “inherent” defects.  Most landlords will resist this because it will impact on the landlord’s ability to charge or sell its investment, but much depends on the bargaining power of the parties at the time. Landlords may be more inclined to accept a lesser obligation in the lease – for example an obligation to use reasonable endeavours to enforce warranties before charging the cost to the service charge.

Older buildings (i.e. more than 12 years old)

Warranties are not relevant here because under the limitation rules they will only be enforceable for a period 12 years from completion. If a tenant is taking a lease in an older building then the comfort for the tenant is that if there are any inherent defects in the building then these should have become apparent before the 12 year period has expired.

What can a tenant do to gain protection from any large or unusual items of “repair” expenditure being included in service charge? The tenant has very limited options – the due diligence points mentioned above become even more important.

Summary

Raising these issues at the Heads of Terms stage and incorporating the points agreed on “repair” into the HOT will invariably save time later on in the legal process and will focus minds on those important issues at an early stage in the negotiation. Dealing with those points in the Heads of Terms will also prevent any “nasty surprises” later on. If the points are not covered in the HOT then invariably a properly advised tenant will raise those issues – dealing with the issues in the HOT could therefore prevent transactions from becoming abortive, with the consequent wasted legal and other fees, if the parties cannot reach agreement. If you require any further information on any of Heads of Terms in commercial real estate, then please do contact our experts.