Office leasing – getting the Heads of Terms right

The main Heads of terms 'headings':

1. PARTIES

Seems obvious – the full name of landlord and tenant should be specified. If either of these parties are overseas companies (i.e. not registered at Companies House) then a “legal opinion” letter will be required from a lawyer practising in that jurisdiction. This will confirm that the company is properly incorporated and has capacity to enter into the transaction – this needs to be flagged early on so that the appropriate law firm can be instructed and a draft legal opinion letter issued.

Tenant – is the company name correct? The landlord will wish to ensure that the tenant company is registered at Companies House, so it is vital that the correct name is specified in the Heads of Terms. Has the landlord checked the covenant strength of the tenant? Is a surety or rent deposit required? Ideally, covenant strength should be resolved before Heads of Terms are issued – we have seen many Heads of Terms where audited accounts are “to follow”. This simply leaves the covenant issue unresolved and will lead to issues/delay later.

2. RENT DEPOSIT

If VAT is chargeable on the principal rent, the rent deposit amount should include a sum equivalent to VAT. The conditions for repayment should be set out – generally on assignment or when the tenant satisfies a profit/net asset test.

3. CONDITIONS

Is the grant of the lease conditional – e.g. on vacant possession, planning consent or bank consent? If so, the conditions need to be spelt out clearly. Who must comply with the condition and by when?

• Vacant possession condition – If the premises are currently occupied then any lease grant will need to be conditional on the existing tenant vacating.
• Planning condition – this is more complicated. There are a wide range of options – too detailed to specify in the Heads of Terms, but the basic provisions should be included: who is responsible for making the planning application/what “use” is being applied for/what constitutes a “satisfactory consent”/onerous conditions/target date for obtaining consent/break rights – long stop date/obligation to appeal/dispute provisions etc.

4. DEMISE:

Generally described by reference to a “net internal area” and a plan. How does tenant check the area? Either (a) by its own measurement or by (b) a letter issued by the measuring company. If (b) then tenant will also require a reliance letter from that company.

Demise plan: Tenant’s surveyor should check for accuracy.

5. SPECIFICATION:

What condition will the premises be in at lease completion? The main options are:

• (a) handed over “as is” – self explanatory.
• (b) in a “shell and core” state – generally this will only be relevant on a newly constructed office building. It is effectively only the basic structure to support the premises which is being delivered. The slab separating the premises from the floor below will be visible, as will the slab separating the premises from the floor above. This will require a complete and extensive fit out by the tenant – i.e. flooring/ceilings/lighting/WCs/partitions/meeting rooms/break out areas/M&E works etc.
• (c)  CAT A specification: this is paragraph (b) plus flooring/M&E works/ceiling and lighting – so all that is required is for tenant to install partitioning/rooms etc.
• (d) CAT B specification: this is paragraph (c) plus all partitioning etc, so effectively a “turn key” specification, under which the tenant can operate from day one.

Protection for tenant: Given that cases (b), (c) and (d) require landlord works, ideally the Heads of Terms for the leasing of any office space should cover:

• Detailed specification, to identify exactly what the landlord is delivering.
• Target date for practical completion.
• Practical completion arrangements.
• Certification by an independent person – often the “Employer’s Agent”. To enable the tenant to rely upon this certification, a duty of care letter should be provided.
• Tenant allowed to make representations at the practical completion meeting which the Employer’s Agent (or whoever is issuing the practical completion certificate) should consider but not be bound by.
• Mutual break date if practical completion is not achieved by a longstop date.
• Target area/measurement provisions/rent adjustment and/or tenant right to break if measured area is outside of agreed tolerances.

6. WARRANTIES

If the building is a “new build” or if the landlord is carrying out major works within the building (e.g. to create a CAT A or CAT B space) the landlord will have obtained warranties (guarantees) from a range of parties:

From the building contractor – warranting that it has carried out the works in a good and workmanlike manner.

From all those involved in the design – architect, structural engineer, mechanical engineer etc – that they have exercised reasonable skill and care in performing their duties.

The warranty will generally last for a period of 12 years from practical completion and will usually contain a provision that an identical warranty can be given to a tenant.

How could these be relevant to a tenant? There are two tenant obligations in the lease where the tenant’s liability could be mitigated or reduced if warranties are obtained:

• (a) the tenant’s obligation to keep the premises in good repair. The tenant’s primary concern will be to ensure that it is not liable for any construction defects in any works carried out by the landlord to create the CAT A or CAT B space – i.e. works within the premises; and
• (b) service charge. The tenant will wish to ensure that any defects in the structure which are caused by defective workmanship/design are excluded from service charge.

How can this objective be achieved? This depends upon the extent of the works which the landlord is carrying out:

Works carried out by the landlord to “create” the CAT A or CAT B space:

The landlord will generally agree to an obligation in the Agreement for Lease to carry out such works in a good and workmanlike manner etc. In a “smaller” office letting, that is probably all the tenant can reasonably expect. However, on a larger letting it would be reasonable for the tenant to request warranties (or “third party rights”, which have the same effect) from the building contractor and professional team responsible for those works.

Construction of the building in which the space is located:

If the tenant is taking a lease in a building which is a new building or up to 12 years old then there are various ways in which the tenant can gain protection:

The tenant will be responsible for paying a “fair” contribution towards the building service charge – see paragraph 11 below. The tenant’s main objective is to ensure that the cost of repairing any defects caused by faulty workmanship or design in the construction/design of the building are NOT included in the building service charge.

The best way to achieve this is to agree a “carve out” in the lease – i.e. so that the cost of remedying latent or inherent defects is excluded. This would mean that the tenant will not be charged for remedying any such defects. A landlord is probably unlikely to agree this because of the adverse effect this may have on any sale or funding, so the next best thing for a tenant is to obtain warranties or third party rights, as above. For a tenant, some of disadvantages with the “warranty route” are:

• (a) the tenant will still need to pay the sum demanded by the landlord and then attempt to recover that sum under the warranty, thus creating a cash flow problem.
• (b) enforcing a warranty is never an easy process. Assuming the company is still in business, the tenant must incur the cost of legal proceedings and prove that the tenant’s loss is recoverable under the warranty.
• (c ) the nature of the damage may be such that it is not clear if the damage is caused by a construction problem or a design issue, so it may not be clear which warranting party is responsible.

8. RENT

Rent: If the area is capable of being measured then a fixed rent will generally be specified in the Heads of Terms, calculated at an agreed rate per square foot and payable quarterly in advance on the usual quarter days.

If the space cannot be measured – e.g. because there are landlord works to be carried out – then the Heads of Terms will provide for a measurement once practical completion has occurred.

Rent will usually be expressed to be exclusive of VAT, business rates, service charge, insurance and other outgoings.

9. RENT REVIEW

Will generally be upwards only and every five years. The main options are:

• Increase in line with Retail Prices Index (RPI)/Consumer Prices Index (CPI) increase over the five year period.
• RPI/CPI compound increase annually (worse for tenant).
• With annual cap/collar.
• Open market rent basis. As the objective is to ascertain a rent payable at some stage in the future, the lease will contain “assumptions” and “disregards” to ensure that as far as possible the rent determined is as close as possible to a rent which would be payable in the open market at the time. It would not be usual in the Heads of Terms to list the assumptions and disregards – these tend to be quite standard. The most important one is probably the “hypothetical specification” at review.

10. RIGHTS GRANTED

As well as the usual rights to use common parts, are there any specific rights which the tenant requires – e.g. to use car parking spaces/bicycle spaces/shower rooms/plant areas?

11. SERVICE CHARGE

In a multi occupied office building, the tenant will be responsible for paying a contribution towards the costs incurred by the landlord in repairing and maintaining the structure, the cleaning/lighting and heating of common parts and any external landscaped areas, concierge services etc.

An estimate (per square foot) will generally be contained in the Heads of Terms. Ideally, the tenant would like this figure to be capped but whether a landlord will agree this will of course depending on bargaining strength at the time.

If there is no cap, at the very least the tenant should obtain confirmation that there are no large or unusual items of expenditure anticipated in the foreseeable future.

In a new building – i.e. less than 12 years old – then the issue of inherent defects/warranties is relevant – see paragraph 6.

Does service charge include any services provided to premises? Sometimes, air conditioning/cooled/chilled water or hot water is included – tenant to check.

12. INSURANCE

Landlord will insure the building and tenant will pay a proportion of premium. An estimate should be available.

13. TENANT COVENANTS

Only the main covenants will be set out in the Heads of Terms:

• (i) User:

The user will be generally be as offices. No change of use will be permitted.

• (ii) Repair:

If the Heads of Terms specify that the tenant is obliged to keep the premises in good repair and condition then it is of vital importance that the tenant arranges a full survey of the premises, so that any existing defects can be identified and excluded from the repair liability. For “new” buildings, are warranties or third party rights available? See paragraph 6. For space which is not in good repair and condition, a “Schedule of Condition” may be required – see below.

• (iii) Reinstatement:

For a tenant the potential reinstatement liability at the end of the lease term could be very expensive. The key question here is the condition in which the premises were handed over at the start of the term:

If the premises are handed over by the landlord in a new CAT A condition then it is only fair that a tenant is obliged to remove all partitioning and fit out works which the tenant has carried out  at the end of the term and return the premises to the landlord in a new CAT A condition.

However, if the premises handed over to the tenant are “tired” then unless the tenant is getting some incentive (such as a rent free period), it would be unfair to expect the tenant to have to spend money to improve the condition of the premises and give the premises back in new CAT A condition. In these cases, a common solution is to prepare a “Schedule of Condition” and specify that the tenant does not need to give the premises back in any better state of repair than is evidenced by the Schedule of Condition.

• (iv) Assignment:

The tenant will normally be allowed to assign the whole (but not part), but only with the consent of the landlord. The tenant may be permitted to sub-let the whole or part.

The main test which the incoming tenant must satisfy is that it must be of sufficient financial strength to be able to pay the lease rents.

• (v) Alterations:

The tenant will generally be permitted to carry out internal non-structural alterations, subject to obtaining the consent of the landlord. Structural alterations are prohibited. The tenant may be allowed to erect internal demountable partitioning without consent.

14. GREEN LEASE PROVISIONS

UK Government policies are obligating developers, landlords and occupiers to focus on the environmental performance and sustainability of buildings. The UK Government’s objective to meet “net zero”, “Paris Agreement” and COP 26 [Glasgow] goals means an increased focus on this area. Landlords are now producing ‘green leases’ that incorporate clauses with specific responsibilities on landlord/tenant in respect of energy consumption, waste reduction, emission of greenhouse gases and water efficiency. A “Climate Clause” may therefore be mentioned in the Heads of Terms.

15. TENANT’s FIT OUT

If the tenant is taking the space as a shell or in a CAT A state then the tenant will wish to fit out the space and will require the landlord’s approval. The Heads of Terms will generally deal with this point – the landlord’s approval to the fit out shall not be unreasonably withheld or delayed and will be documented in a “Licence to Alter” which will generally be completed at the same time as the Lease.

The Licence to Alter will constitute the formal approval of the landlord to the tenant’s fit out plans and the licence will govern the way in which the tenant must carry out those works. Attached to the licence will be a set of the approved fit out plans.