Lease Option Forensics: Options to Renew or Break, IFRS and Landlords' Ledgers

Understanding Lease Options to Renew or Break, and Their Impact on Business and IFRS Accounting in Retail Property

In this episode of 'That Retail Property Guy,' host Gary Marshall explores the complexities of property lease options and their implications for retail tenants. Covering specific factors like the option to renew and the option to break, Gary explains how different clauses in leases can impact a tenant's balance sheet under IFRS accounting rules and their strategy for moving forward (or not). The discussion delves into the nuances of lease breaks and options to renew, potential pitfalls, and how break options might alter a business tenant's financial outlook. Gary also highlights the importance of reconciling accounts with landlords to avoid discrepancies that could invalidate break notices. Practical advice is provided to ensure that business tenants manage their leases effectively, keeping in mind the conditions and dates specified in their agreements.

00:00 Introduction to Retail Property Management

00:19 Understanding Lease Options

01:38 The Impact of Options to Renew or Break on Business

02:21 IFRS Accounting Rules and Lease Liabilities

05:38 Exploring Break Options in Leases

07:39 Practical Concerns for Exercising Break Options

10:42 The Importance of Accurate Landlord Ledger Reconciliation

14:13 Final Tips and Cautionary Notes

18:53 Conclusion and Farewell

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Transcript

0:00

Welcome to that Retail Property guy with your host, Gary Marshall. In each podcast episode, we delve into topics relating to estate management and accounts payable from the perspective of a retailer as tenant. We hope you'll be entertained, enlightened, and may be a little inspired. In this episode, let's discuss our options. I mean, let's discuss the options that we often find in our property leases. Mostly leases contain clauses that stipulate what must be done or must not be done, and the consequences for not complying. But some of these clauses are about what might happen if certain conditions are intentionally invoked. An example of such an option might be an option to break or an option to renew. The option to renew isn't so common in UK leases, particularly in England and Wales, where business tenants of commercial leases often rely heavily on the good old 1954 landlord and tenant act, which supports their rights to a new lease at the expiry of the old one. They don't generally need an option to renew because statutory legislation provides that reassurance at source. But they're pretty normal. In other jurisdictions like Europe, where the benefit of an option to renew offers the same reassurance that the landlord and Tenant Act offers. In England, a business tenant can invest both in shop fitting and in brand development without the worry that at least expiry the landlord will suddenly hike the rent, or even worse, take the property back and let it to the competition. But options to renew are not without their pitfalls. Generally, unless specifically stated to the contrary, in the original lease, the renewed lease will be on exactly the same terms, like an automated renewal of a contract for broadband or mobile phone services. I. Okay, so in many cases, exactly the same isn't a huge issue, but it does mean there's no wiggle room for negotiation. Maybe to vary, a clause to be less or more restrictive perhaps as a result of a lesson learned in business or in the evolution of the contemporary marketplace, and an option to renew can have an impact on the tenant's balance sheet too. Under IFRS accounting Rules, a business must report the total liability of all its business leases, with some exceptions in the most simple terms, this is like adding up all the rents, payable on all the leases until the last lease runs out. This sum can be huge, sitting like a millstone on the balance sheet, literally weighing a business down, demonstrating that these lease liabilities are to a great extent, treated like debt. So for a business to be a lean and mean effective machine, it really needs a low total liability for IFRS. So the balance sheet doesn't look like the business has more debt than it can handle. The bigger the obligation or liability in lease commitments, the bigger the apparent debt, the total of rent liability for a 10 year lease could be effectively double the liability of a five year lease. It isn't exactly double IFRS calculations are complex, discounted cash flows. But for the sake of this simple discussion, let's assume double. You can see that longer leases have a dramatic effect on the balance sheet. But what difference does an option to renew add? I hear you ask. Well, if the option is to all intents and purposes, an automated guaranteed outcome. Then IFRS rules say that the future renewable lease term, say another five years, should be added to the calculation for the current term, say an original five years to show a theoretical 10 years. So rent times 10, not rent times five, which is a much bigger sum, sitting on a balance sheet looking like a huge debt. Of course the actual lease isn't for 10 years. It's for five plus an option of another five. But if the option is almost guaranteed to be used, then five plus five looks like 10, and that's good enough for the IFRS rules. I. So maybe an option to renew isn't so helpful after all. Maybe it's no different to taking a longer lease in the first place, a straight 10 years, not five plus an option for another five. The same total liability hits the balance sheet. The business tenant has reassurance for 10 years. And with the option to renew, what happens at the end of the renewal period at the end of the 10th year? Is there another option? Is that 10 now looking like 15? Is this a loop that never ends? Could the hypothetical assumed longer lease carry such an IFRS burden that it cripples the business? Well, thankfully in England and Wales at least we don't have that worry. The protection of the 1954 Landlord and Tenant Act isn't considered part of the contract, so isn't subject to be included as an extended theoretical lease term. I. Five years is five years until the tenant and landlord agree to renew it. IFRS calculations are based on the actual shorter term, but the tenants of a protected business lease can have the reassurance of a future occupation, so can make all the necessary longer term decisions and commitments for investment purposes. But other options can also have an impact both on commercial decisions and on IFRS Liabilities. A more common option in many UK leases is an option to break. This gives the tenant or the landlord. Break options can work both ways. An opportunity to terminate the lease at a date, which is earlier than the contractual expiry. So the lease might have a 10 year term, but contain a braid option at the end of the fifth year. So if the necessary conditions are fulfilled, 10 years could become five years. I. All three or whatever was agreed between the parties when the lease was negotiated. More on that in a moment, particularly for the tenant. This can have considerable impacts on IFRS accounting liabilities on the weight of apparent debt attached to the balance sheet. Longer leases generally mean bigger liabilities. Shorter leases mean lighter liabilities. So does the presence of a break clause, which allows 10 years to become five years, mean that the lease should be considered as shorter. Should the IFRS calculation assume only the five years, not the full 10, effectively halving the IFRS millstone? Well, in simple terms, no. The accounting powers that be thought of that a business tenant shouldn't simply assume that all of their break options will mean shorter leases. Well, it depends. Consider the example of a business tenant, which has many leases with breaks, and which is actively using these breaks to change the nature of their bricks and mortar portfolio, maybe as part of a strategic restructuring or for relocation or downsizing or maybe taking the business online. So maybe they have a provable track record of actioning their breaks. So they can demonstrate quite clearly that it's a reasonable assumption for the purposes of the IFRS calculations that any future breaks will also be actioned. But the onus of responsibility is on the tenant to demonstrate it beyond a reasonable doubt. But we've digressed, we're talking about break options, not IFRS accounting. So what are the practical concerns for a business tenant looking to exercise the break in their lease? Well, for starters, as I often say, read the lease. The business management team or their property specialist should know and should plan for all the terms and conditions, the detail, the minutiae, which govern how the break option works. It's all written in the lease. There will be conditions. There'll be dates for complying with those conditions. There might be obligations to pay some penalties or rents upfront to not have any arrears, maybe to have complied with all the repair obligations, and most likely there'll be a stipulated method for serving a brake notice, which is the trigger document for activating the brake option. As we mentioned earlier, breaks can work both ways. The lease could contain a landlord only break option. Maybe the landlord needs some certainty about an uncertainty, but maybe if some uncertain future plans to develop a site come to fruition, then they can be certain of recovering possession of the tenant's premises to include in that grand scheme. But if the plans don't work out, then the tenant remains in occupation till lease end. And if that sounds a bit one-sided, unfairly weighted in favor of the landlord, remember that nobody forced the tenant to sign that lease. They went into the arrangement willingly with eyes open. The same conditionality might apply to the tenant that they get the option to choose whether to break for their business reasons. Or it might be a mutual clause where both sides get the option, maybe even based on different criteria. Anything is possible if it was negotiated and agreed between the parties when the lease was signed. I. For example, the break clause might be of the rolling variety. This means the effective date for the break isn't fixed. It can roll along. Maybe be effective anytime after a certain date or maybe at any time in a window between two certain dates. I. And it might be personal, for example, granted by a specific landlord to a specific tenant, so written into the lease, but only applicable while that named tenant is the occupier. If they choose to assign the lease to another tenant, the break option could fall away, become null and void, cease to be effective. I recall one case where an occupying tenant planned to activate a break option, but realized that. It had in fact ceased to be because as part of an accounting restructure, a few years earlier, they had assigned the lease from one corporate entity to another, but the option was personal only to the original tenant, and the assignment had broken that connection. Always be wary of the conditions around the lease. Always read the lease. Get your facts straight, be ready, plan correctly, don't assume, and ultimately be sure to execute the break option correctly. And as a fundamental part of getting your facts straight and your proverbial ducks in a row, don't forget the state of the accounts. This is the ledger that the landlord or their agent maintains. If the lease stipulates that the break option is only valid, if there are no arrears, then be absolutely sure that there are no arrears. And in this sense, I mean the tenant should dig deeper. Than just scrutinizing their own accounts, because the landlord's ledger might show a very different position, which could sc the break. For example, the tenant might quickly check, yes, we've paid the latest quarters rent, therefore everything is up to date. But the landlord's ledger could show a debit balance. Maybe an outstanding invoice for insurance, maybe a shortfall on rent or service charge. This misalignment between the tenant's ledger and the landlord's ledger is more common than most people think. In fact, my business team at Smarter Estates specializes in resolving these discrepancies. There are literally millions of pounds at stake. Take an example. The tenant makes payments believing they are settling each invoice or lease cost obligation, but they don't know for sure that the landlord or more, usually their agent is applying those payments to the right item. It's so common to see a landlord's credit controller a. Apply a rent payment to a service charge item, leaving a shortfall in the rent, and it could easily be possible that the tenant wasn't even aware of the service charge item because again, it's so common that invoices for non-regular charges seem to go adrift, get misplaced, never reached the tenant's accounts team. So yes, I'm saying that often a landlord or their agent might have a completely different view of the ledger position, and maybe they're correct. Maybe the tenant did miss something. Maybe they are in arrears. So maybe that break notice will be invalid for the want of a few quid on a year end service charge reconciliation or a fee for an insurance reevaluation or some such item that the tenant isn't looking out for. The signature service from Smarter Estates is reconciliation of those landlord's, ledgers, trolling through them line by line, going back years, identifying all the invoices raised, all the allocations made, and checking that these matched to what the tenant believed they were paying, that there are no gaps and no duplications. Don't assume the landlord's credit controller applies the tenant's funds as the tenant intended. Check that they did it. And if, as we so often find they did something else, if they misallocated the payment to a different invoice, even to a different lease, maybe on a different property, then the tenant must apply pressure to ensure they reallocate it. This housekeeping task involves frequently checking the landlord's ledger, not taking it for granted, not giving credibility to an arrear statement, which could be a selective work of fiction based on some mess up by the landlord's, accounts receivable team without actually checking the whole picture. Trust me on this, even if you're not considering actioning a break, just do this due diligence. Do the forensic checks. Tenants should be smarter than the landlord's controller. It's amazing what can be uncovered. If it turns up a credit, then that's the tenant's hard won profit being misdirected. Get it back. If it turns up a debit, a balanced due, then correct that as quickly as possible, especially if there's a break coming up or some other negotiations with the landlord are about to start. And one more thing, another personal beef of mine that can so easily compromise a break. Notice the date of the break option itself. Or rather the clarity of the instruction about it when the lease is being agreed, and this is usually contained in a summary or heads of terms shared between the negotiating parties who might be an acquisition surveyor or a letting agent, maybe a self advised tenant and an independent landlord. These heads of terms form the basis of the instruction for the lawyers who will draw up the lease document ready for the tenant and landlord to sign and therefore to commit themselves to for the duration of the lease contract. Now this is something I've seen many, many times and it's frankly bonkers. A small detail but which can have considerable consequences. I'm talking about negotiators who specify the effective date of a break option as being on the third anniversary of the lease commencement, or the fifth anniversary, whichever anniversary, in my humble opinion, never specify an anniversary. It's probably a day more than you think it is. And that can cause consequences. Take this example as a comparison. A simple five year lease from the 1st of January, 2020 will expire on the 31st of December, 2025, but the anniversary of lease commencement will always fall on the 1st of January. So a 10 year lease with a break on the fifth anniversary. And this is a common statement in those heads of terms. Means that the break will be effective on the 1st of January, 2026, not the 31st of December, 2025. So what's in a day I hear you say it's mere detail. We all know it means five years except consider the consequences. I mean, for a start, it's an extra day for which rent and all of the charges will be due. And maybe for the purposes of complying with the conditions of a break clause, it means that any periodic charges which apply on that date must have been paid in full. So if the rent is due monthly on the first of each month, then in theory, a full month is due on the 1st of January, 2026. Not an apportioned single day, but a full month, maybe even a full quarter for some charges. And if it isn't paid correctly, then perhaps the condition about no arrears isn't complied with. So the landlord could argue that the break notice has failed. I. On a slight technicality, but failed nonetheless. This could mean the tenant is then stuck with that lease for the remainder of the term, maybe another five years at full rent service charge maintenance obligations, not forgetting business rates and so on. All for the lack of attention on one minor detail about an anniversary date. So a cautionary note to all negotiators and estate managers acting for tenants. Consider what you actually intend when you suggest a break is effective on an anniversary. It's common to see a suggested break at the fifth, which gets translated as the fifth anniversary, which is the first day of the sixth year when the tenant was probably thinking it meant the last day of the fifth year, and beware the domino effect of all the consequences if a break does fall on the rent due date. And a final cautionary note about apportioning any final charges. If the break clause in the lease requires no arrears, then consider if the final payment will be a full period payment or an apportionment. Don't assume unless it is specifically agreed to the contrary, that prudent tenant might consider making a full period of payment to avoid any argument that might compromise the break. This is especially true if rents are autogenerated by an estate management database and critically true. If the break is, as we've discussed on an anniversary, in theory, any small overpayment could be recovered in a final reconciliation, but that might be put on a back burner while a deal applications position is negotiated. But even if it can't be recovered, there might be logic in a rationale. The overpaying part of a rent period is better than compromising the break and therefore having to pay all the remaining rent periods to the contractual expiry at the lease. It's a small loss. The devil is in the detail. The break options are in the lease. Read the lease. Be aware of the terms and conditions that apply. Manage them. Well. Be wary of the pitfalls. And if all of this sounds daunting, then always reach out and seek the support of a property specialist with the relevant experience in the right sector. Thank you for listening to that Retail Property guy. I hope you enjoyed today's discussion and found it insightful. Don't forget to explore more episodes and be sure to like, share and subscribe for more information, visit that retail property guy.com. Thanks again for tuning in.