Retail Property Leases: Challenges of Subletting, Assignment & Privity of Contract

Challenges of Subletting and Assignment: Key Considerations for Retailers

What can tenants do to mitigate the financial burdens of surplus properties including various strategies like subletting, underletting, and assignment in the UK retail property market? Join That Retail Property Guy' as host Gary Marshall discusses strategies for tenants to dispose of surplus leases. Gary explains the importance of reading lease terms, securing landlord consent, and the implications of the 1995 Landlord and Tenant Covenants Act. He delves into the risks and responsibilities involved in underletting, subletting, and assignment, and provides practical advice on mitigating financial losses, dealing with non-paying subtenants, and managing potential lease-end complications.

00:00 Introduction and Episode Overview

00:11 Understanding Lease Contracts and Tenant Obligations

01:27 Options for Retailers with Surplus Properties

01:34 Exploring Break Clauses and Alienation Rights

02:10 Underletting and Subletting Explained

03:32 Navigating the 1954 Landlord and Tenant Act

06:12 Landlord's Approval and Reasonable Consent

08:55 Assignment of Leases: Risks and Rewards

10:46 The 1995 Landlord and Tenant Covenant Act

14:01 Managing Financial Support and Lease Expiry

16:15 Conclusion and Final Thoughts.

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Transcript

0:00

Welcome to that Retail Property guy with your host, Gary Marshall. We hope you'll be entertained, enlightened, and may be a little inspired. In this episode, let's discuss leases as contracts for a fixed period of time and what a tenant occupier might do if they want to escape the cost burden of that contract before the end of that contract. I recall a visiting American finance director once instructing his UK property team to just shutter up and hand back the keys for a number of surplus properties. Like checking out of a hotel. It took a while to explain to them that the typical UK lease contract isn't that flexible, that the covenants and obligations continue to run, whether or not the tenant wants to remain in occupation. Surplus properties and whether this is due to poor performance, operational changes, locational degradation, or funding issues, these can be a major headache for any retailer. If a property isn't an operational store, the accounts team must financially impair it, which basically means taking a hit to the accounts equal to the aggregate of all the cost obligations on the lease till expiry. That's like getting a bill for all the rent, service charge, and business rates to the end of the lease in one go. And that big negative value sits in the books like a millstone, while the money flows out with no income to support it. So what options does a retailer have? As always, the first strategic point is read the lease. Is there a break clause that the tenant can instigate to terminate the contract much earlier than the contractual expiry? No. Well, okay. Tenant lease breaks are not standard in all leases, and even if they do exist, they often have specific conditions like a fixed date, which might not be now. So what else? What does the lease say about alienation rights? Alienation refers to the tenant's ability if it has one, to under let or sublet, or maybe even to assign. All subject to the landlord's consent, which hopefully is not to be unreasonably withheld. Under letting and subletting are different though often the term sublet is used as a general catchall under letting refers to a tenant being able to create a shorter lease, maybe two or three days shorter than their own lease by which they can then find their own tenant. To occupy all of the space, a subletting means creating a similar shorter lease, but this time only for part of the space may be a flat upstairs or a room as an office or part of the sales space to another retailer, bear in mind that the main tenant's, original deal with the superior landlord still stands. They have to keep paying the rent in their lease, but they can collect some rent from the Undertenant or subtenant if it's part only, and maybe mitigate some business rates at the same time. Depending on the circumstances, the main tenant might collect more rent than they're paying out, which is known as a profit rent. In other circumstances, they might have to accept a lower income, particularly if rental levels have fallen since they took their own lease. But assuming that the under letting or subletting stacks up as a reasonable deal, they can use this tactic to mitigate their losses and wait for time to pass till their head lease expires. Hopefully the new undertenant will continue to trade well, we'll pay the rent on time and present. No problems though. It's not always like that. Now an interesting point. A tenant looking to ground an under lease or a sublease would be well advised to consider excluding it from the security of tenure provisions of the 1954 Landlord and Tenant Act. This could be a moot point if the original lease already has a provision that. Insisting that any under leases should be outside the act. But if it doesn't, and if the new undertenant really wants that protection, then seeking to exclude it from the ACT could complicate the negotiations. The 1954 Act and its tenant protection rights is a matter for a whole other episode. But here's the reason it's important when considering granting an under lease or a sublease, many commercial leases require the tenant to give the property back to the landlord at expiry with vacant possession. If the tenant creates an under letting or a subletting, they also create a management headache. In theory, they need to be sure that their new undertenant will vacate the premises at their expiry date a few days earlier than the main lease expiry date. So the original tenant can give vp, sorry, that's vacant possession to the superior landlord. But if the subtenant doesn't vacate, this can cause problems for the tenants in the. They might end up facing ongoing obligations continuing after their contractual expiry until they can get back possession from their undertenant to then be able to give vacant possession to the superior landlord. But in happier circumstances as the middle lease expires, the superior landlord might be quite willing to take on the Undertenant as their new direct tenant. The original tenant who's been in the middle for a while now, just steps outta the picture. But don't forget those missing days. If the under lease or sublease is a few days shorter than the original lease. What happens on those days? Sometimes the superior landlord might allow the undertenant to remain in occupation for those extra few days of the middle tenant's lease. Kind of looking the other way. Sometimes they might accept an early surrender from the middle tenant just to facilitate granting the new lease to the occupying retailer. It's rare that the superior landlord expects the undertenant to vacate for just a couple of days and then move back in. But it could happen exiting the middle lease expiry can be fraught with problems, so a middle tenant should pay close attention as their contractual expiry date approaches, not simply assume that their lease will end and all will be well. Hopefully, of course, yes it will, but better to be on guard, ready to react than to find out several months later that there was a costly issue. Now you recall we mentioned getting landlord's approval, which hopefully is not to be unreasonably withheld. It depends what the actual lease says. But generally a well negotiated lease contains a modern, reasonable, fair alienation clause. If the tenant wants to do a deal to under let sublet or even a sign, they should ask for the landlord's approval. The landlord might ask for full disclosure evidence that the new occupier is a substantial tenant with a proven track record with audited accounts to demonstrate that with references from other landlords. But the new Undertenant might not be able to provide any of that. Maybe this is a new venture for them. Even so, the landlord usually can't just refuse to grant consent. They have to be reasonable. But the nugget of wisdom here is that the original tenant shouldn't assume, definitely shouldn't allow the new tenant to take possession. Shouldn't even sign the new unies until consent has been given in writing without any conditions. The tenant doesn't want to end up in breach of their lease, but unable to get possession back from an unapproved under 10. A good lawyer would explain all of this, of course. The tenant should be smart enough to be aware anyway. A landlord could ask for payments of their costs in considering this request. Maybe they need to take advice from their lawyer. Maybe they need to talk to their accountant or their managing agent, all of which could cost money. So it isn't unusual for a landlord to require costs, and often they won't even start to consider the requests until the funds are in their bank. Yep. Managing property is a headache and it can be expensive. And the original tenant needs to ensure that the new under tenant's lease mirrors their own lease. This means the same permitted user clause, so maybe a grocer shop constantly become a cafe or a barber shop. And again, a good lawyer would explain this, but the tenant should already be prepared. Oh, and speaking of being prepared, let's consider a worst case scenario that hopefully never happens, but let's put it out there. Be aware, be prepared, just in case. What if the new tenant doesn't pay the rent? I. The original tenant is still contractually bound to the original landlord. This Undertenant has no relationship with the original landlord who's now known as the superior landlord, so the original tenant sitting in the middle has to pay the original rent, whether or not they receive rent from their undertenant. This cashflow can be risky if the undertenant doesn't pay. The middle tenant has to handle the litigation, maybe the bailiff, the recovery action, but all the while still paying the superior landlord. Now, we've considered under letting and subletting, often blurred in name, but difference in effect. So let's consider the other aspects of alienation, which is assignment. Assignment is when the original tenant transfers their lease to another occupier, they step outta the picture and the new occupier starts paying the original landlord directly. Wow, this sounds better than under luting, doesn't it? Some leases specifically exclude the right to assign giving the original landlord the absolute right to refuse any suggestion of transferring the lease. Maybe under letting is permitted, but assignment isn't read the lease. If assignment is permitted, it probably still needs landlord's consent, which hopefully cannot be unreasonably withheld, and the landlord might ask for costs. Not all suggested assignments pass muster. A landlord might be acting quite reasonably if they refuse consent to a sign to a risky unknown, limited company with a whiff of suspicious activity about it. And in many circumstances, they might require a guarantee from the outgoing tenant, now known as the Assignor. The main lease probably specifies this. It would probably mention an arga, which is an authorized guarantee agreement, which comes into effect under the 1995 Landlord and Tenant Covenant Act. Some old leases still exist, which were granted before this act came into effect, so they're not subject to it, but most modern leases are. Old leases bound the landlord and the original tenant in legal obligation for the entire term of the contract. If the tenant wanted to assign, they were locked into a residual liability known as prty of contract for any shortcomings by their assignee. If the assignee failed to pay the rent to the landlord or didn't repair or anything else, the landlord could look to the original tenant and expect them to cough up. So the 1995 Act. Set out to release tenants of these onerous contractual obligations when they assigned Hurrah, but it got watered down. It got diluted to be of almost no effect. The 95 Act allows a landlord to insist on an arga. That guarantee, which seems so similar to the original scenario of privity. The notable difference is that the arga only relates to the first assignment. The first assignee taking the lease. If they subsequently assign to someone else, they have to grant a new Arga in their name and the original Assign ORs ARGA slips away. The 95 Act is pretty clear on how an Arga works and what the landlord must do to claim under this open-ended guarantee. First, they have to serve what's known as a section 17 notice within six months of any unpaid rent or other non-compliance, the longer the landlord leaves it before serving a section 17. The more they allow an interval to arise for which the AGA can't be imposed, if the assignee goes bust and their administrator or liquidator disclaims the lease, meaning they say that it's no longer binding, then the landlord can use the AGA to require the guarantor. That's the original assignor to take a new lease. Although he doesn't always get that far, the disgruntled landlord might not receive the rent. So they serve a Section 17 notice on the original tenant, the as assignor who provided that guarantee under the aga. The notice requires that the assignor pays the unpaid invoice infuriatingly. This can also mean paying the VAT, but the assignor can't reclaim that because the invoice isn't made out to them, so they end up paying 120% of the charge. Ouch. This could repeat every rent day for ages to the end of the lease. In fact, the landlord has no legal obligation to do anything to mitigate the loss. And they probably wouldn't choose to forfeit the lease. That means take it back off the tenant, unless the occupier's bankruptcy leads to it being disclaimed. Why would they want to do that when they can just keep looking to the original tenant under the AGA to cough up and keep the cash flow coming? Does this seem a bit unreasonable, a bit unfair on the original tenant who assigned their lease away? Well, they willingly gave that aga. There's no hiding from that. But if they think that they need to take control, then the 95 Act does allow them to demand that the landlord grants them a new lease, known as an overriding lease, which positions them between the original landlord and the occupier, who is now in default. In effect, it turns the assignee into an undertenant With the original tenant becoming their intermediate landlord, now at least the original tenant can take control, do something to mitigate the losses, possibly even forfeit the lease to get possession, and then relet the premises. Wow. Assignments can be a minefield, but assignments are still the preferred method of disposal for most original tenant occupiers. They need to be aware of their exposure to risk of unpaid rent or poor maintenance that leads to a dilapidations claim or other breaches by their assignee. My nugget of wisdom here is keep the assignee on a short leash. In the current market, it isn't unusual for the contractual rent in the original lease to be higher than the general market level having been set years ago when rents were higher and being on a non downwards upward only ratchet. Maybe the assignee doesn't want to commit to that high historic rent. Maybe they want a current market rent, but assignment doesn't allow the lease rent to change. So many Assignors find themselves having to offer incentives and financial support to their assignees. The support package attempts to ease the burden to make up the difference, to soften the blow. If the historic rent is a hundred thousand pounds per annum and the current market value is only 50,000 pounds per annum, and a signor might still think it's a good deal to mitigate their loss by half the rent, so they agree in some way to pay half the rent back to the assignee. But some assignors got their fingers burned here, initially naive. They offered lump sums of the difference in rent only to then watch the assignee disappear into the distance, taking the lump sum, and leaving an empty shop where the landlord simply reached for the aga. So keep that leash short. If an assignor has to agree a financial package, they should structure it as a drip feed reimbursement. Basically they should demand proof that the assignee has already paid the full rent to the landlord before they quickly reimburse their agreed share proof. First refund after no cash, upfronts. And then eventually the original lease comes to an end. The assignee is in occupation. They are probably protected by the 1954 Landlord and Tenant Act, and they can claim a new lease from the landlord. In theory, the original tenant's obligation expires when the lease expires. But there is always the haunting specter of a dilapidations claim until the claim is settled or a new lease is granted. The original tenant is never truly off the hook. Thank you for listening to that Retail Property guy. If you enjoyed the show, please consider leaving a review. Your feedback is greatly appreciated. Be sure to like, share and subscribe so you can never miss an episode. For more information, visit that retail property guy.com. Thanks again for tuning in.