Value in Variation

Understanding Deeds of Variation in Commercial Leases 

In this episode of 'That Retail Property Guy,' hosted by Gary Marshall, we take an in-depth look at Deeds of Variation - legal documents that allow modifications to existing commercial leases. Common reasons for these variations include adjusting rent review frequencies, allowing structural changes, removing break clauses, and modifying the actual demised space. He also discusses potential implications, such as tax liabilities and balance sheet variances, advising tenants to seek professional advice when considering lease modifications. 

Tune in to gain valuable knowledge applicable to estate management, particularly from a retail tenant's perspective.

00:00 Introduction to Retail Property Management

00:29 Understanding Lease Contracts

02:17 Flexibility in Lease Agreements

03:28 Deeds of Variation Explained

05:25 Practical Examples of Lease Variations

11:01 Legal and Financial Implications

15:53 Conclusion and Final Thoughts

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Transcript

0:00

Hello, and welcome to that Retail Property guy with your host, Gary Marshall. In each podcast episode, we delve into topics relating to the particular overlap between estate management and accounts payable from the perspective of a retailer as tenant sharing stories and insights through Gary's unique lens. We hope you'll be entertained, enlightened, and maybe a little inspired. Our regular listeners will recognize our frequent mantra. Read the lease! Between retail tenants and landlords, the lease is the Legally binding contract. Yes, contract.. Enforcable by law. Fixed Avoiding confusion, focusing the mind, the definitive example of putting an agreement down in black and white. The lease should describe the extent of the property being demised to the tenant, whether that property is a building or land, or both, maybe with rights over another building or piece of land. The lease contract should cover all the obligations, the rights, the benefits, the conditions which apply between the tenants and the landlord. It should stipulate the lease term. That's how long the lease will last. It should define the rent and any mechanism to review it. It should be crystal clear about who must repair what, whether alterations can be carried out, what use is allowed or prohibited. It might contain other conditions may be granted on a personal basis to a specific first tenant, but not assignable to any subsequent occupier. If the first tenant sells on their lease, it might contain options such as break clauses or renewal options on top of any statutory security of tenure that might be afforded by the 1954 Landlord and Tenant Act, or options to extend or purchase the freehold or change the permitted use. Generally we tend to think of the lease contracts as fixed unswerving, non elastic. If the lease prescribes that the tenant cannot sell hot food, then they cannot sell hot food forever. Right? If the lease allows a tenant a right to break the lease at any time, the landlord has to sweat it, tail in anticipation day after day of uncertainty, right? Well, yes, but maybe also no. Yes, because within the terms of that lease contract, everything is fixed, wander off the straight and narrow, and the other party could litigate for specific performance that's legalese for enforcement of the lease terms or for damages, legalese for compensation, for losses or injuries. The courts should help a claimant to ensure that the lease contract isn't ignored or trampled over. So on face value, once the lease is signed, it becomes contractually binding, and that's it. No flexibility until it expires, and even then, maybe it can be renewed on the same basis again and again. All protected by the 54 Act. But maybe also no, because in the world of contract, anything can be negotiable. So in theory, as long as the parties to a lease contract are willing to agree it in writing a new document can be created, which amends the original lease without surrendering it in. Starting again. In other words, a deed of variation. Also contractually binding, which modifies the original lease for some mutual benefits. So in this episode, let's discuss some of the common reasons for deeds of variation and their impact on the original lease contract, and maybe on FRS or IFRS, liabilities on the balance sheet, and maybe on SDLT stamp duty. Let's start with the basics. A deed of variation is a legal document. It allows a tenant and landlord to formally amend one or more specific terms of an existing commercial lease. It is a supplementary agreement to the original lease. The two documents now have to be read together as one. The changes are legally binding, so they're enforceable in a court of law, just like the lease had always been that way. Why would a tenant and a landlord do this? Why not just rip up the old lease and grant a new one on the new basis? Well, an obvious point is that legal costs are expensive, so a new lease could be costly and time consuming if negotiations cover loads of the minute details of clauses which aren't even relevant to the change, starting from scratch isn't always necessary. Stick to the essential point. There are lots of possible reasons to vary a lease. Sometimes it's to the tenant's advantage. Sometimes it helps the landlord out. Usually there's a consideration, a payment, a trade off, maybe the exchange of money or a quid pro quo. Sometimes it will permit a commercial change, like an alternative use, which was previously prohibited. Sometimes it'll permit a physical change. Maybe the original lease prohibits certain alterations, but the landlord is willing to relax. That owner is clause. Most variations are pretty straightforward, and the change impacts nobody except the tenants and the landlord as the parties to that lease and the new deed. But changes to rent or the length of a lease can have further reaching consequences. Let's circle back to this later. Let's start with some easier possibilities. Let's say a landlord buys an investment property with a sitting tenant, a retailer on a long lease with an unusual rent review clause. A common frequency for rent reviews could be every three years or every five years, but let's imagine this lease with seven yearly rent reviews. Now this has two possible impacts, one for the landlord and another for the tenant. The landlord finds it a pain because they have to wait seven years to instigate a review when all of the comparable properties nearby might be on a five year basis, seven yearly. It's out of cycle with the markets. The tenant dislikes it because when the rent is reviewed, there's a possibility of a higher than normal rent outcome because of a factor known as overage where the landlord might make a case that the seven yearly pattern is such a financial advantage to the tenant, that the rent should actually be tweaked by a small percentage upwards. Of course, neither party really seems to benefit from this unusual frequency. Maybe the most practical solution is just to remove it from the lease and make the frequency five yearly, like all the other shops in the locality, which act as comparables for rent reviews. So by mutual agreement, the tenant and the landlord decide to do just that by way of a deed of variation. Maybe the landlord pays the legal cost just to sweeten the deal, but after the variation is completed, it's like the actual lease had always had a five yearly rent review pattern. Let's consider another example. Maybe the retailer tenant finds their business is going really well. They need more retail space, and there's a big yard at the bank where they could build a small extension, but the lease doesn't allow structural alterations. It's absolute. On that point, the landlord has no obligation to be reasonable, to consider requests to agree to anything that isn't in the lease. But outside the bounds of the lease, they are willing to consider a variation, perhaps if the tenant pays the legal fees and funds the actual building costs. The variation changes the terms of the original lease, as if alterations had always been permitted, and the tenant is able to make their alterations, improve their business, get on with life. In another case, a tenant reads their lease for the umpteenth time and considers that it contains a rolling break option in their favor. This means that at any time or maybe on specific dates, they have a legal right to serve a break notice and cut the lease short. This would mean the landlord then has to find a new tenant and re-let the space. But maybe the economic moment isn't right. Maybe there's a glut of available space and few potential tenants. So the landlord maybe wouldn't necessarily come out on top. They might have a void period. They might have to offer some incentives, like a rent-free period, maybe even do some physical works to freshen up the curb appeal of the property, maybe even accept a lower rent than the current tenant is paying. So the landlord is constantly waiting for the potential hammer to fall, and while they wait to hear if the tenant intends to serve the break, they struggle to make long-term plans, get low cost funding, maybe even struggle to sell their investment. The tenant recognizes the commercial advantage that they hold over the landlord. The landlord recognizes the potential upside if they could settle this break issue once and for all. So a quick discussion reveals that the tenant has no real intention of breaking, and the landlord is willing to offer a modest rent-free period as an incentive or a reward for removing that break clause from the lease. It's a simple deal, commercially attractive on both sides. So the deed of variation becomes the legal documents that amends the original lease, as if there never was a break clause, and there always was a rent-free period. Of course, when a deed of variation is completed, it's absolutely necessary that the two documents are always read in conjunction. I've witnessed numerous examples where a landlord or indeed a tenant looks into their archive of legal documents, finds the lease. And assumes that's the full story and either tries to enforce something that was later amended or fails to optimize on advantageous terms that were added. From the tenant's perspective, knowing your documents is paramount. There's no substitutes for a robust archive system with an index or other system to highlight the chronological order of the documentation, including the lease and any subsequent deeds of variation. And there can be more than one per lease. This is as well as any rent review, memoranda, personal concessions, side letters, reversionary, lease extensions, all the exchanges of correspondence and legal stuff between the tenant and the landlord that impact on the fruitful use of the demise premises. And when lease renewal comes around, the lawyers should definitely read the whole bundle of useful data on numerous occasions. Over the years, I've witnessed both sides of legal advisors on a lease renewal, earnestly negotiating the new lease as a modernization of the old lease, but completely unaware of the existence of a deed of variation. That substantially amended that earlier lease, and so needs to be incorporated wholly into the new lease. A renewed lease that didn't recognize the deed of variation would essentially take a step backwards, undoing the commercially agreed advantage of the deed. So be alert and of course read the lease, but also always check for any document that modifies amends or changes it. And speaking of lawyers and legal changes, deeds of variation, let's circle back now to that earlier point that may, a deed of variation, which amends the rent or the length of the lease term might have a bigger implication. In some circumstances, the financial authorities might view a substantial variation that turns a five year lease into a 10 year lease, or halves the rent or some combination of both to act like a surrender and grants of a new lease. Their argument could be that the varied outcome represents a different taxable situation than the original lease, as if the older lease was ripped up and replaced with a new one on markedly different terms. And of course, a primary reason for doing a deed of variation is precisely to avoid doing a surrender and re-grant. But if there are tax or accounting implications, the powers that be might try to catch you out anyway. One possible consequence could be that SDLT stamp duty land tax becomes payable as it would for a new lease. SDLT is a tax based on the calculated value of a lease, which is a mathematical calculation of number of years times rent. So a variation that creates a longer term or a different rent means a different value for tax. Oh, and don't forget that a calculation for SDLT includes any VAT on the rent as well as the rent. So yeah, tax on tax. How unreasonable is that? There might be a chance of some overlap relief where some released SDLT from the original lease gets offset, but that wouldn't apply if the original lease was granted before the 1st of December, 2003. So tread carefully on SDLT. Another impact could be on the balance sheet through a recalculation of liability for the right of use asset under domestic FRS or international IFRS accounting rules. As a rule of thumb, these calculations of liability are a discounted cash flow and roughly they sum up the rent due for the remaining term of the lease. If the rent. Or the remaining term of the lease or both are varied, then the new calculation could look very different from the original one, which shows up as a large variance on the balance sheet, which might require a footnote of explanation in the audited accounts. So tread carefully on the accounting impact. So variations which might trigger this bigger impact are probably, but not necessarily driven less by a relaxation of the repairing clause and more by material changes like a change in the demise space, in the rent or in the lease term itself. An example often helps, so let's say a lease was granted for a retail shop, which also had several floors of residential accommodation upstairs. At the time the lease was granted, the space was vacant and the landlord wasn't interested in the separate management of it, including getting the lease to the retail tenant made it the tenant's problem. They paid a rent for that space, whether they used it or not. If they were smart, they maybe could sublet it and hopefully make a profit rent, but maybe that's not their specialty. Maybe they don't have the time or the energy or the interest. So it just sits vacant as a cost to the tenant. But times change. And at some point the landlord figures that maybe they could do something more useful with that space if only they hadn't leased it to the retailer. So the discussion goes something like this, the landlord says, suggest that they'd be willing to take it back by a deed of variation. The tenant gets a rent reduction and maybe another sweetener as well. And the landlord recovers access to some space they could optimize. This kind of deal might come under the microscope for SDLT changes. And it would probably impact on an FRS or IFRS calculation. There are so many possible reasons to consider a deed of variation, to act as a tweak, a nip, and took an alteration to a lease, which previously both parties considered to be fixed. Unchangeable. Even if Ill suited to the current circumstances, landlords might be minded to buy back, break options, renewal options, even the statutory protected rights under the 1954 landlord and talent tax. Either party might be persuaded to release a user clause, whether it impacts the tenant or the landlord, or a neighbor. Some leases prevent the tenant using the space for a specific purpose, while other leases prevent the landlord from allowing other tenants to compete. The same applies to relaxing otherwise in favor of someone else allowing parking or access to a utility or broadband connection, or putting up a satellite dish or creating a fire escape. Anything that was restricted can be relaxed in return for suitable recompense, of course, there's pretty much always a value in trading off an advantageous lease clause, even if that only means the other side, paying your legal fees. So in conclusion, as usual, we urge tenants to read the lease and also read any deeds of variation, but also acknowledge that while leases are contractually binding, they don't have to stay. That way the parties can agree to change anything for a price. If you are considering a variation to release a restriction or improve your operational position, be sure to seek sound advice from someone with the relevant professional experience in this sector. As always, bear in mind that the benefits of good advice generally outweighs the cost of it. Thanks for tuning in to that retail property guy. I hope you enjoyed the discussion and found the subject both entertaining and insightful. Check out more podcast episodes and if you have a suggestion for a future topic, please leave a suggestion or send us a message. If you liked what you heard, please consider leaving a review. Your invaluable feedback helps improve content. Remember to like, share and subscribe to never miss an episode. And if you'd like more info, go to thatretailpropertyguy.com. Thanks for listening.