Break clauses – save time and money by talking

 

In the rush to secure a property, it can be easy to overlook the small print in a conditional lease in relation to dilapidations – with potentially expensive results.

Landlords too can benefit from taking time to consider the wider commercial perspective in negotiating exit agreements, which can easily be ignored if there’s too much posturing or too much focus on the detail.

Both landlords and tenants can get entrenched in their relative positions in dilapidations cases, especially where one party wields more power or control i.e. where break clauses are involved.

As a quick reminder, ‘dilapidations’ is a term mostly used in the context of property repair and redecoration for lease expiries and break clauses. Dilapidations also include the reinstatement of alterations and compliance with statute, all of which can involve substantial works, especially if elements such as the DDA (Disabled Discrimination Act) and asbestos need to be factored in.

Where a tenant seeks to exercise a break clause, the extent and nature of dilapidation works generally becomes more complicated if that clause is conditional, i.e. for the break to be effective, the tenant must have complied with the lease covenants and clauses.

The following cases illustrate the nuances of break clause cases. In both, the outcome was a £2 million bill for the tenant.

Case 1

The tenant had acquired warehousing space on a deliberately short five-year lease with a third-year tenant’s break. The building was a stop gap whilst a suitable new-build option was found, the intention being to move and exercise the break option after three years.

A new warehouse was located and built and the tenant moved across three months ahead of the third-year break date. The break notice had been served and the tenant made repeated requests for a site meeting with the landlord to agree the extent of dilapidation works, or hopefully a cash sum in lieu. These requests met with a mixture of silence and prevarication so very little work had been completed by the break date other than cursory cleaning and redecoration of certain offices.

Immediately following the break date, the tenant received a letter from the landlord’s solicitors stating that 1) the conditions of the break clause hadn’t been met and 2) the lease would continue until its contractual expiry, two years hence. The breached clauses were failure to:

  1. Yield up in repair.
  2. Redecorate in the last year of the term.
  3. Yield up free of tenants’ fixtures and fittings – the tenant had left high-bay racking in situ.
  4. Comply with the insurer’s requirements following vacation, i.e. to provide a 24-hour security presence.
  5. Retain possession and avoid breach of alienation – the tenant had given up possession by vacating the whole and had also granted possession of part of the yard to a neighbour, albeit by informal agreement locally.
  6. Pay the rent reserved by the lease, i.e. quarterly in advance – the tenant had paid the rent but only (pro-rata) up to the break date.

The break failed and the additional rent paid for a property the tenant thought they had given up was over £2 million!

The breaches in respect of items 1, 2 and 3 should have been anticipated. Items 4 and 5 could have caught some out, especially with a locally agreed sub-letting that had not been reported to head office. I suspect item 6 would have caught most out, although I could see this being tested in court had it been the only breach.

Case 2

The property was a high-bay aircraft maintenance hanger in a large commercial airport, which the tenant no longer occupied. The lease contained a highly conditional break clause, which the tenant triggered.

The works process here required 10 clear months to complete (four months for tenders, security clearance and site set up, six months for the works). The parties would have had until about nine months before the break date to negotiate openly before the balance of power started to shift to the landlord, with the tenant needing to start the contractor and the landlord beginning to think about the tenant failing and the lease continuing. Unfortunately, meaningful talks never really got underway.

The required works were largely straightforward repair and redecoration items but, because of the onerous wording of the break clause, the tenant spent upwards of £2 million to ensure full lease compliance and an effective break. Putting this into context, the rebuild cost for the building would only have been around £3.4 million.

An early discussion between landlord and tenant could have achieved a different outcome:

Perhaps a cash settlement for the tenant, possibly at a discount, saving the stress and risk of trying to achieve full lease compliance. The landlord could then have carried out a lesser refurbishment, still sufficient to satisfy a reletting but costing perhaps around £1-1.5 million, giving the landlord cash in hand.

More time for the landlord to test the reletting market before the tenant works’ start date. The size of the hangar, questioned by some as too small to accommodate the next generation of aircraft, could have been assessed more fully.

Demolition or substantial alteration of the building may have been preferred and could have benefited both parties. Again, the tenant might have achieved a negotiated exit with a discount on its £2 million liability and the landlord might have received a substantial proportion towards its preferred works, instead of a fully refurbished building.

In summary, the key to considering the wider picture is time. If the parties talk 12-18 months in advance of the break date, it is possible to speak openly and on an equal footing. Tenants will probably have to instigate an early dialogue as landlords will always sit tight, hoping tenants will miss a break. But it is worth making the effort as the closer one gets to the break date, the more distorted the parties’ respective positions and power become, making a negotiated settlement much less likely.

Andrew Clamp
Edwin Hill Chartered Surveyors