Current economic uncertainty pre, as well as post Pandemic has fostered an increased desire for risk mitigating factors to be included within commercial leases. Specifically, redevelopments and extensions in shopping centres have become particularly uncertain for tenants due to insufficient trade area for new development, additional competition from other centres and poor or ill-conceived design.
Tenants currently are therefore looking to mitigate their leasing risk through break clauses and capped occupancy costs.
What is a break clause?
A break clause will give the Lessee the right to break the lease before the lease term has concluded, with a penalty and conditions attached. Reasonable notice will still be required during a notice period specified in the break clause – typically the second year of a lease, or often around the mid-point. The lease will stipulate any requisite conditions which must be fulfilled to enact the break clause, as well as what the penalty will amount to. A typical penalty could be a sum totalling 3-12 months’ rent, or as negotiated.
Typical break clause conditions usually involve a certain audited sales target not being achieved or a certain level of occupancy for a new shopping centre not reaching a target.
What are capped occupancy costs?
Capped occupancy costs refer to when the Lessor sets out an initial expected base rent, however, if turnover fails to meet an agreed occupancy ratio, the base rent will be capped at that given ratio.
For example: rent may be set at $150,000 per annum with an agreed capped occupancy of 15% net. If sales only achieve $800,000, rent will be capped at $120,000 (allowing for a refund of $30,000). If sales the next year exceed $1,000,000, the rent will return to the original sum of $150,000.
This therefore offers some relief to a business who may not be experiencing the returns they had expected, particularly useful in a newly ventured, volatile or uncertain market.
When are these provisions useful?
These mitigation provisions should be negotiated into shopping centre extensions or redevelopments where the market will be uncertain for the first few years of the lease term or in situations where there is not yet an established market. It is also increasingly common for break clauses to be incorporated in international lease deals or certain corporate lease deals where the business may be reliant on a wide and unpredictable combination of factors.
Therefore, if a commercial venture is not as successful as expected, break clauses or capped occupancy costs provide a preventative means to mitigate future losses.
It should not be misconstrued or overstated – the majority of leases do not contain either of these provisions and even if included, in most cases, a lease will last the entire term and a capped occupancy ratio is unlikely to be met. However, a break clause or capped occupancy clause will allow for extra security in the case of unforeseen unfortunate economic circumstances, making them useful and risk-mitigating provisions which can be extremely valuable to negotiate into a lease.
How do I negotiate for inclusion of these clauses?
As with any negotiation, it is important to do your homework and arrive prepared with research and fact-based evidence to support your request. You should be looking to find instances of similar provisions within comparable properties and tenancies.
If you attempt to negotiate a break clause or capped occupancy clause, remember that Landlords rarely provide these in the case of “stable shopping centres”. The main reason for this is that it increases the Landlords’ risk significantly. Therefore, any successful negotiations will likely be in the case there is a new development or extension as this indicates risk on both sides.
This post was authored by Simon Fonteyn. Simon is one of Australia’s leading experts in retail, childcare and medical leasing and rental valuations. He holds a Degree in Accounting & Finance, a Diploma of Valuation, a Masters of Management and is an Associate of the Australian Property Institute. With over 25 years experience in the commercial property industry, Simon founded LeaseInfo® as a way to provide more transparency to the industry.