Lease Negotiation is the final and arguably the most complex part of the site selection process. The average shopping centre lease will cost the retailer well over half a million dollars and sometimes more than one million over the term of the lease including fitout. With that much money at stake it is critical that you get it right.
Welcome to the third and final instalment of the LeaseInfo Group blog series covering Common Retail Leasing Mistakes. In this article, we will cover how you should prepare for a retail lease negotiation including the 11 key lease terms you need to understand before entering into a negotiation.
It is imperative that when you negotiate your lease, you do so from a position of strength. To do this, gather relevant information about the following topics:
NOTE: Conducting relevant research will also help to align your expectation of rental expenditure with actual market values.
- Market understanding – A thorough understanding of your market and your competition (including price points).
- Your financials – A detailed plan of your revenue projections, and ideally, a 5 or 10-year plan. And a track record showing financial viability.
- Fitout – A detailed plan of your fitout, including cost and time breakdown – this will assist if you are wishing to obtain a fitout contribution.
- Comparables – Comparable leasing evidence relating primarily to the proposed shop usage, but also across the entire shopping centre.
- Know your obligations – Understand your obligations under the lease, including bank guarantees, turnover provisions, and personal guarantees (if required).
Entering into a retail lease often involves entering into a long-term commitment. Like any long-term commitment, it is important to make sure both the premises and the lease terms are suitable to your needs and circumstances, not just now, but also in the future.
When evaluating a lease there are 11 critical negotiation points you need to be aware of as well as tips and tricks within those items which will enable you to structure your negotiation and budgeting effectively.
1 – Rent
Retail leases are usually negotiated on a per-square-metre basis with the exception of kiosks and large structures. The annual cost of the lease is usually determined by multiplying the square metre of the premises by the asking price per square metre (psm).
A 50m² shop at $350psm equates to $17,500 per annum and $1,458.33 per calender month.
You should always keep in mind that GST will be applicable on top of rent.
Some landlords also offer incentives in the form of rent free periods or a contribution to fitout. Landlords will often have certain margins they work within in regards to incentives. They will consider factors such as the term of the lease and the rent increases throughout the term when considering incentive structures.
If you receive an incentive, bear in mind that the rent will be inflated by that incentive over the term of the lease. This is called the face rent.
Let us consider the following example:
If a shop has a market rent of $350/m2 and is 50m2 then the effective rent is 17,500 per annum. Effective rent is the rent after applying incentives.
If a tenant receives an incentive at $50,000 and signs a 5 year deal. The landlord will include an extra $10,000 each year over the term of the lease to cover that incentive. Bringing the total yearly rent to $27,500. This is known as the face rent. In short incentives are not free money, there is no such thing as a free lunch.
2 – Security Deposits and Bank Guarantees
The landlord will usually require a bank guarantee or security deposit to be provided when you enter into a retail lease. These bank guarantees can be held by the landlord or by the Retail/Small Business Commissioner in some States in Australia. The landlord will have the ability to ‘draw down’ or ‘call up’ these forms of security in the event of default by a tenant under the lease.
A bank guarantee is a form of undertaking from a bank or credit union to guarantee payment of a provisional sum to a landlord. The lease will outline the circumstances in which the landlord can ‘call up’ or ‘draw down’ the bank guarantee. Typical bank guarantees accounts for 3 months of the rent, outgoings + promotion levy + GST of the lease, however this can vary slightly from lease to lease.
You should factor this cost in when looking at your budget.
In addition to bank guarantees and security deposits, a retailer may be required to give a personal guarantee, also known as a covenant. This is a serious undertaking whereby a director or other party personally guarantees performance written into the lease. In the event of default, the guarantor is personally liable for damages under the lease. There are serious financial consequences of providing personal guarantees and retailers should seek financial and legal advice before undertaking to provide these guarantees.
3 – Lease Term and Options
You always need to consider the lease term when negotiating a retail lease and make sure the length of the lease suits your particular circumstances and needs.
Some tenants are looking for a long-term lease to allow them time to build up their business with that security of tenure. A long-term lease will be a consideration for tenants who wish to have a business that is a saleable asset.
On the other hand, if you enter into a long-term lease and your businesses grows faster than expected, you may find yourself in a position where you outgrow the premises and you still have a couple of years to run in your lease term.
Landlords usually like long-term leases from a security point of view. As a general rule, the longer the lease the higher the incentive (if available). However, also remember the longer the lease the more rent reviews.
An option is the right but not the obligation to obtain a further lease at the expiration of the existing lease. They favour the Lessee as they can be exercised at the lessee’s discretion.
See our previous blog to further understand options and how they are exercised.
4 – Rent Reviews
Retail leases will almost always contain rent reviews. There are not many landlords who will want a fixed rent over the term of the lease.
A rent review will contain one or a combination of the following forms:
- Consumer Price Index increase or CPI plus a fixed % e.g. CPI + 2.5%
- Fixed percentage increase (for example, 3.5% each year)
- Fixed amount increase; or
- Market rent review.
You should factor these increases into your budget.
If you enter into a five-year lease of $100,000 per annum with fixed increases of 4% per annum you will be looking at a rent increase of approximately 17% over the lease term. By the end of your lease you will be paying $116,985.90.
5 – Fitout
You need to consider whether the commercial space you are looking at requires a fitout.
If it does, you should get an idea of fitout costs from a licenced fitout contractor or builder. The cost of fitout should always be considered when you are looking at your budget.
As indicated in tip one, sometimes the landlord will be prepared to offer an incentive in the form of a contribution towards the costs of your fitout. You should note often these contributions may only be provided after the works have been completed, paid for and final certificates obtained.
You must negotiate a fitout period, which is rent free which allows you access to the shop prior to rent commencement. The usual minimum is 4 weeks however it may vary by landlord and fitout style.
6 – Permitted use of the premises
The lease will need to contain a permitted use. What will you be using the premises for?
It is in a tenant’s interest to negotiate a broad permitted use. This will allow for future diversification of the business if need be or may allow a sub-lease arrangement (landlord consent will likely be needed to enter a sub-lease). Furthermore, when you attempt to transfer or amend the lease, a narrow permitted use may block your ability to sell/transfer the business.
Once a lease is signed and binding, any changes to the lease may not be possible unless the lease is varied or amended. This can be timely and costly.
7 – Net, Semi-Gross and Gross in Relation to Outgoings
There are three broad types of outgoing recovery methods in retail leases:
This is where, in addition to the rent, the tenant is required to pay all recoverable outgoings of the lessor. Which outgoings are recoverable are governed by the Retail Leases Act in each State. For example, in VIC and QLD Land tax is not recoverable.
This is where the lessee is responsible for paying some of the outgoings in addition to the rent. These outgoings are specified in the lease.
Specific outgoings are recoverable or part thereof; for example only Council, Water and Land Tax are recoverable.
Another type of semi-gross lease in where the tenant pays for increases over a base.
Increases over a base à this is where total recoverable outgoings are estimated at the start of the lease (base year) and the lease pays a percentage increase over that base year. For example a tenant leases a shop on 1/1/2019 and total outgoings for that year was $100/m2. In 2020, the outgoings for that shop are $110/m2, therefore the tenant pays an increase over a base line; $10/m2 in 2020 for outgoings.
A gross lease is where all the outgoings are included in the rent and there are no additional outgoings to pay.
In relation to outgoings, typically tenant usage changes that are undocumented by the tenant exclusively do not form part of outgoings. They typically included:
- Metered power
- Grease trap removal
- Metered gas
- Telecommunications/ internet
- Water usage
Read our blog to learn more about lease terms and other basics including outgoings.
8 – Assignment and Sub-Letting
You should make sure your lease allows you the ability to assign the lease or to sub-lease part of the premises.
For example, if you were to sell your business you would need the ability to assign the lease to an incoming purchaser.
If business structures change (for example, shareholdings or restructuring) the lease may also need to be assigned.
Assignments and subleases are subject to landlord’s consent. There are often conditions attached to this consent process and they are also governed by the Retail Leases Act in each state.
9 – “Make Good”
You should always be aware of the ‘make good’ conditions otherwise referred to as “yield up” clause in you lease.
All retail leases state something to the effect that at the end of the lease the tenancy must be brought back to the condition it was leased in, allowing for fair wear and tear.
Significant issues arrive when a lease has taken over an existing fitout or has renewed an existing lease. Therefore, at commencement of every new lease, a dilapidation report should be prepared and agreed between landlord and retailer.
10 – Additional Costs
You should be clear on who pays what in relation to the leasing process.
Types of costs involved in retail leases include legal costs, mortgagee consent fees, and registration costs, as well as design fees for fitout.
The Retail Leases Act governs rules around what can be recovered around lease preparation. All other costs are usually negotiable or can be capped by agreement. This can run into the thousands of dollars, so careful consideration must be applied.
11 – Marketing Levy
If the lease is in a shopping centre, the retailer maybe required to pay a contribution to the marketing/promotion fund to contribute to the marketing of the centre. This is usually held by the landlord in a separate trust. Marketing levy usually is between 3-5% of the rent and is payable with the monthly rent and outgoings.
Shops outside shopping centres do not pay marketing levies.
This blog is not legal or financial advice and cannot be relied upon by any third party as such. Appropriate professional advice should be sought prior to entry into a lease.
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.