Commercial Leases - Practical considerations when exercising a break option

Given the pressure that the current crisis is placing on businesses in most sectors it is likely that companies are reviewing cash flow and outgoings. We expect most businesses are reviewing spending and considering where costs might be reduced. An obvious and substantial cost is going to be rent payable under a lease of business premises.

In a previous advisory we examined the potential to reduce outgoings by deferring rates.
It is anticipated that the current Covid-19 crisis shall lead to extensive landlord & tenant engagement on rent freezes, holidays, abatements or reductions. We have prepared a recent advisory in relation to this which is accessible on our website.

Tenant break options are a relatively common feature of commercial leases in the Irish market, particularly where the term of the lease extends beyond ten years. A break option affords a tenant (and a landlord if a mutual break) an opportunity to surrender the lease on a particular date subject to compliance with various terms and conditions of the lease. Tenants with upcoming break options could exploit the availability of the break to improve their position when negotiating concessions.

The important thing to appreciate in serving a break notice is that once served properly, it becomes binding on the parties and cannot be unilaterally revoked by either party. Tenants must therefore tread carefully when considering whether to actually serve a break notice as part of their overall negotiation strategy.

Key considerations in a review of a break clause include the following:

Timing

A typical break clause shall require a tenant to send a notice to the landlord setting out the intention to break the lease. The period of advance notice owed to the landlord can vary from 3-12 months. Unlike most other provisions of a lease, the break clause shall provide that time is of the essence. In short, if a tenant fails to provide the requisite advance notice, the right is lost. In light of the current circumstances, it is worthwhile giving some additional thought to the timing of the notice and the mechanics of delivery. Firstly, it is important that the specific notice provisions of the lease are followed to the letter, as failure to do so shall invalidate the break notice. Secondly, as most of the workforce are now working from home, tenants may face a logistical challenge around signatories and accessing postal services. Therefore if serving a break now, a business should ensure that a notice is delivered far enough in advance to overcome these hurdles.

Financial

Certain leases require that the tenant make an upfront payment which is handed over with the break notice. Breaks are not always contingent on a penalty payment being made. It will depend on what the parties agreed to at the outset. Prior to service, tenants should review their lease to understand what their financial obligations are upon serving a notice, as the failure to comply shall invalidate the notice. Even where a break notice has been served, a tenant remains responsible for the rent, service charge, insurance, utilities and all other monies payable under the lease until the property is vacated. 

Vacant Possession

In order to exercise a break option and exit a lease early, the tenant must deliver full vacant possession of the premises on the break date. Typically vacant possession includes the removal of all tenants stock, machinery and fixtures & fittings. If for example a tenants business is heavy manufacturing, this shall likely entail a requirement to engage third parties to effect the removal of the machinery. Likewise, if the tenant trades in a specialist sector that is subject to specific regulations such as hazardous materials, or contains stock the subject of specific industry protocols such as pharmaceutical, specialist third parties may be required to effect vacant possession.

Landlords and tenants alike shall have to be cognisant of the potential restrictions on a tenant’s ability to satisfy its vacant possession obligations in the current climate where the ability to undertake the removal of stock, machinery and fixtures & fittings may be impeded by the unavailability of tradesmen or other suitably qualified professionals, or through actual access to the premises itself being restricted.

Repair

Two further clauses requiring careful analysis when considering whether to exercise a break option are the yield up and repair clauses. The yield up clause determines the condition upon which the tenant must hand back the premises to the landlord and it is usually in accordance with the repair obligations. Usually a schedule of dilapidations is prepared by the landlord identifying the remedial works required to the premises with a calculation of the cost of completing the work. This can result in a significant additional cost to the tenant on termination and one that may not have necessarily been factored into the cost -v- benefit analysis undertaken when serving the break notice. If the yield
up clause requires the removal of a tenant fit-out, third party contractors shall be required to effect its removal. As previously identified, the ability to engage suitably qualified professionals to satisfy this requirement may be hampered by the current Covid-19 restrictions.

An additional issue that may also arise relates to inspection of premises for the purposes of undertaking the dilapidations survey and the restriction on access to certain premises.

General

Typically, a tenant must return the original lease together with an executed deed of surrender at the end of the lease. Tenants should consider now any operational difficulties that may arise in complying with such obligations resulting from Covid-19 restrictions, including access to original documentation and the availability of signatories.

Tax

On exiting a lease, both landlords and tenants should engage with tax advisers to understand the VAT implications of exercising a break. Typically any VAT liability accruing to the Landlord as a direct result of the break option is an additional costs that the tenant must bear.

The above represent a non-exhaustive list of items to consider prior to serving a break notice. Each element of the lease needs to be considered in detail so that the implications of the break are fully understood by the business. Clearly a tenant’s ability to comply with the provisions of the lease may be compromised by the current crisis and this has ramifications. Most leases will allow assignment or sub-letting on notice to the landlord. Given the costs that can be associated with a break, these could be viable alternatives to consider right now. How realistic an alternative this is will depend on the property.