Lease incentives – protecting your investment
Incentives to enter into leases are consistently offered by landlords trying to secure tenants in today’s commercial property markets. The only questions are how much of an incentive the landlord will provide the tenant, and in what form, and what the landlord will get in return. Landlords want to ensure that any incentive offered to a potential tenant will provide an appropriate return in terms of future rent and lease compliance by the tenant. So when a tenant who has benefitted from an incentive either breaches the lease or wants out of the lease, what can a landlord do to recover its investment in the incentive?
It has been fairly standard practice amongst landlords to include “claw-back” clauses in leases, to try to give the landlord the ability to recoup any incentive paid or allowed to the tenant. However will a “claw-back” clause actually help you to recover your incentive? What else might be considered?
In this Property Reporter, Moulis Legal senior lawyers Lisa Eldridge and Ann Jovanovic give their insights on the value of claw-back provisions in leases, and some alternative options for providing incentives to tenants.
Claw-back of incentive clause struck down
If the recent Queensland case of GWC Property Group Pty Ltd v Higginson & Ors (“the GWC case”) is given effect throughout Australia, then a “claw-back” clause in your lease will not help landlords to get their money back. The GWC case says that a landlord cannot recover any monetary incentives already paid or allowed to a tenant upon early termination of the lease due to a breach by the tenant. The court explained this on the basis that it would be unfair for the landlord to recover any monetary incentives when such recovery would place it in a better position than if the tenant had fulfilled its obligations under the lease.
The result of the GWC case, therefore, is that where a lease is terminated due to a breach of the lease by the tenant, the landlord is only able to claim from the tenant:
- any unpaid rent that would have actually been paid by the tenant if the lease had not been terminated;
- any other payments required to be made by the tenant under the lease, such as for utilities;
- the cost of re-letting the premises; and
- any difference between the rent payable by a new tenant and the rent the landlord would have received under the terminated lease.
The rent and other payments are only able to be claimed up to the date that a new tenant leases the premises or the date that the lease would have expired.
According to the GWC case, the fact that the incentive may have been something that the landlord would consider to be a cost that was evenly spread over the whole of the expected term of the lease does not mean that it can be recovered under a “claw-back” clause.
So what can you do? There are a few options available to a landlord that may minimise the risk that a landlord will not see a return on its investment when providing an incentive to a tenant. Each of them departs from the upfront lump sum incentive approach that tenants like and that many landlords typically adopt.
Rewarding good behaviour
A technique commonly used to encourage payment in service contracts is for a discount to be given if certain conditions are met – for example, if payment is made by the due date. This technique could be applied to leases by discounting the rent payable each month only if the previous month’s rent has been paid on time and there have been no other breaches of the lease by the tenant. The “reward” would operate as part of the tenant’s obligation to pay rent each month in the ordinary course of an ongoing lease, rather than being a penalty for the termination of the lease due to the tenant’s breach of the lease. Thus, the forward rental that the landlord would miss out on in the case of termination for the tenant’s breach would be the higher, undiscounted amount.
In our view, the prohibition on “claw-back” could still be applied by a court, however it would only apply to the amount that could otherwise be clawed back – being the discounts given before the termination.
While the concept of a “reward for good behaviour” has not yet been tested in relation to leases, this concept has been allowed in other situations including mortgage repayments and service contracts. We expect that providing the incentive in such a way would allow a landlord to recover the remaining rent payments in full and prevent the tenant from being able to claim the rest of the incentive.
Upside-down rent free periods
Where rent-free periods are used as an incentive, the rent-free period frequently occurs at the start of the lease. As an alternative, the rent-free period could occur at the end of the lease – for example, the last six months of the lease. With this option, the tenant would not receive the incentive unless it had already complied with the obligations under the lease before then, and the landlord would not provide the incentive without ensuring that there had been such compliance.
Whether “loading” a building with significant end-of-term penalties for a landlord is a good idea from the perspective of any future sale is a commercial matter that would also have to be considered by the landlord.
Another option would be for any rent-free period to be split into smaller rent-free periods. For example, if the lease is a three year lease and the incentive equates to three months of rent, the last month of each year of the lease could be a designated rent free period.
However, where the incentive is split in this way, if the tenant does not stay until the end of the lease, the landlord will not be able to claw back any rent free periods already provided to the tenant.
Usage rights as incentives instead of cash
Instead of providing rent-free periods, landlords will regularly propose that they pay for or contribute towards tenant fit-out or furniture. If this type of incentive is used, the landlord should include a term in the lease which provides that the landlord:
- owns the fit-out or furniture;
- grants the tenant a licence to use the fit-out or furniture,
for the duration that the tenant is in possession of the premises. At the end of the lease, the fit-out or furniture could either remain as the landlord’s property or the ownership could pass to the tenant.
Whether an incoming tenant, who moves into space that has been vacated by a defaulting tenant, will see any value in the type and configuration of the defaulting tenant’s fit-out is another question entirely, however at least the potential for the fit out to retain some residual value will remain.
The result of the GWC case is that a “claw-back” clause intended to recover consideration already given to a tenant will not be effective. We have identified some of the options open to landlords to avoid using “claw-back” clauses while minimising any potential lost investment caused by a terminated lease.
Regardless of which option is pursued, a landlord will always have an obligation to mitigate any losses it may suffer as a result of a lease being terminated because of the tenant’s breach of that lease.
Moulis Legal services national-level organisations who seek secure income streams from major and landmark properties, and for the key tenants who deliver those income streams. Our experience covers the acquisition and sale of commercial property, ownership structures, major leases, development approval procedures and construction contracts and their negotiation.
This memo presents an overview and commentary of the subject matter. It is not provided in the context of a solicitor-client relationship and no duty of care is assumed or accepted. It does not constitute legal advice.