Approaching ‘outgoings’ in lease negotiations
|Services:||Real Estate & Construction|
|Industry Focus:||Real Estate & Construction|
|Date:||30 October 2017|
|Author:||Bill Burrough, Partner|
What you need to know
- The costs associated with a landlord’s ‘outgoings’, from building maintenance to rates and taxes, can be addressed in a lease in several different ways.
- Outgoings often become a hot topic in lease negotiations, with landlords seeking to pass on those costs and tenants seeking to ensure they fully understand exactly what they are expected to cover.
- Both landlords and tenants should pay close attention to the outgoings provision in any lease they are negotiating, to ensure their terms are clear and they reduce the risk of surprise or disputes arising.
Building owners incur substantial costs arising from their ownership, commonly referred to as ‘outgoings’.
In the landlord and tenant context, outgoings are often a topic of debate in lease negotiations. Invariably, landlords will want to pass on the costs of outgoings to their tenants. Conversely, tenants will want to carefully consider the costs they are required to cover. To facilitate smooth negotiations, it is important for each party to understand the other’s perspective and for both to ensure their lease is clear about how outgoings are to be addressed.
How do leases provide for outgoings?
There are three main ways in which a lease might deal with outgoings:
- A lease may provide for a gross rent with no separate outgoings recovery provision. This does not mean the landlord will cover the costs of outgoings; rather, it means those costs will have been factored into the rental amount.
- A lease might provide for a net rent with separate provisions requiring the tenant to pay its share of an extensive list of outgoings (usually on a pro rata basis according to the proportion of the building it occupies).
- A hybrid scenario is for a lease to include a separate outgoings provision requiring the tenant to pay only its share of increases in the outgoings incurred over a particular 'base year'.
All of this will be important for a tenant to consider and evaluate when choosing between alternative premises.
Where there are to be separate provisions in a lease for the recovery of outgoings, particular consideration should be given to the drafting of those provisions. Earlier this year, we published an alert that highlighted what can go wrong where an outgoings clause is poorly drafted.
A case study: how unexpected outgoings can arise
An American tenant occupied premises in a prestigious CBD office building. While the American tenant’s office was small, its profile was high. As a result of certain overseas activities and anti-US sentiment, the building was subjected to demonstrations because of the American tenant’s presence. This resulted in significantly increased security costs. So how were those costs to be treated?
The American tenant was not in breach of its lease and did not cause the need for the additional security, which was for the benefit of the whole building and not the American tenant alone. The American tenant’s contribution to the outgoings of the building was small, as it was determined by reference to its proportion of the building’s lettable area. The other tenants whose businesses were disrupted by the demonstrations, which arose solely because of the American tenant’s presence, were not happy about paying for the increased security under the outgoings provisions in their leases.
This real life scenario resulted in the landlord requiring special provisions in its future leases where it thought the nature of the tenant might pose a security risk. Of course, such additional obligations might not be acceptable to tenants who have competing, less onerous offers of accommodation. Commercial negotiations tend to reveal that both landlords and tenants will give more weight to provisions governing situations where they have personally experienced past difficulties.
Landlord’s perspective on outgoings
Outgoings which a landlord will generally seek to pass on to its tenants include:
- rates, taxes (including land taxes) and other charges payable to any authority, although this will usually exclude income and capital gains tax on the basis that these are personal to the landlord
- the cost of insuring the building (including for loss of rent which is perhaps fair if the lease provides that the tenant’s obligation to pay rent is to be abated where the building is so damaged that the tenant’s premises cannot be used)
- maintaining the building’s services and common areas for the benefit of the building’s occupants, noting that the level to which a building
is maintained and presented may be an important factor to many tenants as this will reflect upon the tenant and its business.
Usually, it will be in a landlord’s interests to ensure the definition of the outgoings it can recover from a tenant is drafted as widely as possible.
However, if a landlord makes the outgoings provisions in its leases too onerous, it may find itself spending a lot of time and expense on lease negotiation or even losing tenants to its competitors.
Tenant’s perspective on outgoings
Tenants may want certain costs to be excluded from the outgoings which their landlords are able to recover from them. The usual carve outs that most tenants will seek (and that landlords may proactively provide for to avoid delays in finalising the lease) will exclude:
- Any items of capital or structural expenditure. While tenants are generally prepared to contribute to the running costs of buildings, they will not usually want to pay towards its upkeep or improvement.
- Any liability or expense for which a particular tenant or occupier of the building is liable. Leases may have provisions where a tenant is individually liable for an outgoing which is wholly referable to that tenant. Other tenants will not want to contribute to that outgoing in such circumstances.
- Management costs, which can be widely defined although the compromise is generally to leave these in as an item of outgoings but to cap them to a given percentage of rental.
The extent of any carve outs that end up in a lease will depend upon negotiation. Some tenants may seek additional exclusions because of the nature of the premises they are leasing. For example, a tenant of ground floor premises may not want to contribute to the cost of lift services in a high rise building. However, many landlords will, as a matter of policy, require all tenants in a building to contribute to the cost of services benefiting the building as a whole, whether or not a particular tenant makes use of those services.
Tenants will almost certainly want their leases to provide that any outgoings to which they are to contribute must be reasonably and properly incurred. They may also seek a requirement that the outgoings to which they are to contribute be independently audited, with details provided to the tenant with adjustments as appropriate. Whether this is necessary will depend upon the extent to which the tenant is required to contribute to outgoings and the nature of those outgoings.
Further considerations apply for tenants entering into leases which provide for the payment of increases only in outgoings. If the outgoings for the base year are effectively included in the calculation of the rental for that year, to what extent might the landlord be 'double dipping' if it is receiving in subsequent years a rental increase as well as increases in the outgoings? Do the outgoings in the base year reflect what the amount of outgoings might be in a normal year of operation? If it is a lease in a new building, there may be costs which are covered in the early years by builders’ warranties and suppliers’ guarantees meaning that the landlord’s outgoings for the base year could be much lower than they would otherwise be.
Some legislative safeguards for retail tenants
Retail lease legislation provides certain safeguards for tenants in relation to landlords’ rights to recover outgoings, although this protection does not extend to leases not covered by that legislation. Each State has different legislation that needs to be carefully considered. Generally speaking, however, a landlord cannot recover an outgoing from a tenant of a retail shop unless it is specifically referred to in the lease and has been disclosed to the tenant before the lease was entered into. Prospective landlords and tenants of retail shops should seek specific advice in this regard before marketing or entering into negotiations.
Where leases are not covered by the legislation, a prudent tenant might ask to see outgoings statements for preceding years and a budget for the current year to determine their likely liability for outgoings under the lease.
The key takeaway is that both landlords and tenants should pay close attention to the outgoings provisions when negotiating their leases. By doing so, both parties can ensure that they each understand who is responsible for costs that are likely to arise during the term. This will hopefully avoid unwelcome surprises and costly disputes down the track.
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