Landlord and tenant: fitting in a fit-out

The real estate sector is undergoing a challenging time due to stubbornly high inflation causing high debt costs, resulting in lower investment values. Additionally, occupiers are more cautious.

In order to agree a letting a landlord might, therefore, to sweeten the deal, agree to grant a tenant a rent-free period reflecting the time and expense incurred by the prospective tenant in making the property suitable for the tenant’s business needs. How should the tenant approach this?

What is a rent-free period?

When agreeing a new lease of commercial premises, it is common for the landlord to grant to the incoming tenant an incentive in the form of a rent-free period. A rent-free period is an inducement for the tenant to enter into the lease and acknowledges the time that the tenant will spend on making the property suitable for its business needs. During its period of fitting out, the tenant will be incurring costs but not generating an income from the property.

A rent-free period is not a given but is something that needs to be negotiated between the parties.

Why would the parties agree this?

The property market will generally dictate the availability of a rent-free period. A landlord may agree to grant a rent-free period as an incentive for the tenant to take the lease where it has found a particular property difficult to let. The landlord might also recognise that a property is not suitable for a tenant’s needs and business.

Alternatively, a property might be in disrepair, and it might be more practical for the tenant to carry out the necessary remedial works. The tenant will know exactly what it intends to do with the property. If the repair works are carried out at the same time as the fit-out works, then then they are likely to be less disruptive.

The property might also need to be brought to a standard compliant with legislation. For example, there may be a requirement that fire safety compliant doors or fire exits are installed, or that works are needed to satisfy health and safety regulations for a restaurant. It is possible this might only come to light when legal advisers undertake enquiries and searches. In these circumstances, the tenant could seek to negotiate a rent-free period reflecting the time that it will take the tenant to carry out these works.

In the content of energy efficiency legislation, it should be noted that (unless the landlord has applied for an exemption) if a property offered by the landlord has an EPC rating of F or G, the landlord must bring the property up to standard before completing the letting. The tenant may carry out works to further improve the energy efficiency of the property, but it does not have to do so.

The length of rent-free offered by the landlord is unlikely to be equivalent to the costs incurred by the tenant in carrying out its fit-out; the amount is simply too uncertain. The rent-free is an incentive in return for the tenant’s expenditure and commitment. The length and structure of the rent-free period is a matter for negotiation between the landlord and the tenant or their respective surveyors. The agreement reached will be documented by the legal advisers.

How is it structured and how should it be documented?

A rent-free period might be agreed in various forms, with common ones being:

1. A period where no rent is payable at all. If you are a tenant this will be attractive, as it will mean you do not incur the extra expense of rent when you are not yet generating an income from the property.
2. A (usually longer) period where 50% of the rent is payable. If you are a landlord, you might prefer this option as it can address any cash flow issues by ensuring you do still receive an income.

The rent-free period will normally be documented in the lease. If you are a landlord, you may prefer to document the rent-free arrangements in a side letter, which will mean the commercial terms are confidential.

The tenant’s fit-out should be documented in a licence for alterations. The licence will detail what works are agreed and the standard of work required. When a lease comes to an end, the licence will remove any doubt as to which alterations, fixtures and fittings should be removed and which should stay.

When?

Rent-free periods for fit-out works are almost always seen at the start of the lease. This makes sense practically, as it minimises any negative impact on the tenant’s business while the works are being carried out.

However, a tenant’s needs could well change during the course of the lease. If a tenant decides later down the line that it wishes to carry out further works to the property, it might be responsible for the landlord’s costs in documenting this new agreement and is unlikely to be able to negotiate a further rent-free at that stage. It is therefore in the tenant’s interest to consider what works are required at the outset.

Rent-free periods can be agreed in other circumstances, for example, as an incentive if the tenant decides not to exercise a break right.

It is important to note that a fresh rent-free period might not be available to the tenant when a lease is renewed. The landlord’s view is that a tenant has already carried out any fit-out works; it does not need the benefit of a new rent-free period. On the other hand, if a new tenant would be offered a rent-free period, why should the existing tenant suffer?

What next?

Your legal adviser will be able to provide advice on negotiating a rent-free fit-out period and correctly document the agreed deal. After raising enquiries and undertaking searches, the legal adviser will also be able to advise whether any works are required to bring the property to a standard compliant with relevant regulations and legislation. Whether you are a landlord or a tenant, we can put you in touch with an agent who will be able to negotiate the rent-free terms on your behalf.