Tom Merrick, Aimee Dring and Annabel Lindsay begin a three-part series on alienation by considering what it is and why it is important for both landlords and tenants.
Recent uncertainty in the market has led to the concept of flexibility, once again, becoming a top priority for corporate occupiers when considering and negotiating terms for a new lease.
The alienation provisions in a lease can provide a tenant with a flexible solution to adapt where needed, although the constraints that may be imposed on these options often lead to many occupiers opting for even greater flexibility in the form of “flex leases” which are now commonplace.
Traditional alienation provisions within a lease will determine what a tenant can and cannot do in terms of dealing with its interest in the property. Personnel changes or market pressures and/or demands could mean that some, or all, of the property becomes surplus to a tenant’s requirements or may require a tenant to scale up and relocate to larger space to facilitate business growth.
The alienation provisions can therefore provide essential mechanisms should a tenant need to part with their property during the term of the lease where no other early exit options are available.
In this three-part series, we will consider what alienation is (focusing on the different options available to tenants), why it is important for both landlords and tenants, and the key legislative provisions and case law in this area.
In this article we will also briefly explore the flexible lease as a modern alternative to relying on the more traditional alienation provisions.
What is alienation?
An alienation provision within a commercial lease will determine whether a tenant can assign, underlet, charge or otherwise deal with its interest in the lease. It would be unusual for a lease not to include any alienation provisions (except in long leases where a tenant has paid the landlord a premium), otherwise a tenant would be free to deal with the lease as it so wishes, which could be to the detriment of the landlord.
If a lease contains an absolute prohibition on dealing, a tenant will not be able to assign or underlet its lease. As a consequence, the tenant could find itself paying rent and other outgoings for the remainder of the term for space it may no longer require (unless the landlord, at its complete discretion, is willing to agree to an assignment or underletting or is prepared to accept an early surrender of the lease – in either case at a cost
to the tenant and on terms dictated by the landlord – or the tenant was
able to include a tenant break option in the lease).
Lease assignments of part are rarely permitted due to the legal and practical complexities which they create. A lease will therefore usually permit the tenant to assign the whole of the lease with the consent of the landlord and subject to certain conditions being met by the outgoing tenant and possibly the incoming tenant (depending on the circumstances).
When a tenant assigns a lease, it transfers its interest in that lease to a third party. That third party takes on the lease for the remainder of the contractual term, meaning the incoming tenant “steps into the shoes” of the outgoing tenant.
A tenant may wish to assign its lease when there is no longer a business need for the property or if it wants to downsize/upsize or just relocate to more modern space. Alternatively, if the assets of a business are being sold, any property would need to be assigned to the buyer pursuant to the assignment provisions within the lease as part of the business sale.
Underletting the whole or part of a property creates a new tenancy which sits beneath the existing lease (an underlease). It is granted to the undertenant by the existing tenant (who becomes the undertenant’s landlord).
This option may be preferable if the tenant wishes to retain its interest in the lease (as it may need to use the property again in the future), but only wants to use part of it or where it cannot find a tenant to take on the existing lease.
The terms of an underlease must be shorter than the term of the lease out of which it is granted, otherwise it would take effect as an assignment at law (which creates legal issues for the parties involved). Again, consent from the landlord will usually be required and any conditions to such consent will typically be set out within the underletting provisions in the lease.
A lease will also usually contain provisions dealing with charging the property and sharing or parting with possession of the property, notably sharing occupation with group companies or business associates without needing landlord consent (provided no relationship of landlord and tenant is created).
Why are alienation provisions important?
A tenant should ensure that it has some flexibility in relation to how it may deal with its interest in the lease during the term. Aside from the negotiation of a tenant break option (which may come at a cost) the alienation provisions can provide such flexibility and a means of future-proofing the lease.
They can enable a tenant to adapt to circumstances (both external and internal) which require it to re-evaluate its use and need for physical space earlier than anticipated.
On the other hand, a landlord will want to control how much flexibility a tenant has in order to protect its asset and its future rental income stream. Landlord’s consent is generally required, and conditions are put in place to ensure that any incoming tenant or undertenant will be able to comply with the tenant covenants in the lease and/or underlease.
A landlord may require additional security from an incoming tenant with a lesser covenant strength than the existing tenant as well as an authorised guarantee agreement from an outgoing tenant on an assignment. The negotiation of the terms of such conditions in a lease prior to its grant can therefore be key.
Beyond alienation and the rise of flexible leases
Post pandemic working has changed the office environment. It has led landlords and tenants to reassess what flexibility in the office space looks like. Previously, a typical office lease term would have been 10-15 years, offering both landlords and tenants certainty.
However, in recent years, there has been a marked increase in leases granted for a term of five years or less with many tenants opting for short-term flexible leases of:
- co-working spaces;
- serviced offices;
- hot desks;
- virtual offices; and
- managed offices.
The flexible lease solution allows tenants to exit space easily and more quickly and increase/decrease their footprint as may be needed from time to time. These flexi options remove the need for a tenant to rely on traditional alienation provisions in the lease which rely on the tenant finding somebody to take the space and are often subject to conditions and costs that a tenant may prefer to avoid.
Flexible leases may not always be appropriate and can create an element of uncertainty for both parties. An increase in rotation of tenants is an administrative burden for a landlord, which creates risks to its rental stream and limits the ability to demonstrate to investors or funders a flow of income for a prolonged period.
As a result, landlords will often look to offset this uncertainty by charging tenants a higher rent and/or including a high break payment (if a break is exercised). Some tenants are happy to pay these additional payments in return for the flexibility their business needs.
Flex leases: pros and cons
Pros
1. Upfront certainty and fewer constraints on exiting the space
2. Versatility and adaptability to react to market conditions and business decisions
3. Dynamic workspaces with networking and collaboration opportunities
4. Use of modern infrastructure and amenities without capital outlay
5. Landlord opportunity to generate more revenue per sq ft
Cons
1. Flexibility at a premium, eg higher rents
2. Lack of traditional certainties for both parties
3. Higher turnover rates resulting in unpredictable income streams for a landlord
4. Additional administrative burdens and costs
5. Confidentiality and date security risks if sharing space with others
Tom Merrick is a managing associate, Aimee Dring and Annabel Lindsay associates in the real estate team at Lewis Silkin
Read part 2: Lease assignments under the microscope
Read part 3: An overview of underlettings
