FRI Leases in a recession - not always the protection you expect

The Financial Times reported today that "Maintenance Cuts threaten property values". For those who cannot be bothered the article what it says it that whilst UK property is generally let on full repairing and insuring tenant covenants landlords are cutting back on repair and maintaining those parts of the properties for which they have responsibility and for which they recover the cost through the service charge due to fears over whether the costs are recoverable arising from tenant default and increasing voids. Meanwhile, landlords are facing an increasing number of void units in disrepair due to tenants failing to repair and then becoming insolvent.

The failure by landlords to carry out anything but the most urgent of repairs is, of course, a double edged sword for a landlord. It exposes the landlord to the risk of tenants seeking to enforce landlords' repairing obligations (although this might be unlikely save where the disrepair is likely to damage the tenant's business). More importantly, it makes reletting the unit at the best rent very difficult since the centre in which the unit is quickly becomes dilapidated and less attractive to potential tenants. Hence, one could argue that failing to repair is only prolonging the pain for the landlord. In truth, however, landlords will probably wait until real signs that the market is picking up before deciding to carry out repairs. The timing does need to be right since if a competing location is in better repair and condition it may prove more attractive and take away potential new tenants.

Repair of individual units is even more tricky for landlords. Is there any point in carrying works of repair to a vacant unit with little chance of letting. On the other hand what chance is there of letting a unit in disrepair and what effect will this have on rent. Some landlords may opt to wait until a potential tenant is found and then agree to put the property in repair (or pay a reverse premium to the tenant to do this). This means that the level of rent should not be affected. However, a tenant looking to move in quickly (especially in the run-up to Christmas to make the most of the holiday trade) is more likely to opt for a unit ready to go.

Finally, all landlords (and tenants when landlords are carrying out works) would be well advised to check carefully the terms of service charge provisions in the various leases to check what works are recoverable and what are not. How are voids treated? What are the obligations in terms of repair?

Is the FRI lease manifestly unfair?

I sat in a very interesting meeting the other day which was a general discussion on various points in negotiating an agreement for lease and lease when acting for landlords and tenants. Much of the discussion focused on the inter-relationship between warranties, repairing obligations and service charges and then moved on to insurance and uninsured risks. However, what was most interesting was that the discussion touched on a more general issue about the English institutional fully repairing and insuring (FRI) lease - is the whole proposition of an FRI lease not manifestly unfair and unbalanced.

For the uninitiated, in England and Wales the starting point with a lease which will be acceptable to institutional investors is one in which the investor receives all the rent and the tenant is financially liable for every cost associated with the property (apart from "income" tax on the rent). This works by imposing full repairing obligations on the tenant, requiring the tenant to fully re-imburse the landlord for the cost of insuring the building and requiring the tenant to pay, through the service charge, for the cost of repairing parts of the building outside the tenant's demise.

Now let us examine the relative positions and aims of the parties.

The landlord owns the property for the purposes of investment. It receives income in the form of rent and the potential for capital increases resulting from rent increases and/or yield compression. It is very much interested in the long term existence of the property.

The tenant is renting the property as a place from which to conduct its business. It does not care about the building per se. Its income is generated out of the property but not from the property and it does not, in general terms, specifically have to be located within a specific property. It does not benefit from changes in yields and only sufferes from rent increases.

Now let us consider where the risk in relation to the property should lie. The tenant requires occupation to run his business but has no interest in the long term existence of the property and sees no benefit from any increase in value. The Landlord benefits not only from the existence of the property but also from the continuing ability of the property to meet the tenant's needs. As the tenant's business flourishes so does the value of the property as it is likely to be let to a tenant with greater covenant strength. Therefore you would expect that the landlord would bear the risk of need to repair the property or it being destroyed; he is the owner afterall.

However, the FRI lease is such that the only risk the landlord is taking is that the tenant goes bust. All other risks are placed firmly at the tenant's door. Repairs within the demise the tenant will be required to carry out itself. Repairs outside the demise the landlord will carry out but recover the cost from the tenant. If the building is destroyed by an insured risk there is likely to be a rent cesser but this will only be for the period for which the loss of rent insurance is available and after that the rent restarts even if the building is still unbuilt. Uninsured risks, all things being equal, can fall completely on the tenant with the landlord being able to recover the cost of rebuilding through the service charge. So a tenant who decided against being an owner/occupier could actually find itself in a worse position as a result with higher annual costs and the potential for huge liability when something goes wrong.

Of course, the above is a worst case scenario but it is one which is likely to represent the legal position on a significant number of leases in the market today. The UK is unusual in its total lack of legislation in seeking to prevent landlords from placing the full burden and risk on the tenant. In Germany, for example, it is against the law for landlords to seek to recover the cost of structural repairs through the service charge; this is a risk the landlord took when he bought/developed the building.

Matters have in the last 20 years moved somewhat from the position highlighted above. Tenants have seen much success in toning down liability for things such as uninsured risks and liability to repair latent defects but the the risk is still most firmly with the tenant. So all you tenants out there, a little less criticism of the tenant lawyer who seeks to negotiate a lease and is reprimanded by his client for delaying the deal; the detail could very well matter.

Is this fair? As always it depends on who you ask. In reality it is market forces and perhaps as a result of the current downturn tenants and their lawyers will use the opportunity to further push the pendulum back towards the landlord in terms of carrying the risk. However, I doubt very much that it will swing too far. The fact is that tenants don't appear to care that much - maybe that is because occupiers are businesses who are used to taking larger risks than the institutional property owner funds who tend to be risk averse. Fair it might not be but so what.