Variety is available in the leasing market but what does that mean?
Whilst serviced offices have been with us for many years (Regus was founded in 1989) the last decade has seen a huge increase in the diversity of options available to occupiers in the UK market. Whether it's work-live, co-working, membership, short term licence, short term lease or traditional FRI, there's a plethora of options but perhaps less clarity of what they all mean. This briefing aims to provide a high level overview of some of the legal issues that result from that variety of options and how that might impact owners and occupiers.
1. Why the change?
The move to more diversity of options (or flex..) in the office space market is primarily customer (or occupier..) driven. There is a perception that it's all about start-ups but that's not, by any means, the whole story. The majority of short term space is actually taken by large corporates seeking more flexible, cost effective and fit for purpose solutions as an element of their overall property portfolio. One thing is clear, however, occupiers are interested in exploring alternatives to the traditional model of 10/15/20 year FRI leases; a model, it should be remembered, that was largely created by institutional landlords to service long term annuity or pension liabilities. The move to flex is a clear shift of power from the owner to the occupier.
2. What is the change?
In legal terms, the move to flex can be characterised by two key developments:
- The first is the move to more occupation under licence agreements rather than leases.
- The second is a shift from long term FRI leases to shorter term leases of five years or less.
We take a look at both below, but before we do it's worth reminding ourselves of the key differences between a lease and a licence from a legal perspective.
- A lease entitles a tenant to exclusive possession of the premises. The tenant can therefore exclude all others from its demise (although it is likely to be subject to rights reserved for entry – for instance to allow the landlord to repair structural parts)
- A lease is capable of benefitting from the security of tenure rights under the Landlord and Tenant Act 1954 (the 1954 Act). These rights aren't available to a licencee under a true licence.
- A lease may (if certain thresholds are exceeded) attract SDLT and also has an accounting impact in terms of being recorded as a liability on a company's balance sheet.
Beyond these key legal differences there are then a range of 'market' differences where different approaches and contractual terms will impact on both owner and occupier. We look at these below.
3. From lease to licence
In addition to the key legal differences between a lease and a licence the flex market is resulting in other changes which are important. Some of the key ones are:
- Length of term – One of the principal drawbacks of a traditional lease is its inflexibility in terms of the length of term and, whilst lease terms have been reducing and break rights becoming more common, one of the biggest advantages of licence arrangements is the ability to grow and contract on very short notice (usually monthly).
- Speed/Flexibility – A traditional or even short term lease tends to be a negotiated document. A licence agreement is almost always based on standard 'Ts and Cs' (terms and conditions) and it's worth noting that unlike leases there is more divergence in the Ts and Cs from one provider to another. This means there is usually less cost and time incurred in agreeing a licence agreement, but also less opportunity to mitigate onerous terms. A licence also doesn't, strictly speaking, need to be contracted outside of the 1954 Act which saves time and money.
- Plug and Play – Most licence arrangements (including membership agreements) provide a 'one stop shop' in terms of the provision of services. Hence, internet, catering, fit-out etc. are all supplied by the provider, whereas under a traditional lease the tenant would need to approach different providers for each of these services with the added complexity and timing issues that presents. There is, of course, a corresponding cost implication for licencees that needs to be considered and a more limited ability to choose a particular provider or influence matters such as security.
- The other rents.. (service charges, insurances, rates) – Similar to the point above, under a traditional lease a tenant is not only liable for the yearly rent but also a due proportion of the insurance costs of the landlord for the building and the costs of the repair and maintenance of the common parts and provision of services. Finally, there are business rates to pay to the local authority. Whilst on the face of it this appears an onerous position for a tenant a licence provider still has to cover these costs and make its margin, so, in practice, a licencee may still be paying considerably more than a tenant for the same amount of space.
- Dilapidations – For many, dilapidations (the obligation to return premises held under a lease in the same state as they were provided at the start of the lease) is onerous and 'unjust'. Dilapidations don't apply to licence arrangements and, unless the licencee has caused actual damage, it can just walk away at the expiry of the licence period without further liability. Again, as with service charges etc. the cost of fit-out and renewal of fit-outs will be built into the licence fee.
4. From long lease terms to shorter lease terms
A traditional FRI lease typically is granted for a term of 10 or 15 years with, perhaps, a tenant's break right or two scattered across the term. What we have seen in recent years is a greater willingness from landlords to offer shorter lease terms of perhaps five years or less. In addition, some landlords have been willing to 'rip up the rulebook' on some of the more sacred landlord and tenant provisions making this type of lease more attractive to some occupiers. Some of the developments were seeing in this space include:
- Rent reviews – With a shorter lease term, the traditional upwards only open market rent review isn't an appropriate model for short term leases. As a result, landlords are either providing fixed rent deals, or more typically, providing for annual increases in line with appropriate indices such as the RPI or CPIH. One interesting development we've seen recently is a move to fix all tenancies being granted by a particular landlord with the same annual indexation date. That means rental increases become more like a mobile phone contract with increases taking place on the same date irrespective of when individual lease terms began.
- Service charges – Again, the traditional FRI lease reserves a separate service charge where the regime for providing services to a building are run in accordance with the RICS Code for Service Charges in Commercial Property. That means the service charge potentially varies from year to year as owners and managers must not seek to recover no more than 100% of the actual costs of the provision of the services. For many occupiers cost certainty is more important and landlords are moving to models where fixed service charges are being offered to meet this demand.
- Dilapidations – With a much shorter lease term the rationale for full dilapidations provisions is reduced. More often there is more discussion about responsibility for fit out and its associated costs and also rights for the tenant to walk away at lease expiry and that discussion should and does have a link to how much the tenant is willing to pay in yearly rent. Again, from the occupier's perspective increased costs certainty and fewer contingent liabilities is the objective.
It is clear to see that customer demand is driving very significant changes to the range of options available to occupiers. Some are even going as far to say the traditional models are broken and will not survive.
We're not sure that's correct, but what is certain is that a 'spectrum of offers' is developing in the office market and there are considerable pros and cons attached to the various options. We would also argue that we are really still nearer the beginning of this journey than the end and there remain very material issues to overcome.
For instance, for owners (and their financiers) the valuation of underlying land interests which are the subject to the newer arrangements is still problematic and is something the RICS are urgently seeking to address.
Further, for occupiers the new options aren't always providing the solutions they are looking for. By way of example, membership agreements which are attached to individuals are proving inflexible and too costly for some occupiers. Finally, the traditional risk allocations are shifting and both owners and occupiers are having to consider and price the implications when the tools for doing so are relatively under-developed.
A final thought is that not only are we likely to see this diversity of options available to occupiers increase, but we are also likely to see that choice being offered within single buildings or on a single campus. This provides customers with even more flex as they can choose to take less space (perhaps omitting that suite of client meeting rooms) but combine that with memberships of flexible space providers that will allow them to pick and choose when to rent that meeting room at a time best suited to their business.