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There is no argument that real estate is one of the most important (if not the most important) systems in Australian society. This may be just my personal opinion, but I feel that almost every Australian has a secret desire to be a property investor – after all, it is where most of the money seems to be made. Indeed the standard for success in Australia is to get a good job, save up (or get your parents to go guarantor if you are lucky), make an appointment with your friendly mortgage broker and get into the market. I've even seen an article that called property investors “entrepreneurs”. This is the standard path that Australians are expected to follow.
What about the other half that don't choose this path? Those few that elect to do it the hard way and risk it all by starting a small business and doing it on their own? I am not talking about the “tech startups” whose entire business model depends on perpetually seeking new investors and rounds of funding. This is about the small business owners that open shops, sign up to obligations and deal with real suppliers and customers on a day-to-day basis. They meet a lot of challenges and one that a lot of them share is leasing commercial premises.
Signing a commercial lease agreement is a right of passage in small business – it’s a very serious undertaking that can leave a business owner in a precarious state should things go wrong. This article is dedicated to this topic.
In addition to these issues, there appears to be a bit of a disconnect between the landlords, commercial real estate agents and tenants. Somewhere along the line, the understanding that it's the tenant who does the hard work in the real economy and generates the money necessary to pay the rent has been lost… there appears to be a sense of entitlement built up in the commercial real estate sector with both landlords and real estate agents treating tenants no better than a feudal overlord. Both landlords and leasing agents seem to have a suspiciously uniform no-negotiation policy for situations where the tenant's business enters a hardship due to external factors and the tenant has no choice but to ask for rent relief. I have referenced two high profile examples in the article and met many SME's who have been in this situation first hand.
Commercial Lease – The undisputed champion of onerous contracts
Please note: to keep the article from becoming too complex, the term “commercial lease” also refers to retail releases. Please seek legal advice in regard to particular technical differences.
There are two particular recurring issues with commercial lease agreements. These problems are the reason why I think this topic deserves more attention, and perhaps even more regulation:
- Small business owners that enter commercial lease contracts are often inexperienced, do not do due diligence and fail to seek professional legal advice. As such, they are often not aware of their obligations.
- There are some aspects of commercial lease that are highly questionable. These include: Directors guarantees, free rent periods, outgoings, loss of bargain damages, and re-entry clauses. These parts of a commercial lease contract offer the landlord significant protection, where one side gets to enjoy a well protected and guaranteed rental income stream, in addition to capital gains on the property... and the other side carries all the risk.
Even the big guys get themselves into dead end situations when it comes to commercial leases. For example, Myer has recently had to enlist the help of a high-profile insolvency specialist to negotiate a way out from their retail releases - “Besieged department store Myer has brought in high-profile restructuring and insolvency administrator Mark Korda to help it try to squeeze out from under suffocating leases.” (1). Sumo Salad was another case that made it into mainstream media - “SumoSalad's groundbreaking use of the insolvency laws to force Westfield shopping centres to negotiate lower rents for its fast food franchisees has proved successful.” (2). It has to be noted that small business owners simply do not have the same bargaining powers as big name brands and franchisors. Thus they deserve every bit of extra protection they can get.
Inexperience is the root of problems
There is a short period of excitement and unbridled enthusiasm that occurs just when you start a business for the first time. It's the dreamy time when you have just quit your secure nine-to-five corporate job and became your own boss – a period when opportunities and growth seem unlimited. It's also the time when you are most likely to be emotional and can easily bite off more than you can chew. This is the time when new business operators sign into onerous contracts on a whim.
p>What you actually have to do is to turn off your emotions and turn on the logic. You need to sit down and crunch the numbers. Can you really afford to enter the lease and make regular payments? Do you have a proper business plan? Or, are you just jumping into this particular business because you saw a shop somewhere full of customers and thought you could do it better? Do you have a plan B if your cash-flow projections don't work out? If you have a friend or family who runs a business or previously has, this is a good time to talk to them and gain some insight.
How do commercial leases catch out inexperienced business owners? Here are some particular aspects of commercial leases that can leave you in financial ruin.
A directors guarantee allows you to be held personally liable for a debt incurred by your company.
Directors guarantees do have their place in business, however they have somehow managed to make their way into commercial leases as a necessary requirement.
There is no particular reason why a start-up business owner should risk their personal assets (e.g. family home) just because they decided to lease commercial premises. Signing a directors guarantee effectively defeats the purpose of running a company as a separate entity in the first place.
There are alternatives to singing a directors guarantee when entering a commercial lease agreement. This is where a consultation with a legal professional is a good idea and negotiation of terms is key.
Rent Free Periods
Rent Free periods are an incentive that can easily push new business owners to sign up for a longer lease than intended.
A 3-month rent free period will usually be an incentive to sign on a 3-year lease agreement. This may appeal to a start-up business owner as a way to get the cash-flow going; the trade-off is a longer lease term.
A common scenario that plays out is where a new business owner expects to use the rent-free period to get their business up and running – i.e. after a few months, they expect to rely on cash-flow customers to pay rent. Should that scenario fail and there is not enough cash-flow in the business to become self-sufficient, the business owner can be in a serious problem if there is no access to external funds to keep the lease contract from being terminated by the landlord.
Outgoings include all external expenses imposed upon the landlord. Normally the landlord deals with these expenses. However when a commercial lease agreement is signed, paying for outgoings can become the tenants responsibility.
The issue with outgoings is that in the majority of cases they are separated from rent, thus are able to increase at their own rate. Tenants can be exposed to unexpected increases on a yearly basis.
Some landlords do incorporate outgoings into the whole rent payment. This is known as “gross rent” and in this case, the landlord carries the risk. It's a more honest scenario and something that can be negotiated.
Loss of Bargain Damages
Loss of bargain damages refer to unpaid rent owed by the tenant after the lease is terminated.
Some tenants may not be aware that if the landlord terminates the lease and takes possession of the premises, they are still liable for ongoing rent payments without actually occupying and making use of the property.
Loss of bargain damages can be hard to grasp. Consider that the landlord could kick out the tenants for non-payment of rent and at the same time continue charging rent in the future, where the tenants are expected to come up with rent payments without being able to use the premises to generate cash-flow. While this system works for situations where the tenant abandons the premises without good reason, it doesn't make any sense in situations where a small family business suffers financial hardship due to changes in market conditions, falls behind in rent and the landlord refuses to negotiate.
Please note that there are some additional requirements imposed on a landlord when claiming for loss of bargain damages.
Picture a scenario that your life partner suffers ill health and you fall behind on your mortgage.
In 14 days after failing to make payment, you receive a letter from your bank to remedy the breach of contract within a couple of working days.
You fail to make payment in the next couple of days. The locksmith comes and changes the locks on the family home. You are threatened with trespass if you enter the premises. The bank isn't interested to talk to you or listen to your problems.
imagine the outrage in the community if these sort of practices existed in the residential real estate sector – either for borrowers or tenants. I guarantee that laws would be amended in a heartbeat. However in the world of small business, this is the reality. If you do not make rent because of a slow Christmas or some unexpected change in market conditions, the landlord can exercise this option and put you and your business in financial ruin.
Finally, I feel like I have to mention this point on its own. There is no exit clause in a commercial lease agreement if you have changed your mind a few months in.
The reality is that commercial leases need to be better regulated. New business owners need to be better educated about the subject. I hope this article encourages those who are considering entering commercial lease agreements to do their due diligence, do independent research and seek qualified legal advice before singing the dotted line.
1. https://www.smh.com.au/business/companies/myer-calls-in-big-gun-mark- korda-to-soften-up-landlords-20180416-p4z9xs.html
2. http://www.afr.com/brand/chanticleer/sumosalad-wins-lower-rents-from- westfield-20170718-gxdrlo
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