Buying a Tenanted Commercial Property: Why the Lease May Matter as Much as the Building
When acquiring a commercial investment property, it is natural to focus on the property itself.
Location. Purchase price. Building condition. Development potential. Rental yield.
But where the property is already leased, the purchaser is acquiring something else of considerable importance: an existing landlord and tenant relationship.
The value and risk profile of the investment may therefore depend not only on the building, but also on the lease sitting behind the rental income.
Start with the income – then read what supports it
Suppose an industrial property is marketed for $5 million with annual rental income of $300,000.00.
On its face, that may appear to provide a 6% gross yield. But that figure alone tells the purchaser relatively little.
A proper review might reveal:
the lease expires in 12 months;
the tenant has no further option;
the rent is materially above current market rent;
the landlord is responsible for substantial maintenance costs;
the tenant received a significant incentive which has not yet been fully accounted for;
the security deposit is modest;
there is no director's guarantee; or
the tenant has a history of arrears.
The headline rental figure has not changed. The quality and durability of that income may have.
How long is the tenant actually committed?
A purchaser should understand both the remaining lease term and any options.
A lease described as "5 + 5 years" does not necessarily mean there are 10 years of secure income remaining.
If 4 years of the initial 5-year term have already elapsed, there may be only 1 year remaining before the tenant decides whether to exercise its option.
Conversely, a long remaining term with a financially strong tenant may be an important part of the investment proposition.
The lease should be reviewed together with any:
renewals;
variations;
assignments;
deeds of consent;
incentive arrangements; and
other documents affecting the landlord and tenant relationship.
Who is the tenant?
A lease is only as useful as the obligations it creates and the parties standing behind them.
A purchaser should identify the actual tenant entity rather than relying simply on the trading name displayed on the building.
Questions may include:
Is the tenant an established operating company?
Has the lease been assigned?
Has there been a change in ownership or control?
Are directors or related entities providing guarantees?
Is there a security deposit or bank guarantee?
Is that security sufficient and capable of being transferred to the purchaser at settlement?
Example
A property is occupied by a successful national business.
That may sound reassuring. But the lease may actually be held by a separate subsidiary with limited assets, without a parent-company guarantee.
The commercial reputation of the group and the legal identity of the tenant are not necessarily the same thing.
Who pays for what?
The rent is only one side of the equation.
The lease may allocate responsibility for rates, taxes, insurance, repairs, maintenance, essential safety measures, structural works and other outgoings between landlord and tenant.
Two properties producing the same annual rent can therefore produce very different net returns to their owners.
This is particularly important with older buildings or properties where substantial capital expenditure may be required.
Rent reviews can materially affect the investment
The lease may provide for fixed annual increases, CPI reviews, market reviews or a combination of them.
A purchaser should understand when the next review occurs and how it operates.
A high current rent is not necessarily an advantage if it is unsustainable at the next market review. Equally, a below-market rent may have future upside depending on the lease terms.
The legal mechanism for reviewing the rent matters.
Options are not merely dates in the lease
An option may give the tenant a valuable right to extend the lease.
Whether it can be exercised may depend upon compliance with notice periods and other conditions.
Purchasers should therefore understand whether an option has already been exercised, when future options may be exercised and whether any existing circumstances could affect those rights.
Incentives can change the economics
Commercial leases are sometimes accompanied by rent-free periods, fit-out contributions or other incentives.
These arrangements may not always be obvious from the face of the lease.
A purchaser should establish whether any incentive obligations remain outstanding and who bears them after settlement.
Paying a price based on the face rent without understanding the underlying incentive may give an incomplete picture of the actual return.
What happens at the end?
The lease should also be reviewed for the tenant's make good and reinstatement obligations.
For some properties, particularly heavily fitted-out industrial, medical, hospitality or specialised premises, the cost of removing tenant works and returning the premises to an agreed condition can be substantial.
A broadly drafted or weak make-good provision can shift that cost back to the owner.
Legal due diligence should support commercial due diligence
A legal review cannot tell an investor whether a property is a good investment.
It can, however, identify the legal rights and obligations that sit behind many of the assumptions on which the investment decision is based.
For a significant commercial acquisition, due diligence may therefore include consideration of:
title and encumbrances;
the contract of sale;
leases and related documents;
planning and permitted use;
guarantees and security;
existing defaults or disputes;
outgoings;
landlord obligations;
options and rent reviews;
make-good obligations; and
financing and ownership structure.
The purchaser's accountant, financial adviser, valuer and other advisers may need to consider the transaction from their respective perspectives.
Look beyond the bricks and mortar
A commercial investment property is not simply a building producing rent.
It is a combination of the real estate, the tenant, the lease, the income stream and the obligations attached to ownership.
Understanding all of those elements before the contract becomes unconditional can provide a much clearer picture of what the purchaser is actually acquiring.
At KCT Legal, we advise private investors, family groups and businesses on commercial property acquisitions, disposals, leasing, ownership structures and property investment arrangements. We work with our clients' other advisers where appropriate so that the legal aspects of an acquisition are considered within the client's broader investment strategy.
This article is provided for general information only and does not constitute legal advice. The information may not be appropriate for your particular circumstances. You should obtain specific legal advice before acting or relying on any information contained in this article.