What’s in a lease?

Sunday, September 20, 2015

An often-heard comment from GRESB participants is that the structure of landlord and tenant relationships makes it impossible for them as landlord to engage with tenants, particularly on energy, water and waste data sharing. I would like to shed some light on this sometimes-contentious issue.

It is true that in many jurisdictions lease structures hand over all or most control over building management, including utilities purchasing, to the tenant. Where the tenant has a direct relationship with the utility provider there is indeed a barrier to data collection. However, if you ask landlords to explain how and why the lease limits their control over an asset, this can reveal limited knowledge of the mechanics of the lease. No one expects property, asset and fund managers to know the legal complexities of every tenant’s lease. There are too many tenants and too many variations in lease terms. However, there is a risk that the assertion ‘my lease gives me no control’ becomes a mantra that discourages any lateral thinking about tenant engagement.

For example, in the UK the standard lease format where a single tenant leases a whole building is known as an FRI (full repairing and insuring) lease. You often hear that these leases are (a) for lengthy terms and (b) give a landlord almost zero control over the asset. It is true that an FRI lease limits landlord control but it does not remove such control, and opportunities for engagement remain. Indeed, if you completely ignore the tenant, except for negotiating periodic increases in rent, the building returned to you may turn out to be in a pretty poor state. A more opportunistic landlord might say that it will have sold the asset before the lease ends. Maybe, but the opportunity to chip at the price because of disrepair or regulatory compliance issues incrementally increases as the lease term progresses. The danger is that by repeating the mantra ‘I have no control over the building’ landlords don’t think deeply enough even to be aware of these risks. If you do end up with a building at the expiry of the lease, you could end up with a property in disrepair, that doesn’t comply with regulatory obligations and which requires substantial capital expenditure to bring it up to par. In the UK, it is notoriously difficult to recover all the costs of returning a property to good repair, particularly if extensive works are required.

That said, among GRESB participants there are many examples of creative engagement that circumvent the problems of lack of landlord control. What you often see is that these landlords engage early, even before the tenant is contractually bound, and that the landlord makes the sustainable management of the building an up-front selling point for the asset. Good property managers are also crucial here. We have all heard the stories of the property managers that mismanage service charge, don’t react promptly to tenant concerns and struggle with managing communication between tenant, asset manager, fund manager and other external advisors e.g. lawyers and building engineers. These types of issues harm the landlord and tenant relationship and, at their worst, create an adversarial relationship that runs from the tenant throughout the supply chain right to the landlord. However, the corollary of that is that a good property manager can have a positive impact on the management of the asset, building strong and trusting relationships with tenants. Even if the tenant’s right to withhold utilities information remains absolute, where the relationship is good, it is going to be far simpler to gain access to the building, and to identify and fix areas of concern.

The conclusion? Make no assumptions about a landlord’s control over the asset, keep on top of property managers, understand the basic principles of the lease structure and make sure that you instruct commercially aware real estate lawyers who recognize the value in a productive working relationship with tenants, who monitor and understand the impact of ESG regulatory obligations and who can think creatively to use the terms of the lease to allow a landlord access to the building and engage with the tenant, when it’s necessary to do so.