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Wednesday 3 December 2008
Time for lease flexibility
Comparing the Hong Kong property market with a roller-coaster ride is not entirely appropriate. Averaged out over the past 30 years, for instance, the “coaster” has tracked steadily upwards.
Comparing the Hong Kong property market with a roller-coaster ride is not entirely appropriate. Averaged out over the past 30 years, for instance, the “coaster” has tracked steadily upwards.
Despite this general trend, peaks and troughs do emerge. Viewed over a short time frame, the drops can appear quite sharp and, for those on the wrong side of the deal-making, agonizingly protracted.
But each of the corrections to the long-term uptrend has its own unique character and the current drop is no exception. In 2003, for example, the collapse of confidence associated with the Sars outbreak, following on the heels of the Asian financial crisis, coincided with an office vacancy rate in core Central of almost 20 per cent. In contrast, the current turmoil accompanies a core Central vacancy rate of less than 2 per cent.
As a result this time around there is a wider gap between landlord and tenant perceptions of how rental prices will be affected by the global economic slump.
Landlords emphasise that tight supply will continue, as no major new buildings are anticipated in core Central for several more years. Tenants, however, expect gloomy market sentiment and financial distress to hold rents and transaction volumes down for some time.
Independent analysts, meanwhile, tend to the latter view and argue that business contraction and bankruptcies will increase supply of office space. Tenants, predictably, are therefore responding to the market shift by deferring decisions and holding out for lower rentals and increasing demands for lease flexibility.
The Hong Kong leasing market is often frustrating for tenants since many landlords seek complete control of the landlord-tenant contractual relationship and take the view that all risk, both physical and economic, is appropriately the tenant’s.
There is often a “take it or leave it” approach to lease discussions: a position that may leave a tenant feeling sore at the end of a negotiation. One landlord earlier this year insisted that a prospective tenant sign a binding agreement to take a lease using the landlord’s specified form and refused even to let the tenant see the form before signing up. This kind of high-handed approach is particularly galling to international corporate tenants.
We would argue that the time has come for landlords to adapt their leasing practices. A modicum of responsibility on issues such as the provision of insurance, landlord’s liability for its own negligence and default and the provision of audited service charge accounts is hardly groundbreaking stuff. Such provisions are standard in Britain, the United States and Australia.
Many tenants today are facing unprecedented business uncertainty and quite reasonably seek to build into lease arrangements some protection against uncertain markets. Restrictive terms such as prohibitions on change in tenant corporate ownership have no place in leases in the current climate. Tenants also need mechanisms allowing them flexibility to reduce overheads if business plans prove unachievable.
The key flexibility mechanisms tenants are looking for are alienation and surrender rights. Alienation generally refers to the right to transfer premises to someone else and surrender refers to the right to give premises back to the landlord.
Of the two, surrender rights are much more valuable to tenants since the tenant does not need to find someone to take over the space.
A complete break clause - the right to surrender the entire premises to the landlord - is uncommon in commercial leasing, but tenants may seek rights to surrender portions of their space at specified times during the lease term.
Alienation rights that allow a tenant to find another person to take over all or part of its space are of various types. Tenants would prefer a right that fully excuses the assigning tenant from its lease obligations, but it is more common to find subletting rights that keep the original tenant liable if the new tenant does not perform.
Hong Kong landlords often prefer to allow transfers to a tenant’s affiliates but to date have strongly resisted transfers to third parties.
Landlords usually negotiate to limit subletting and other transfer rights by, for example, requiring the landlord’s consent before any transfer. Since landlords are not required to be reasonable in giving consent, a “right” subject to landlord consent gives the tenant almost nothing. Landlords also may limit the rent that a tenant may accept from its subtenant. They may say that the subtenant’s rent cannot be lower than the tenant’s. This encourages “back-room deals” and obfuscates market rental levels, which may be the point.
Tenants in a weaker rental market are better positioned to negotiate commercial terms that result in a “net effective rent” that is lower than the rent stated in a lease. The most common mechanism is an extended rent-free period but landlords may also offer fitting-out allowances or other concessions. Landlords like to put concessions in private side letters that are not registered with the Land Registry where they would be available for public inspection, the intent again being to keep apparent rents artificially high. This creates a distinct lack of transparency in the market. Tenants need to understand that terms in unregistered documents outside the lease are generally only personal contracts, so they normally will not be enforceable against a new landlord if the original landlord transfers the property.
Landlords who respond to their tenants’ business concerns will be able to build long-term mutually beneficial relationships and increase their competitive edge. A clear balance can be drawn between landlords’ and tenants’ interests - it just hasn’t been very noticeable to date in Hong Kong.
Fiona Connell is a consultant of Cordells, a Hong Kong-based property law specialist firm with particular expertise in commercial leasing and development
1 comment:
Time for lease flexibility
Fiona Connell
3 December 2008
Comparing the Hong Kong property market with a roller-coaster ride is not entirely appropriate. Averaged out over the past 30 years, for instance, the “coaster” has tracked steadily upwards.
Despite this general trend, peaks and troughs do emerge. Viewed over a short time frame, the drops can appear quite sharp and, for those on the wrong side of the deal-making, agonizingly protracted.
But each of the corrections to the long-term uptrend has its own unique character and the current drop is no exception. In 2003, for example, the collapse of confidence associated with the Sars outbreak, following on the heels of the Asian financial crisis, coincided with an office vacancy rate in core Central of almost 20 per cent. In contrast, the current turmoil accompanies a core Central vacancy rate of less than 2 per cent.
As a result this time around there is a wider gap between landlord and tenant perceptions of how rental prices will be affected by the global economic slump.
Landlords emphasise that tight supply will continue, as no major new buildings are anticipated in core Central for several more years. Tenants, however, expect gloomy market sentiment and financial distress to hold rents and transaction volumes down for some time.
Independent analysts, meanwhile, tend to the latter view and argue that business contraction and bankruptcies will increase supply of office space. Tenants, predictably, are therefore responding to the market shift by deferring decisions and holding out for lower rentals and increasing demands for lease flexibility.
The Hong Kong leasing market is often frustrating for tenants since many landlords seek complete control of the landlord-tenant contractual relationship and take the view that all risk, both physical and economic, is appropriately the tenant’s.
There is often a “take it or leave it” approach to lease discussions: a position that may leave a tenant feeling sore at the end of a negotiation. One landlord earlier this year insisted that a prospective tenant sign a binding agreement to take a lease using the landlord’s specified form and refused even to let the tenant see the form before signing up. This kind of high-handed approach is particularly galling to international corporate tenants.
We would argue that the time has come for landlords to adapt their leasing practices. A modicum of responsibility on issues such as the provision of insurance, landlord’s liability for its own negligence and default and the provision of audited service charge accounts is hardly groundbreaking stuff. Such provisions are standard in Britain, the United States and Australia.
Many tenants today are facing unprecedented business uncertainty and quite reasonably seek to build into lease arrangements some protection against uncertain markets. Restrictive terms such as prohibitions on change in tenant corporate ownership have no place in leases in the current climate. Tenants also need mechanisms allowing them flexibility to reduce overheads if business plans prove unachievable.
The key flexibility mechanisms tenants are looking for are alienation and surrender rights. Alienation generally refers to the right to transfer premises to someone else and surrender refers to the right to give premises back to the landlord.
Of the two, surrender rights are much more valuable to tenants since the tenant does not need to find someone to take over the space.
A complete break clause - the right to surrender the entire premises to the landlord - is uncommon in commercial leasing, but tenants may seek rights to surrender portions of their space at specified times during the lease term.
Alienation rights that allow a tenant to find another person to take over all or part of its space are of various types. Tenants would prefer a right that fully excuses the assigning tenant from its lease obligations, but it is more common to find subletting rights that keep the original tenant liable if the new tenant does not perform.
Hong Kong landlords often prefer to allow transfers to a tenant’s affiliates but to date have strongly resisted transfers to third parties.
Landlords usually negotiate to limit subletting and other transfer rights by, for example, requiring the landlord’s consent before any transfer. Since landlords are not required to be reasonable in giving consent, a “right” subject to landlord consent gives the tenant almost nothing. Landlords also may limit the rent that a tenant may accept from its subtenant. They may say that the subtenant’s rent cannot be lower than the tenant’s. This encourages “back-room deals” and obfuscates market rental levels, which may be the point.
Tenants in a weaker rental market are better positioned to negotiate commercial terms that result in a “net effective rent” that is lower than the rent stated in a lease. The most common mechanism is an extended rent-free period but landlords may also offer fitting-out allowances or other concessions. Landlords like to put concessions in private side letters that are not registered with the Land Registry where they would be available for public inspection, the intent again being to keep apparent rents artificially high. This creates a distinct lack of transparency in the market. Tenants need to understand that terms in unregistered documents outside the lease are generally only personal contracts, so they normally will not be enforceable against a new landlord if the original landlord transfers the property.
Landlords who respond to their tenants’ business concerns will be able to build long-term mutually beneficial relationships and increase their competitive edge. A clear balance can be drawn between landlords’ and tenants’ interests - it just hasn’t been very noticeable to date in Hong Kong.
Fiona Connell is a consultant of Cordells, a Hong Kong-based property law specialist firm with particular expertise in commercial leasing and development
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