TO BUY OR TO LEASE?
By Tom Lumsden, Partner
Although many care homes are freehold properties, care homes remain a very attractive asset for property investors, and a large proportion of recent care home investments have been ‘new builds’ that are pre-let on a new 25 to 40 year lease, with Retail Price Index rent reviews.
Care homes are expected to remain a popular investment because of continued high demand and also because of the limited amount of new homes being built. Ultimately, this is likely to drive prices higher and sharpen yields. Given lease lengths of 25 to 40 years, it is now more important than ever that an operator is properly advised, since the adverse financial and other consequences should they sign up to a badly-drawn lease, could be significant.
Unlike residential leases, there is little statutory regulation or protection for commercial tenants. Once a lease is in place, tenants are generally stuck with that document, no matter how much the lease may be drafted in favour of the landlord. There are many issues for an operator to consider and I will try to set out some of the more common and important points.
Firstly, it is important to consider finance and tax. Most commercial leases are granted without any premium i.e. capital sum, but they can still command high starting rents. It is important for the operator to be fully aware of the need for good cash flow in order to meet quarterly rent payments. Failing to pay rent on time gives a landlord a right to forfeit a lease i.e. take back possession.
Operators should always speak to their accountants about taking on leasehold obligations, as to how they can mitigate tax liabilities. A tax that is highly relevant is SDLT (Stamp Duty Land Tax). SDLT is calculated using a complicated formula, on what is known as the ‘net present value’. The amount of SDLT payable can be a shock to some. Some operators are surprised that there is any SDLT at all, as those only familiar with freehold purchases might assume that SDLT does not apply to commercial leases.
One of the most important things is to take advice before or at the time the heads of terms of any commercial lease are agreed. I have seen a number of cases where tenants have negotiated the terms of a commercial lease with the landlord or the landlord’s agents directly, without taking legal advice, where the terms that have been agreed are either unworkable, or completely biased in favour of the landlord. It is far more difficult to unpick heads of terms once they have been agreed, than to negotiate them properly from the start.
Many lease terms are up for negotiation. For example, a prudent tenant will ask for a rent-free period to reflect the amount of time that it will take the tenant to carry out fitting out works.
It is also essential to think carefully about the identity of the tenant. Smaller operators might be tempted to take the lease in their personal name as a sole trader or individual names as a partnership, or they may agree to a request (if their business is a limited company) to one or more of the company’s directors standing as guarantor. This should be avoided if possible, as a lease is a very onerous obligation and there could be significant personal liability if the business proves unviable and becomes insolvent.
If the landlord insists on a personal guarantee, then it is absolutely essential that the guarantor takes independent legal advice (but it is not normally possible for the same solicitor acting for the tenant company to give that advice due to conflicts of interest). Commercial lease guarantee wording is almost always in favour of the landlord and very onerous, and a guarantor’s position can be significantly improved by negotiation, for example by capping the amount of the liability or seeking to reduce the time period over which the guarantee applies.
Tenants would also be well advised to ask for a break clause to end the lease early, which would give flexibility by allowing the tenant to break the lease on notice (usually three months or six months). There are however some pitfalls here, since many landlords try to make tenant break clauses conditional on compliance with the tenant’s covenants. This can invalidate a tenant break notice, because the courts have consistently held that even a trivial breach of tenant covenant means the condition has not been met, and the tenant cannot exercise its break clause.
One well known example occurred when a lease stated that, at the end of the term, the tenant had to repaint the interior with three coats of good quality paint. By the end of the lease (when the tenant exercised its break clause) paint technology had moved on considerably and only two coats were needed. However, the landlord challenged the tenant’s exercise of the break clause, and the courts agreed with the landlord, which meant that the tenant was stuck with the lease and rent and other obligations until the lease ended.
In terms of a request to pay the landlord’s legal costs this would not be standard practice unless the market is such that there is significant competition for the property from numerous tenants. The starting point should always be that each party pays its own professional costs.
It is important also to try to limit a tenant’s repairing obligations, perhaps to the interior only or alternatively (especially if the building is an older building) to repairing the property by reference to a schedule of condition so that the property does not have to be put back into a better state of repair and condition than shown in that schedule. The schedule is normally a photographic schedule, although these are of somewhat limited use. Far better would be a detailed written and photographic schedule prepared by an expert building surveyor.
Care should also be taken with new build properties to ensure that the landlord (if the landlord constructed the building) obtained the appropriate warranties and indemnities from its professional team e.g. architect, structural engineer, building contractor. There should also be a ‘carve out’, so that any inherent defects are not within the tenant’s repairing liability.
For example if, two years into the lease of a brand new building, it transpires that there are catastrophic structural problems and the building requires underpinning because of negligence on the part of the architect or the engineer, the costs could be enormous. However, it would be completely unfair for the tenant to shoulder these costs under the repairing obligations, simply because the landlord’s professional team had made a mistake. If the landlord has developed the property following best practice, the landlord will be able to claim against the architect or building contractor or other member of the professional team, who would then claim on their professional insurance.
The lease should also be inside the security of tenure provisions of the Landlord & Tenant Act 1954 which means that, at the end of the lease, the tenant can apply for a new lease at a market rent on the same terms. If the lease is outside of the security of tenure provisions, then the landlord does not have to renew the lease at all. If, however, he decides that he will renew the lease, he can ask for whatever rent he wishes, and can also impose stricter terms.
Other important clauses in the lease should include the permitted use i.e. what is or is not allowed, and also the rent review provisions. A poorly drafted or poorly negotiated rent review clause can mean that on a rent review a tenant is badly stung and pays a higher rent than is necessary.
The lease should also allow assignments and underlettings on terms that are not in any way restrictive or that penalise the care home operator for wishing to dispose of his interest in the property. Care also needs to be taken with the alterations provisions in a lease, to ensure that the operator can carry out material alterations without any difficulty.
If the care home is part of a larger building or development, the lease may contain service charge provisions. Again, it is absolutely essential that this is carefully drafted and negotiated because, unlike residential leases, there is no effective statutory protection for commercial tenants. A badly drafted service charge schedule can have very serious financial consequences for an ill-advised operator.
In summary, care home operators taking on leasehold premises should not assume that a lease is a ‘safer bet’ than a freehold property. The reality is that a badly negotiated lease will be far more onerous and cause an operator far more problems than a freehold property.
On the other hand, a well-balanced commercial lease will provide an operator with a secure basis from which to operate, without having to outlay a large capital premium for a freehold purchase, and will usually give the operator a degree of flexibility, especially if a tenant break clause can be negotiated. The best route to the latter outcome is, of course, to take sensible professional advice, at the earliest stage possible.
This article first appeared in the September 2019 issue of The Care Home Environment www.thecarehomeenvironment.com
Disclaimer: The above article is not intended as legal advice and must not be relied upon as such.