Short versus long term leases – Which is the best option for you?

When negotiating a lease, it’s unlikely you and your potential tenant will have the same priorities. But because a good quality lease depends on a harmonious relationship between you and your tenant, it’s in your best interests to compromise. This is particularly important during the negotiation of lease terms.

Short term versus long term – the pros and cons

One of the first decisions you’ll need to make is about the duration of the lease – will it be short or long term?

A long term lease is typically five years or longer. Offering stability and security, they’re favoured by landlords and investors looking for a high return on investment (ROI), and tenants eager for stability of location.

A short term lease is generally for a period of 5 years or less. Perfect for landlords in a high demand area and agile and flexible tenants, they’re a great lower risk option.

And if you can’t decide between the two, you can always consider including the option of an additional term/s – it might be just what you need to satisfy both parties.

But how do you decide which option is right for you? Here are some of the advantages and disadvantages of long and short term leases, from the landlord and tenant’s perspectives.

Long term leases – The landlord’s perspective

Advantages

Stability - Long term leases offer stability of income and a guaranteed ongoing tenancy.

Certainty – A long term lease allows you to calculate your ROI over the period of the lease. This pays off in the long run as commercial properties are valued and sold based on ROI or yield. This is particularly so if your premises are located in an area where supply outstrips demand. If there is a likelihood the premises will remain vacant for any length of time while a new tenant is found, a long lease will work in your favour.

Disadvantages

More complex negotiations – Commercial leases can be lengthy and complex and negotiating a long term lease that satisfies everyone can be challenging.

Rigidity – Terminating or exiting a long term lease is difficult. Landlords may only do so under pre-determined, specific circumstances. To avoid these problems, consider the situations under which you might want to exit the lease. You can pre-empt them to a degree by including appropriate exit provisions in your lease agreement. However, as with everything in life, you can’t predict, nor plan for all of life’s future events with certainty.

Short term leases – The landlord’s perspective

Advantages

Flexibility - Short term leases give you flexibility in your tenant selection. If your property is in a high demand area – i.e. where demand outstrips supply – you can have the pick of the crop. If the market continues to perform well, you’ll have the security of continuous occupation, along with the opportunity to increase your rent (and alter your lease terms and conditions) with subsequent leases.

Disadvantages

Lack of security – Under a short term lease, you may lack security of income and continuous occupation. This in turn may affect the value of your property and ROI.

Lack of stability – Under a short term lease, you’ll lack the stability that comes with a long term, reliable tenant.

Long term leases – The tenant’s perspective

Advantages

Stability - For tenants wanting to firmly establish themselves in a specific location, long term leases are ideal. Ensuring tenure for an extended period, they provide protection from having to move if the premises are sold or if renewal options aren’t offered.

Certainty - Long term leases allow for long term financial planning. Depending on the rent review terms of the lease, a long term lease allows you to calculate your rental expenses over the long term. Even if the rent review occurs under a market rent review, a long term lease still offers an opportunity for long term financial planning that’s not available under a short term lease.

Flexibility - Tenants may find landlords offering long term leases are more willing to compromise on other lease terms. This may include a rent free period, opportunities to improve or modify the space and exclusivity clauses. Sublease options may also be available, enabling you to cut your long term rental costs. Although these concessions aren’t closed to short term lessees, they may be more difficult to negotiate.

Disadvantages

More complex negotiations – Commercial leases can be lengthy and complex and negotiating a long term lease that satisfies everyone can be challenging.

Increased maintenance and repairs costs – If the property isn’t properly cared for during the term of the lease, maintenance and repair costs can be high.

Greater risk – A long term lease means paying rent over a longer period. For some businesses, this is a financial burden and risk they can’t afford.

Short term leases – The tenant’s perspective

Advantages

Flexibility - For tenants with an uncertain outlook, short term leases offer the ability to scale up or down, moving locations as finances dictate. They’re also a great option for short term or ‘pop up’ businesses wanting to test the market.

A bail out option - It’s estimated that one in three Australian businesses fail in their first year of operation. Another two out of four fail in the second year, and three out of four by the fifth year. A short term lease is a less significant financial risk and offers tenants an ‘out’ in the event of business failure.

Disadvantages

Moving costs – For tenants changing locations with each lease, relocation costs can be high.

Lack of security – Tenants operating under a short term lease may lack security of location and tenure. If the goodwill of your business is dependent on a secure and longer term location, a short term lease may not provide the security of location you need.

Lack of stability – Under a short term lease, tenants may struggle to attract a solid customer or client base, particularly if they’re frequently changing location.

Retail leases

Retail leases operate differently to commercial leases. Other than Queensland, all Australian state and territory retail leasing legislation states that retail leases are automatically for a 5 year term – including any option periods. If a retail lease term is less than 5 years, it’s automatically extended to bring the lease up to a 5 year term. If tenants want a lease term of less than 5 years, they must seek legal advice.

If you’re a potential retail tenant, it’s your solicitor’s responsibility to advise you that if you proceed with a short term lease, you may lose security of tenure and may not recoup your setting up or fitting out costs.

While negotiation should be based on your needs, flexibility is key

Although you and your potential tenant may not have the same needs when it comes to lease terms, it is possible to find a middle ground. In the event that you prefer a long term lease while your tenant prefers a short term lease – compromise. You can always use a combination of the initial term – say 3 years – and grant options of 2 years plus 2 more years (3+2+2).

A compromise like this should satisfy both parties. Your tenant receives a longer term option while satisfying their short term needs. You receive a guaranteed income for a set period, along with the possibility of a longer term tenancy and increased rent if and when the options are exercised. And ultimately, this may be the kind of flexibility you need to exercise to seal the deal.

Options in Commercial Leases

Potentially beneficial to both tenant and landlord, option clauses are standard inclusions in most commercial leases. But knowing what to include in that clause can be difficult. In this post we break down how an option operates, and how to draft yours to maximise your future security.

What is an option?

An option is a clause in a lease agreement allowing a tenant to renew their tenancy for an additional term.

Does every commercial lease have to include an option to renew?

No. As a landlord you’re under no obligation to include an option term in your commercial lease. However, including one may benefit both parties.

As the landlord, you’ll receive greater potential income security, as well as enhancing your property’s value. This is particularly so if you have a long term tenant, as the risks associated with long term leases are lower.

Meanwhile, your tenant will benefit from continued security of location.

What happens if I don’t include an option term in my commercial lease?

Your tenant will have no right to renew the lease at the end of the term. If you both wish to continue the tenancy, you’ll have to re-negotiate the lease, including lease term and rent.

How is an option exercised?

How your option is exercised depends on the terms of your option clause. Most commercial leases require a tenant to give written notice of their intention to exercise the option. For the ease of both parties, the method of exercise should be as clear and unequivocal as possible.

This means being specific about the form and delivery of that notice, setting it out clearly in your option clause. For example, the notice must be made in writing, delivered to the landlord’s place of business, and must include the tenant’s full name, business name, address and signature. This reduces confusion and ensures the formalities of the lease are carried out.

If the tenant fails to properly follow the terms of the option, they lose their right to exercise it. It’s your responsibility as a landlord to ensure they’ve followed the terms as set out in the lease.

Do time limits apply?

Yes. Most commercial leases specify a time limit in which an option must be exercised. This may be done by specifying a date by which the tenant must have exercised the option, or by specifying a period during which the tenant may exercise the option. This is normally during the last year of the current term, most commonly within the last 3 to 6 months of the lease.

If a tenant fails to exercise the option during the specified time period, they subsequently lose the option. In these circumstances, you may still agree to enter a new lease agreement, but you’re not bound to offer it on the same terms as set out in the option clause. That is, the lease may be re-negotiated.

The legal effect of exercise of option

Although we refer to the continuing tenancy as a ‘further term’, ‘option period’ or ‘renewal of lease’, the valid exercise of an option creates an enforceable and binding agreement. That is, a new lease is created and both parties are legally bound to that agreement.

However, the new lease only comes into effect once the new lease or deed of renewal has been prepared and signed by both parties. Until this is done, there is only an ‘agreement to lease’. So it’s essential you have the new lease or deed of renewal executed immediately after the exercise of the option.

Conditions on exercise of option – tenant default

Option clauses commonly state a tenant cannot exercise their option if they are in breach, or have consistently been in breach of the lease throughout the term. This protects you, the landlord, from having to continue a tenancy with an undesirable lessee.

To secure your position and avoid confusion, state your terms as clearly as possible. For example: by stating that a tenant cannot exercise their option:-

• if they are in breach as at the date of exercise of the option, and/or on the last day of the initial term; or
• if they have consistently breached the lease throughout the current term (even if the tenant is not technically in breach of the lease as at the date of exercise of the option).  You may specify, for example, that 3 or more breaches of the lease during the current term by the tenant, will be sufficient grounds for the landlord to refuse to grant the further term.

Terms of the new lease

A well drafted option clause clearly specifies the terms and conditions which will apply to the new lease. This includes the new lease term and rent, as well as rent review mechanisms.

These new terms and conditions must also be clearly set out in the deed of renewal. Any new clauses included in the deed of renewal (that is, ones not set out in the original option clause) must be agreed to by both parties. If not, the original lease terms will continue unaltered.

Rent reviews

When drafting your option terms, it’s important to include a clause clearly stating how the rent will be determined upon the commencement of the new lease term.

Most leases state that a ‘market review’ will occur at the commencement of any further term. A market review is a rent review of similar properties in the surrounding area to determine the current market rate (you can read more about how they operate here ). The rent is then adjusted upwards or downwards to reflect that review. It may be a rate agreed to between you and your tenant, or a rate determined by an independent valuer.

If your lease does not specify how the rent is to be reviewed at the commencement of a further term, you may not be entitled to an increase in rent for the first year of the new lease. That’s why it’s imperative you include clear and unambiguous rent review information in the option clause.

Retail leases

If you’re the landlord of a retail premises, there are some important considerations to note.
Under all Retail Leases legislation, the tenant has the right to request a market rent review . If that determination is not made before the option date, the law may extend the option period until the tenant has been notified of that determination.

(Note that each state’s requirements concerning the procedure for “retail” market rent reviews will vary slightly from state to state.)

This provision provides certainty to tenants who wish to exercise their option, but have concerns about their ability to meet new rent payments if the market review is higher than they’d budged for. If an agreement about future rent can’t be made, the tenant is able to avoid the risk of exercising their option to renew, and look for new premises instead.

Determining the new lease term

For properties in a high demand area, short term leases may be a better option – after all, supply and demand is in your favour. For properties attracting less interest – for example, those in rural areas – a longer term lease will provide greater income security. But whichever option you choose, negotiating a term that’s in yours and your tenant’s best interests should be your primary goal.

Need more information? You can read more about short versus long term leases here.

The big picture

Offering you greater income security and your tenant security of tenure, an options clause represents a win-win for both parties. By considering the options outlined above, you should be able to negotiate a clause that ultimately benefits both parties.

Related Article: Option to buy real estate

Market Rent Reviews and Commercial Leases

From a landlord’s perspective, rent reviews are an essential component of a commercial lease.

Reviewing the rent at specified intervals ensures that the rent keeps pace with current market rates.
Rent reviews may be self-executing and provide for a fixed increase, Consumer Price Index (CPI) review or a fixed percentage increase - or contain mechanisms for rent review, as with market rent reviews. This post examines market rent reviews, and factors to consider when finalising rent review provisions in your Commercial or Retail lease.

What is a market rent review?

Market rent reviews are designed to ensure the rent you’re charging remains consistent with rates in the current market. As such, they’re based on the rent paid by tenants in comparable properties in the surrounding area, heavily influenced by supply and demand of similar properties.  Market rent reviews can be carried out by you (the lessor), a property valuer or estate agent.

When does a market rent review occur?

While CPI or percentage increase reviews are generally carried out annually, market rent reviews occur at specified intervals during the lease period.

Market rent reviews are commonly carried out every 3 to 5 years and/or at the exercise of an option to renew . That’s because market rent reviews may involve an independent valuation, the costs of which can be high, making them too expensive to carry out annually.

Why choose a market rent review?

In well performing markets, market rent reviews provide a better rate of return. However, in poorer markets, they can result in a decrease in rent. That’s why when considering including a market review in your commercial lease, it’s important to consider the market over the entire lease term - not just at the time of signing.

If the market looks like it will continue moving upwards over the lease term, a market rent review’s a good choice. If things aren't as certain, a CPI increase or 3 to 5% fixed annual review will guard against rent decreases.

Market rent review process

The review process generally begins when the landlord sends a written notice to the tenant, proposing a new rental amount. If the tenant agrees to that amount, the lessor’s determination is deemed to be the current market rent.

If the tenant disputes the new rental amount, landlord and tenant work together to agree on a fair market rent. However, in the event an agreement can’t be reached, and to ensure the review process is fair to both parties, most commercial leases include a clause allowing the tenant to have a valuer appointed to independently determine the market rent.

If your lease is a retail lease, the retail leasing legislation in your State imposes strict rules on how the market rent review process is to be carried out.

Time limits

To ensure market rent reviews don’t drag on unnecessarily, it’s wise to include a clause limiting the time the tenant has to dispute the reviewed rent. Most commercial leases with provisions for market rent review state that the new rent is deemed to be accepted if the tenant does not challenge the amount within a prescribed period – usually within 28 days of receiving the notice of review.

Independent reviews

If an independent review is required, both landlord and tenant have the opportunity to make written submissions to the valuer.  A valuer’s decisions are generally binding, and the costs of appointing them are shared equally between landlord and tenant.

Valuers have a wide discretion when applying valuation principles to a market review.  That’s why it’s important to ensure rent review clauses contain valuation criteria for the review.  These criteria set out the directions the valuer must follow, assumptions they should make, matters they must take into account, and matters they should disregard.

Initiating a market rent review

Who can initiate a market rent review depends on the terms of your lease.  However, most commercial leases allow either party to initiate a review.  That said, there are some important differences you should note between retail and commercial leases.

Under section 32 of the New South Wales Retail Leases Act, the tenant has the right to request a rental determination.  If that determination is not made before the option date occurs, the option period is extended until the tenant is notified of the determination.  This is so that the tenant may take into account the new rental amount when determining whether or not to take up the option to renew the lease.  In addition, where an early determination is made, the tenant must exercise their option within 21 days of the determination – not the time frame noted in the lease.

(Note that the requirements concerning the procedure for “retail” market rent reviews will vary slightly from state to state.)

Time is also an important factor in a commercial lease. As a landlord, you should ensure you prescribe a time limit in which you have the right to initiate the review process.  Take careful note of these limits, because if you fail to act within that time, your tenant may claim you have lost the right of review.  This is particularly so if the lease states that time is of the essence.

Ratchet clauses

Because market rent reviews are based on current market rates, they may result in a decrease in rent. Landlords have been known to guard against this by including a ‘Ratchet clause’ in the lease, prohibiting a decrease of rent after a market rent review.

Once common in commercial leases, it’s important to note that Ratchet clauses are void and unlawful in retail leases under state and territory legislation.  Under a retail lease, the market rent review is a ‘true market rent review’, meaning the new rent may be less than the rent prior to review.

Is a market rent review right for you?

Whether a market rent review is suitable for you as a landlord depends on your circumstances. If you prefer the certainty of fixed rent increases over time, a CPI or fixed percentage increase may be more appropriate. However, if you’re happy with a higher level of risk and the market is performing well, market rent reviews are a great option.

If you’d prefer to cover all your bases, you can combine a market rent review with a CPI or fixed percentage increase (as long as this is not viewed as a way to avoid a decrease in rent under retail shop leases legislation if your lease is a retail lease).  Just remember to consider your needs before making a decision.