What is the Purpose of Heads of Terms?
In general terms, a tenant of commercial premises may either acquire an existing lease (known as an assignment) or may accept the grant of a new lease on agreed terms.
If the tenant takes over an existing lease by way of assignment, the transaction will usually be agreed upon between the parties by reference to the existing lease terms. Generally, such terms should be quite straightforward, detailing the amount if any of the purchase price (premium) and any security required from the tenant by way of a rent deposit deed. It is common for the Landlord’s consent to be required on such a transaction and a Licence to Assign (a legal document) is often necessary.
As an alternative, a Tenant may prefer to take a new lease of commercial premises. On the grant of a new lease (unlike an assignment), the Tenant will have more scope to negotiate terms that apply to the lease including the length of the term, the rental amount and any rights relating to use, sale, alteration and repair.
In agreeing to the terms on any such transaction, it is usual for both Landlord and Tenant to appoint an independent agent for each side to represent their commercial interests. This will be relevant for negotiating the level of the rental by reference to the Lease term and the condition of the premises. Such agents are qualified in valuing leasehold premises and will seek to ensure that their client’s commercial property interest is maximised in the negotiation. Once the terms have been settled between the parties they are issued to the respective solicitors acting for the Landlord and the Tenant to instruct and inform the drafting of the legal documentation. These are known as the Heads of Terms.
What should the Heads of Terms include?
The Heads of Terms set out the broad intention of the parties by reference to the overall scope of the transaction and are intended to record the main points of principle between the parties by reference to the proposed transaction before legal costs are incurred. They are non-binding but include an intention to create legal relations. Understandably both landlords and proposed tenants can become disgruntled should the other party seek to amend the proposed terms once they have been settled. We therefore often recommend that parties have their lawyers review the Heads of Terms for any comments before the transaction proceeds so that any issues can be addressed at an early stage in the process. Heads of Terms are not drafted in the same detail as the legal documentation itself but they should determine how the transaction is to be structured and help to speed up the subsequent drafting of the legal documentation.
The opening part of the Heads of Terms will usually provide details of the relevant parties i.e., the identity of the Landlord and the Tenant and details of any guarantor, if relevant. Secondly, the Property (or premises) needs to be properly described in the Heads of Terms. This removes any doubt as to the exact extent of the Property.
Once these have been established it is then important for the Lease terms themselves to be agreed upon. These general terms will focus on the length of the Lease, the main financial terms (rent payable, any rent-free period, the rent review method where applicable, service charge payable), any use condition (what the tenant is allowed to do in the premises), rights of sale or sub-leasing, any break option, rights to carry out works to the premises and obligations relating to repair.
It is usually discussed at the outset whether there are going to be other documents that need to be entered into by the Landlord and Tenant apart from the Lease itself.
The Landlord will consider the covenant strength of the Tenant – the ability to pay the rent throughout the term. The Landlord may decide when granting a new lease, that a Rent Deposit Deed is required. And depending on the fitting out requirements of the Tenant, a Licence for Alterations may be necessary. We discuss these documents in turn below.
Is a Rent Deposit Deed Required?
For the Landlord to ensure that they will get good security from the Tenant, they may require the Tenant to appoint someone to act as guarantor so that if the Tenant defaults, the Landlord may enforce the guarantee provided by the guarantor. Alternatively, the Landlord may require a cash deposit to be paid as security. The legal status of the deposit monies will be documented in the Rent Deposit Deed.
For example, if a company has been set up to take on a shop lease, but has little or no trading history, the Landlord will want assurance that the rent will be paid on time and the Tenant obligations complied with. To do this the Landlord may require that the Tenant enters a Rent Deposit Deed, whereby the landlord can secure a deposit of say 6 months’ rental payable. In that way, the Landlord has some security should the Tenant default.
In addition, or alternatively, the Landlord may request that a director/shareholder of the newly set up company (or someone of sufficient status) stands as a guarantor to the Tenant obligations in the Lease. In which case the guarantor will need to be a named party on the documents.
Should the Tenant not be able to pay the rent (and other costs) when it falls due or otherwise breaches its covenants, the guarantor becomes personally liable. Or in the case of a Rent Deposit, the Landlord may call on the Rent Deposit to the extent of the breach and on the terms therein specified.
Is a Licence to Alter required?
In many instances, the commercial premises will be completely empty so that the Tenant can design the space to reflect their desired use and specification. The Lease will have certain provisions contained within it, that may prohibit the Tenant from carrying out certain works without the Landlord’s consent.
It is therefore important at the outset of the transaction for the Tenant to provide plans and specifications to the Landlord, to get their consent to carry out these works. Failure to do so may cause the Tenant problems in the future when they look to return the Lease to the Landlord or transfer the Lease to a third party, as the Lease will be in breach if works have been carried out without consent. There are also insurance and planning and energy performance considerations that will apply in respect of works carried out on the premises. The necessary legal procedures must be followed before embarking on any works to commercial property.
The following flow chart (last page in the below pdf) shows the processes involved in taking out a commercial lease.