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‘Contracting Out’ – What Does it Mean for Commercial Tenants?

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When you’re taking on a new or existing lease for your business, there are so many pressing issues to think about: how much rent will I have to pay, how long will the lease last, what if I want to leave or sell my business … so when the question of ‘is the lease contracted out or not?’ comes up, it’s all too easy to overlook it. However, it’s really important that commercial tenants understand the implications of a ‘contracted out’ lease and any impact it could have on their plans for the future.

The Landlord and Tenant Act 1954 gives tenants occupying a property for the purpose of a business automatic rights to renew their lease at the end of the lease term- provided that they are still running their business from the property at the renewal time.

A landlord can only refuse to grant a new lease in limited circumstances. ‘Contracting out’ of the Act means that the tenant will give up this right to renew- staying on will only be possible if they agree a new lease with the landlord. If they don’t, the tenant will have to leave when their lease comes to an end.

One side effect of contracting out is that at the end of the lease term, the tenant is not entitled to any compensation when they leave- even if by leaving they effectively lose the goodwill of their business.

If a lease is inside the Act and the landlord successfully recovers possession, then in certain circumstances the landlord could have to pay the tenant compensation (calculated by reference to the rateable value of the property) when they leave. Compensation is often not payable if the tenant has occupied the property for less than 5 years.

So, how do you decide what’s best for you as a tenant? Unfortunately, sometimes the landlord may insist that it’s just not open to negotiation as it gives them flexibility, for example if they have plans to develop their property in the future and want to be able to regain possession quickly and easily. You can generally expect short-term leases to be contracted out as well as leases of part of a building or estate.

If you are taking on a long-term lease, or you are likely to spend a significant amount on your fit-out, then it would be fair for you to expect to have the protection of the Act and the potential right to compensation if you have to leave. If the location of your business is vital in your business plan and you will build up valuable goodwill then you should press hard for a lease covered by the Act.

It’s key to find out at an early stage whether the lease you are taking on will be contracted out or not, and what room for negotiation there may be, so you can decide if it will work for you and your business.