Purchasing a tenanted commercial property can be an attractive proposition: immediate rental income, an established business in place, and a ready made investment from day one.
But buying a tenanted property is not simply buying bricks and mortar plus rent. You are buying into the lease itself, and the terms of that lease will govern your investment for years to come. The property is the thing you inspect. The lease is the thing that determines what it earns.
The lease is the asset
Before exchanging contracts on a commercial investment, the lease must be reviewed in full, not just the rent and the expiry date. Key items to examine include:
Permitted use. Is the use clause broad enough to attract a replacement tenant if this one leaves?
Rent review mechanism. Fixed increases, CPI, or market review? Each carries a different risk profile.
Options to renew. Does the tenant hold options? At what rent? Have any already been exercised?
Assignment and subletting restrictions. Can the tenant assign the lease without your consent?
Make good and reinstatement obligations. Who is responsible for what at the end of the term?
Outgoings. What costs are recoverable from the tenant, and are there any caps or exclusions?
Each of these shifts the value of what you are buying. A narrow permitted use clause on a specialised fitout can leave you with a property that is difficult to re-let. A tenant holding two five year options at a fixed increase can lock in your return for a decade, for better or worse.
Retail or commercial? The answer changes your obligations
One point that is easy to miss at the due diligence stage is whether the lease you are acquiring is a retail lease or a commercial lease. In New South Wales, that classification is set by legislation rather than by what the lease is called, and it determines what you can recover as landlord and what statutory obligations attach to you once you own the property.
If the lease is retail, there are restrictions on recoverable outgoings and prohibitions on charging certain costs that do not apply to a commercial lease. Assuming the wrong classification can undermine the numbers your purchase was based on. We set out the two step test in Retail vs Commercial Leases: Why the Distinction Matters More Than You Think.
Verify the rental reality
The rent shown on a marketing brochure is not always the rent being collected. Purchasers should request and review:
The current rent roll and payment history. Are there any arrears?
Any rent free periods or incentives still running.
Outstanding landlord obligations that have not yet been performed.
Bank guarantees or bonds held. Are they current, and are they sufficient?
Incentives are the item most often overlooked. A lease showing an attractive face rent may have a rent free period or a fitout contribution still running against it, which means the income you actually receive in year one is lower than the figure the yield was calculated on.
Bank guarantees deserve the same attention. A guarantee that has expired, or that was never increased when the rent rose, leaves you with less security than the lease contemplates.
Landlord consent and assignment
Where an existing lease contains a landlord consent requirement for assignment, a change of ownership may trigger obligations or notifications under the lease.
Your solicitor should advise whether the lease requires the tenant’s acknowledgement of the new landlord, and ensure all lease documents transfer correctly at settlement. Original executed leases, variations, guarantees and bank guarantee instruments all need to be accounted for and handed over, not simply referred to.
The contract matters too
The contract of sale for a commercial investment property should accurately reflect the lease terms, any arrears, incentives, and the obligations being assumed. Errors or omissions in the contract can create costly disputes after settlement, at the point where you have the least leverage to resolve them.
The GST position is worth settling early as well. Where a tenanted commercial property is sold with the leasing enterprise intact, the sale can often be GST free as the supply of a going concern, but only where the specific requirements are met and the contract says so in writing. Getting this wrong adds ten per cent to the transaction. We explain the requirements in The Going Concern: Selling Real Estate GST Free.
What proper due diligence looks like
Pulled together, a purchaser buying a tenanted commercial property should have clear answers on:
What the lease permits, restricts and requires, in full
Whether the lease is retail or commercial, and what follows from that
What rent is actually being collected, net of incentives
Whether the tenant is in arrears, and what security is held
What landlord obligations you are inheriting
How the contract deals with adjustments, arrears and GST
Some of these are negotiable before exchange. Very few are negotiable after it.
How we can help
At Gelder Peters Law, we assist purchasers of commercial investment properties with full lease and contract review before exchange. Understanding what you are buying protects your investment from day one.
You can see the full range of our legal services, or contact our team if you have a tenanted commercial property under consideration and want the lease read properly before you commit.
DISCLAIMER: This article provides general information only and does not constitute legal advice. You should seek independent legal advice before acting on any information contained herein. Gelder Peters Law Pty Ltd accepts no liability for any loss or damage arising from reliance on this material.
