Risks associated with leasing incentives The provision of leasing incentives, be they fitout contributions, rent free or rent abatement, have become a permanent part of the commercial and retail leasing landscape in Australia, and are now widely taken into account by valuers in assessing market rents.
But the provision of leasing incentives comes with some risks for a landlord – if the incentives are "front- loaded" and the lease is terminated early for default or insolvency on the part of the tenant, the landlord's investment in providing incentives to secure the tenancy can be substantially lost.
It is common for landlords to require tenants, in these circumstances, to repay the incentive, or at least a part of it. These are commonly referred to as clawback provisions. Prudent landlords will also ensure that any personal guarantees or security given by tenants, such as a cash bond or bank guarantee, also cover the tenant's liability to repay this amount.
There is a commercial risk for landlords here – the greater the up-front investment by the landlord, the greater the loss that can be suffered on early termination – and hence the need to ensure that the security provided by the tenant is sufficient to cover this exposure, as well as other damages, such as lost rental income, resulting from termination of the lease.
But there is now a more fundamental issue – a recent decision of the Supreme Court of Queensland has found that a clawback provision is unenforceable on the grounds that it is a penalty. In essence, the law relating to penalties is that a contractual payment obligation that flows from a breach of the contract must be a genuine pre-estimate of the loss the other party is likely to suffer, as a result of the breach, assessed at the time the contract is entered into, and if it is not, then it will be regarded as a penalty for the breach and therefore not enforceable.
The case is GWC Property Group Pty Ltd v Higginson & Ors. Judgement was delivered on 29 October 2014. The case will have wide application but it is not yet clear how it may be applied to different fact situations. It should also be noted that the decision may still be subject to appeal. Assuming it is not appealed, or not overturned on appeal, other Australian jurisdictions, although not strictly bound by this Queensland decision, will likely consider it persuasive when applied to similar factual situations.
In this case a lease was granted for an initial term of 7 years and the original owner granted the following incentives:
- a contribution to the tenant's fitout;
- a rent abatement and a signage fee abatement spread over the first three years of the initial term.
The obligations of the tenant were personally guaranteed by Higginson and others. After the lease was entered into the property was sold to the current landlord (GWC Property Group) following which the tenant went into liquidation and the lease was terminated. The landlord sued the guarantors for money due under the incentive clawback provision. The clawback provision in this lease was to the following effect:
- with regard to the fitout contribution, the amount repayable was a pro-rata amount calculated by reference to the period after termination as a proportion of the whole of the initial term; and
- the amount to be repaid on account of the rent and signage fee abatement was the amount of abatement enjoyed up to the date of termination.
The landlord argued that its agreement to grant the incentives was in effect the consideration for the tenant entering into the lease and that it was entitled to recover that amount (or the relevant proportion of it) when the lease failed. The court did not accept this but instead found that the payment was wholly penal in nature, and was not enforceable.
The court's decision
The court concluded that:
- in substance, the payment obligation flowed from a breach by the tenant;
- the landlord was entitled to recover normal damages for breach, which would have included the agreed rental (with abatement), allowing for the landlord's obligation to endeavour to re-let the premises at a market rental; and
- had the tenant not breached the lease the landlord would have received no more than the agreed rental (with abatement) and that therefore, recovery of the leasing incentives, in addition to normal damages, would have placed the landlord in a substantially better position than it would have been had the tenant not breached the lease – hence the clawback provision was a penalty.
Implications of the decision
Evidence was given to the effect that the incentives offered reflected prevailing market conditions. The court considered that the landlord had paid/granted the incentives in order to obtain the market rental and was only entitled to recover as damages the loss of this "market rental". A landlord might consider that the decision produces an uncommercial or unfair result in a number of ways. For example, the landlord's up-front investment in the fitout contribution could be wasted if the fitout is not suitable for another tenant and the landlord had to remove it and provide a new fitout contribution to secure a new tenant. The court's response to this is that any such cost would form part of normal contractual damages recoverable for breach of the lease.
A landlord might also consider that if the rent abatement is given in the early years, and enjoyed by the tenant before the termination occurs, the landlord loses the benefit of the higher rent (ie when the abatement had been exhausted) that would have been payable during the later years of the lease. To take this example one step further, what if the incentive consisted wholly of a rent free period, and the tenant abandoned the premises after the rent free period expired? It is not entirely clear that such a loss would be recoverable under ordinary damages for breach.
It may be possible to structure incentives as a condition of the leasing bargain, so that the clawback is not treated as an unenforceable penalty, but this would need careful consideration, and drafting, having regard to each fact situation. In the meantime it would appear that this case has the effect that a landlord can only resort to ordinary damages for breach in order to recover its lost investment in incentives, and importantly, that the lease security is sufficient to cover this loss in the early years of the lease.
The risk is amplified where the incentives are "front-loaded" and not spread evenly over the initial term of the lease, and the importance of ensuring there is adequate security for these damages is highlighted. For example, it might be appropriate to consider a higher security amount to begin with, reducing over the initial period as the incentive is used up.
Landlords should also bear in mind the principles of the common law right to damages. Loss of bargain damages will only apply where the lease is terminated by the landlord for breach of a fundamental term or repudiation by the tenant, and not where the landlord exercises a contractual right to terminate for a breach that is not a fundamental breach.
Purchasers of investment property should also be mindful of the risks of incentive clawback provisions being potentially unenforceable following early termination of leases.
This publication does not deal with every important topic or change in law and is not intended to be relied upon as a substitute for legal or other advice that may be relevant to the reader's specific circumstances. If you have found this publication of interest and would like to know more or wish to obtain legal advice relevant to your circumstances please contact one of the named individuals listed.