Although there are no signs of any rapid recovery in the commercial real estate market and problems continue with the financing of construction projects, investment experts are quite optimistic about prospects for this market.
Their optimism is largely attributed to a notable reduction in the number of vacant commercial premises, the stabilization of rental rates, and a growing interest in commercial property construction projects among both domestic and foreign developers.
The low competition in the commercial real property market, as noted by experts, the unsatisfied demand for quality premises and the present tendency towards economic stabilization give reason to believe that the practice of making concessions to commercial real property tenants has faded into the past. Both lessors and lessees will now have to defend their commercial interests more vigorously and bargain for more favorable lease terms.
Importance of Lease Agreement
In view of the above, it is particularly important to have a quality, well-balanced and properly drawn-up commercial lease agreement in place as an effective legal instrument for protecting the rights and interests of both the lessor and the lessee.
The negotiation of commercial terms of lease is only half the way. One should bear in mind that the success of such negotiations directly depends on how carefully and accurately the negotiated agreements are reflected in the respective lease agreement executed between the parties. A disregard for legal formalities may lead not only to difficulties in the realization of implied but not properly documented opportunities, as well as additional restrictions and encumbrances, but also to an early termination of lease relations often associated with considerable financial and other losses.
The lease agreement is of major importance from a commercial standpoint, as it contains the main terms of lease. But it is also very important from a legal standpoint, as the lease agreement is a title document certifying the lessee's right to temporarily use the respective real property and establishing mutual rights and obligations arising between the lessor and the lessee.
Meanwhile, almost all material commercial terms of lease are associated with legal aspects which, if ignored, may give rise to significant commercial risks. Let us examine some of them using the example of such lease terms, important for both parties, as the leased property, the term of lease and the rent.
General Formal Requirements
In accordance with the applicable laws of Ukraine, an agreement is deemed to be executed from the moment when its parties reach an agreement on all its material terms and conditions in the form prescribed by law.
The material terms and conditions are the terms and conditions which are either defined as material by the law or recognized as material by the parties.
Thus, in accordance with Article 184 of Commercial Code of Ukraine No. 436-IV of 16 January 2003 (the "Commercial Code"), as amended, the following terms and conditions are included among the material terms and conditions of a lease agreement: the leased property (the composition and the indexation-adjusted value of the property), the term of agreement, the indexation-adjusted rent, the procedure for using depreciation deductions, the procedure for restoring the leased property, and the procedure for returning or buying it out.
Therefore, the parties must reach an agreement on all of these terms and conditions by way of including respective provisions in the lease agreement to ensure that such agreement is treated as properly executed and that it gives rise to the counterparties' rights and obligations arising in connection with the lease of respective commercial premises.
Considering the statutory presumption of the validity of an agreement, the parties can, of course, perform the agreement even in the absence of more than half of the above terms and conditions. However, one should be fully aware of the risks associated with such careless attitude towards the statutory requirements: at the initiative of an interested party, such lease agreement can be invalidated by court due to the absence of any one of the material terms and conditions listed in Article 284 of the Commercial Code.
It is important to note in this context that practice shows that the parties to a lease agreement often overlook the fact that even though the respective property is privately owned by the lessor, the respective lease relations arising under such agreement are also governed by the provisions of Law of Ukraine No. 2269-XII "On the Lease of State and Municipal Property", dated 10 April 1994, unless the parties envisage otherwise in their lease agreement. Meanwhile, Article 10 of the said Law provides a much longer list of the material terms and conditions of a real property lease agreement. Thus, under this Law, the material terms and conditions also include liabilities of the parties, security for the obligations, terms of insurance, the procedure for inspections of the leased property by the lessor, and the fire safety obligations of the parties.
Therefore, by failing to include a reservation clause on inapplicability of the given Law, the parties create additional risks that their lease agreement can be invalidated if at least one of the mandatory terms and conditions, as listed in the mentioned Law, is omitted from the lease agreement executed by them.
Commercial lease agreements, just like lease agreements for any other type of real property, should be executed in writing. Civil Code of Ukraine No. 435-IV of 16 January 2003 (the "Civil Code") provides that agreements signed for three or more years are also subject to the mandatory notarization and state registration. It is particularly important to comply with this requirement because under the applicable laws, such type of lease agreement for real property is treated as properly executed from the moment of its state registration, which is currently performed by notaries simultaneously with the notarization.
Identification of Leased Property
The leased property is one of the material terms and conditions of any real property lease agreement, including commercial lease agreements. Therefore, it is very important to identify the leased property as accurately as possible.
The identification information, which is usually attached to the lease agreement as its integral part, can be obtained from:
- the technical passport for the premises (if the leased property is an integral commercial facility held under a separate title);
- a floor plan with the indication of separate premises (if just some of the premises are leased from a shopping mall or from a group of commercial premises);
- the plan of the premises to be leased;
- an excerpt from the State Register of Ownership rights to Immovable Property, issued by the respective bureau of technical inventory (the "BTI") at the lessor's request for the purposes of lease agreement notarization,
as well as other information about the property enabling accurate identification of the leased premises.
The practice shows that the main means of identification include the address of the leased property, with the indication of respective premises numbers, if any, and the gross leasable area.
The leasable area also serves as the most important component for calculating the amount of rent and the related operating expenses.
For the purposes of a formal technical inventory, BTI officers employ methods described in the Instruction approved by Order No. 127 of the State Committee for Construction, Architecture and Housing Policy adopted on 24 May 2001. It is a mandatory requirement that the leasable area be indicated as measured in the course of such formal inventory both for the purposes of leased property identification and for the purposes of the notarization of a commercial lease agreement executed for three or more years.
Meanwhile, the BOMA standards, which have been developed by the American Building Owners and Managers Association and which are used more and more often for leases of warehouse and office premises in Ukraine, can also be employed by the parties for leases of commercial premises. It should be noted that the BOMA standards are rather rarely used in practice with respect to commercial premises, because the leasable sales area measurement rules do not cover common areas and premises. However, if the parties agree on a mechanism for measuring the leasable area and calculating the rent accordingly in line with the BOMA standards, the official leasable area (in accordance with the BTI data) as well as the commercial leasable area (as measured in line with the BOMA standards) need to be correctly included in the lease agreement from a legal standpoint.
It is also important to closely investigate the lessor's title to the leased property. This investigation should include a thorough examination of the lessor's title documents. Should he lack the right to lease the respective premises or execute the respective lease agreement, this agreement can be later invalidated, and consequently, the lessee can be forced to vacate the leased premises.
Repair and Reconstruction Before Lease
Commercial premises, regardless of whether they are located in a specially organized shopping mall or in a separate group of commercial premises, for example, on the first floor of a residential building, usually require replanning (repair) or reconstruction, as well as the installation of special equipment in line with the technical specifications of the retailer acting as the lessee.
Lessees naturally seek to lease premises that meet their standards and requirements. That is why the best way for the lessee to structure his relations with the lessor is to sign a preliminary lease agreement, under which the lessor undertakes to lease property in a condition that meets all of the retailer's requirements. The lessor will then arrange all necessary repair and reconstruction works at its own cost. Compensation for the related expenses usually included in the rent, unless the parties agree otherwise.
However, given the considerable risk that the lessee may refuse from the lease without providing compensation for the reconstruction (replanning) costs incurred by the lessor, lessors only agree to sign preliminary agreements in exceptional circumstances. This deal structure can be used either during the commercial property construction stage or in the context of a long-term lease when the lessee provides sufficient collateral to secure his obligation to sign the principal lease agreement (such as a bank guarantee for an amount representing the replanning/reconstruction costs incurred by the landlord).
Therefore, the parties will most probably have to find a compromise directly within the scope of principal lease agreement. In doing so, the parties will have to pay a special attention to the following peculiarities of preliminary repair/reconstruction works relating to a leased property: (1) the period of such works is usually not included in the term of lease; (2) a lessee is often not required to pay a rent for the duration of such works since, in this case, commercial premises cannot be used for their intended purpose; however, such rent free period is usually limited in time, and if lessee fails to perform the repair (reconstruction) within agreed fit-out period, he will oblige to sign the transfer deed certifying the commencement of lease term and to start paying rent; (3) such works are usually carried out at the cost and expense of a lessee; (4) a lessee separately reimburses for utilities and incidental operating costs; (5) in most cases, such works change basic technical and economic characteristics of the commercial premises leased, which requires that a lessor register its title to the reconstructed property and that the parties subsequently enter into a supplementary agreement to the lease agreement in respect of the altered commercial real property.
The repair/construction works require a correct and accurate regulation of the work performance procedure, with the rights and obligations of the parties clearly determined and related financial issues covered by a commercial real property lease agreement.
Failing the proper regulation of a fit-out period in the lease agreement, discrepancies are likely to arise between the parties, which may subsequently result in conflicts and disputes. The latter proved to delay the beginning of the term of lease thereby obstructing a lessee from using the premises and a lessor from collecting the rent.
Term of Lease and Term of Lease Agreement
Term is an important condition of lease. Initially, it may seem that the term of lease and the term of lease agreement are identical concepts that deal with legal terminology and have no commercial intent. However, this is not the case.
As a rule, the term of lease agreement begins on a signing date of the agreement, which is determined either as a date when the parties reach an agreement in writing on all of the material terms and conditions or as a date of notarization and state registration of the lease agreement – depending on the established duration of lease relations (up to three years and three and more years, respectively).
The end of the term of lease agreement is mostly associated with the performance in full by the parties of their contractual obligations, in particular, in respect of the return of premises to a lessor, remedy of defects, compensation of damages, etc. Nevertheless, the parties may establish other principles for the calculation of lease agreement term.
On the other hand, the term of lease is directly associated with the payment of rent and incidental operating costs. Therefore, it is important to clearly specify the start and end dates of lease. The start of lease is usually associated with the execution of a delivery and acceptance certificate to certify the transfer of premises to a lessee for temporary use and the end of lease is marked by the return of the premises to a lessor. Like in the case of the term of lease agreement, the parties may also determine here the start and end of the term of lease by specifying an exact date or an exact event.
When competently prepared, the lease agreement enables to suspend the term of lease and refrain from paying rent, by way of example, in the case of repair and/or construction works, removal of failures caused by emergency situations and at other periods when a lessee had no opportunity to use the premises. The Ukrainian legislation does not contain any binding rules in this respect and allows the parties to settle such issues on a contractual basis.
It should be mentioned that the Ukrainian legislation allows to automatically renew an executed lease agreement and to extend the term of lease agreement by a respective agreement to be executed between the parties. Such mechanisms are mainly used by the participants of lease relations so that to avoid the necessity to notarize the agreement and to reduce agreement registration costs.
It should, however, be highlighted that the use of such mechanisms involves certain risks associated with the interpretation of the continuing (extended) term of lease agreement and with the failure to comply, in this respect, with an agreement notarization requirement. As a result, this may constitute the basis for invalidation of so renewed (extended) lease agreement in court. An optional way of mitigate such risk is to use a mechanism that provides for signing a new lease agreement for another term with simultaneous termination of the previous agreement and registration of all the necessary transfer documents related therewith.
As we can see, as simple as they seem at first sight, such commercial terms as a term of lease have an important legal component, which, if disregarded, may entail significant commercial and legal risks for the established lease relations.
In most cases, the amount of rent is agreed between the parties on the basis of a rent price per square meter of the commercial premises transferred to a lessee for temporary use. The rent means a fee payable by a lessee to a lessor for the duration of the term of lease.
The rent calculation principles can vary. The Ukrainian legislation allows to determine the rent as a fixed fee or to provide for rent calculation mechanisms. The rent is usually fixed in a foreign currency – USD or EUR. All settlements between the parties are, however, made in UAH at the exchange rate of the National Bank of Ukraine or at a commercial exchange rate of any bank selected by the parties in effect on the date of payment, unless any other rent calculation procedure is determined by the parties.
In addition, a mixed rent calculation mechanism is widely used: e.g., a monthly fixed fee and a quarterly (annual) percentage of the retail tenant's turnover. Such scheme is justified because it enables to take into account all of the commercial interests of both the lessee and the lessor and minimize all risks associated with their commercial operations. Nevertheless, each component of the scheme described above may be used both autonomously and in any combination whatsoever, at the discretion of the parties.
What is important and should be specified in the lease agreement in addition to the amount of rent and the rent payment procedure is rent indexation and the basis and procedure for changing the amount of rent.
In addition to the rent-related issues, it would be worthwhile for the parties to agree on the procedure for payment of a fee for use of the land under the leased real property, the amount, components and procedure for payment of utilities, cost of management services rendered by a lessor, and on the apportionment of the burden of other incidental operating costs.
The foregoing payments, if properly brought under regulation and structured, will enable to forecast the behavior of contracting parties and to measure stability of lease relations pertaining to the commercial real property as a whole.
The peculiarities described above represent a rather infinite list of pitfalls to be considered when entering into a commercial premises lease agreement.
No less important legal issues to be thoroughly and reasonably examined by a legal counsel are as follows: the procedure for using the commercial premises leased, the procedure for reconstruction and repair works, fit-out works, scope of a lessor's and a lessee's guarantees (including financial guarantees), the procedure for entering into a new lease agreement, the procedure for purchasing a leased property, the basis and procedure for early termination of the lease agreement, liability of the parties, the procedure for calculating and paying penalties, the procedure for returning the premises to a lessor, advertising procedure, mutual marketing obligations, etc.
Subject to the foregoing, one should pay closer attention to the legal component of the lease relations, namely to the lease agreement. It would be wise to hire a legal counsel to prepare the lease agreement because a correctly prepared lease agreement will guarantee stable relations, which, in turn, will reduce commercial risks and prevent financial losses.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.