Commercial notes No. 21

No. 21
14 December 2006

This issue
Procurement of construction services
Market rent review provisions
Current leasing issues for Commonwealth property managers

PROCUREMENT OF CONSTRUCTION SERVICES

Harry Dunstall

Harry Dunstall Special Counsel
T 02 6253 7066
F 02 6253 7301
harry.dunstall@ags.gov.au

Robert Claybourn

Robert Claybourn Senior Executive Lawyer
T 07 3360 5767
F 07 3360 5797
robert.claybourn@ags.gov.au

Finance Circular No. 2005/12 – Construction Services,
released by the Department of Finance and Administration
(Finance), provides further guidance on the definition
of a procurement of construction services.

The Finance Circular confirms that a procurement of
construction services is a 'covered procurement' and
subject to the mandatory procurement procedures (MPPs)
when the value of the procurement exceeds the $6m financial
threshold and the procurement is not otherwise exempt
from the operation of the MPPs.

Application of the MPPs to construction contracts

AGS Commercial notes No.
16
(10 June 2005) discussed the
application of the MPPs (Division 2 of the Commonwealth
Procurement Guidelines (CPGs)) to construction contracts
(see article 'The Implications of the Commonwealth
Procurement Guidelines for Real Property and Infrastructure
Related Activities').

That article noted that the MPPs would apply to construction
contracts if their value exceeded the relevant financial
threshold in the CPGs. The application of the MPPs could
extend to some precommitment leasing and private financing
transactions and related agreements such as management
and consultancy contracts. However, real property leases
and the sale and purchase of real property would not be
covered by the MPPs although they would still be subject
to other aspects of the CPGs (i.e. Divisions 1 and 3 of
the CPGs).

Definition of procurement of construction services

Appendix E of the CPGs defines procurement of construction
services as procurement 'related to the construction
of buildings and all procurements covered by the Public
Works Committee Act 1969 (PWC Act)'.

Finance Circular No. 2005/12 provides that, for the purposes
of that definition, 'building' is used according
to its normal dictionary definition. In relation to the
second part of the definition, 'construction services' includes
all activities meeting the definition of 'work' as
stated in the PWC Act.

For ease of reference, the Finance Circular sets out the
definition of 'work' from the PWC Act. This
definition makes clear that construction services will
include, for example, the alteration, repair, refurbishment
or fitting out of buildings and other structures, and the
installation, alteration or repair of plant and equipment
designed to be used in relation to the buildings and other
structures.

The Finance Circular notes that 'work' also
includes a temporary building or structure and a demountable
building or structure. Accordingly, these are also included
as part of the definition of construction services for
the CPGs.

Valuing a construction procurement

In relation to valuing a construction procurement, the
Finance Circular confirms that a procurement must not be
divided into separate parts for the purpose of avoiding
the procurement threshold. This means that, in considering
the application of the MPPs, a construction project conducted
through a single procurement process cannot be divided
into its various component parts, but rather all the contracts
that might be let in the course of the procurement process
must be taken together for the purposes of valuing the
total procurement.

If the project is to be conducted through several separate
procurement processes (for reasons other than avoiding
the application of the MPPs), the threshold could be applied
to each of those processes separately.

For example, the construction of a building in a single
design and construct process may involve the letting of
contracts for project management, architecture, construction,
fitout, cost planning etc. The value of all these procurements
must be considered together for the purposes of valuing
the procurement. If when taken together these exceed the
$6m threshold, then the letting of each of those contracts
individually must comply with the MPPs.

However, while an initial procurement of construction
services may include provision for maintenance services
for a period after completion of the building, the procurement
of further maintenance services after that period becomes
subject to the CPG requirements for the procurement of
general property and services (i.e. the $80,000 threshold
applies rather than the construction threshold).

Precommitment leasing or PFI arrangements

Appendix B to the CPGs provides that the MPPs do not apply
to the leasing or purchase of real property or accommodation.
The Finance Circular notes that the exemption for leasing
accommodation applies only to leases for accommodation
from 'the commercial property market'.

The exemption does not apply where leasing is being applied
as a method of financing a construction services project
as may be the case in some precommitment leasing or PFI
(private financing initiative) arrangements. In such a
case, these procurements would be considered to be procurements
of construction services for the CPGs.

AGS Commercial notes No.
16
discusses precommitment leases
and PFI projects in more detail.

While the Finance Circular does not provide any guidance
on which types of precommitment leasing or PFI arrangements
will be caught by the MPPs, or perhaps more importantly
on which precommitment leases will not be caught by the
MPPs, it would seem that where a developer designs and
constructs a building to an agency's particular requirements
and the conditions of lease are agreed at the conception
of the project with the agency, the project may be considered
to be a procurement of a construction service rather than
the leasing of accommodation for the purposes of the CPGs.

Many agencies will conduct a tender process for accommodation
that may result in a precommitment leasing arrangement.
In that case, where the agency is prepared to consider
a number of possible locations, it will usually not be
difficult for the acquisition strategy to comply with the
MPPs.

However, if agencies require that premises be built on
a particular parcel of land (not owned by the agency),
the procurement strategy will require careful consideration
very early in the planning for the acquisition strategy.
There are a number of potential approaches that may be
available depending on the circumstances:

  • Where the agency is merely taking the lease of an
    existing property this would be exempted from the MPPs.
    This exemption would probably apply even if some refurbishment
    or fitting out were to be done by the lessor.
  • The agency may be able to rely on the direct sourcing
    exemption under clause 8.65.d of the MPPs to enter into
    design, construct and lease arrangements with the owner
    on the grounds that the property can only be obtained
    from a particular business and there is no reasonable
    alternative due to technical reasons (e.g. the importance
    of that particular location).
  • Where a competitive process is required by the MPPs
    or considered necessary by the agency, notwithstanding
    that the MPPs may allow direct sourcing, there are a
    number of options including:
    • negotiating an option to purchase the land with
      the right to assign that option to a third party. (This
      approach permits the agency to run a competitive process
      for design, construct and lease by including in the
      conditions of tender a provision that the agency will
      assign the option to purchase to the successful tenderer.)
    • purchasing the site and providing in the conditions
      of tender for the transfer of ownership to the successful
      tenderer, who then designs, constructs and leases to
      the agency.

Harry Dunstall practises principally in the
area of Commonwealth procurement of goods and services.
He provides strategic, legal and probity advice to agencies
in their procurement activities and contracting policy
generally.

Robert Claybourn practises in the areas of property,
leasing, construction and procurement law. He specialises
in project delivery advice and documentation.

MARKET RENT REVIEW PROVISIONS

Mark Sheridan

Mark Sheridan Senior Lawyer
T 02 9581 7569 F 02 9581 7445
mark.sheridan@ags.gov.au

Today almost all commercial leases contain provisions
under which the rent payable by the tenant is to be reviewed
at certain points during the term of the lease. There
are rent review provisions which provide for fixed increases:
for example, a percentage or CPI increase. These are
generally self-executing provisions, which means they
operate without the parties having to activate them.

On the other hand, there are those provisions which
the parties must activate before they operate and which
contain machinery for a rent review. An example of a
provision of this type is a current market rent review
clause.

This note examines the operation of a current market rent
review clause and how a clause of this type, if properly
drafted, will ensure an objective market rent review. This
note also considers some of the legal, valuation and drafting
issues involved in the determination of a current market
rent; in particular:

  • who may initiate the process of review
  • timing provisions in rent review clauses
  • some of the relevant criteria that a valuer must take
    into account in making a determination
  • the meaning of the expression 'speaking valuation',
    and what opportunities exist to challenge a determination
  • some process issues for property managers.

Initiating the process of review

It is important to provide in a market review clause that
either the landlord or tenant may initiate the review process.

Landlords will generally resist giving tenants the right
to initiate the review process. Landlords will be looking
to protect themselves and their lenders so that in the
case of a falling market they may choose not to review
the rent.

It is very important that the tenant obtain the right
to initiate the review process. This right of the tenant
becomes most important in circumstances where the landlord
does not want a review to be carried out: for example,
in a falling market.

The question whether the rent review process at any rent
review date may only be triggered by either the landlord
or the tenant, or can be triggered by both parties, can
only be answered by construing the relevant provisions
of the lease. This question has been subject to much litigation
in cases generally where the tenant has not had a clear
right to activate a review in a falling market. The following
cases help to illustrate the point.

Landlord bound to instigate review

A rent review clause provided that the rent 'shall' be
reviewed every 18 months. However, it also said that the 'lessor
may at any time' issue the notice which would instigate
the rent review. It was held that the landlord was bound
to instigate a rent review every 18 months. The landlord
had a discretion as to when to issue their notice, but
not whether to issue it. (Myers & Ors v Pioneer Concrete
(Vic) Pty Ltd [1997] ANZ ConvR 331; Federal Court of Australia,
6 December 1996)

No right to initiate review

A landlord demanded $211,000 rent for the beginning of
the option term. The tenant was paying only $132,000 at
the time and had a valuation which said that the market
rent was $95,000. The tenant served a notice, allegedly
under the lease, which required that the rent be fixed
by a valuer. However, the Court held that the tenant had
no right to serve the notice.

On a proper construction of the lease, the tenant had
no independent entitlement to a rent review. The tenant
could not serve a notice requiring a valuation unless the
landlord had first given a notice setting out its assessment
of the market rent. The landlord had not given such a notice
and was not obliged to do so under the lease. (Highpoint
Homemaker Centre (Vic) Pty Ltd v Sanstar Pty Ltd, Supreme
Court of Victoria, 20 June 1997)

Reviews discretionary despite letter

A letter recording an agreement to lease said that rent
reviews 'will' occur at certain times during
the term of the lease. However, the lease gave the landlord
the sole discretion whether to initiate reviews on the
relevant dates. The lease provided that the letter was
to prevail over the lease if there was any inconsistency
between the two.

The tenant argued that the reviews were mandatory, but
the argument was rejected. There was no inconsistency between
the letter and the lease. The letter simply defined specific
dates for reviews, and did not make the reviews mandatory
on those dates. (Commonwealth of Australia v GIO Compulsory
Third Party Insurance Ltd, Supreme Court of Western Australia,
22 July 1997)

Review not instigated – rent stays the same

A lease provided for three-yearly rent reviews. Under
the lease, the landlord would activate a review by serving
the tenant with a notice setting out the landlord's
opinion of the current market rent. The figure contained
in the landlord's notice would become the new rent
if the tenant did not dispute it. If the tenant did dispute
the notice, the new rent would be determined by a valuer.

The lease contained a ratchet clause, which said that 'the
rent payable by the Lessee following the review date shall
not … be less than the rent payable at the commencement
of the Lease'. At the first review date, the rent
was increased from the initial $300,342.60 to $639,618.50.

At the second review date there was no review. The landlord
also did not activate the review procedure at the third
review date and the tenant commenced proceedings to argue
that in a falling market the rent should be reduced to
the initial rent of $300,342.60.

The tenant's argument was rejected. It was held
that the lease only provided for a rent review at the landlord's
discretion. This meant it was possible for there to be
no review on a particular review date. The court said that
if the rent was not reviewed, clear words were required
if the rent was nevertheless to be varied. It found no
such clear words in the lease in question. It held that,
without a fresh review instigated by the landlord, the
rent remained at $639,618.50. (New Zealand Post Ltd
v ASB Bank Ltd, [1998] ANZ ConvR 393, Court of Appeal of New
Zealand, 15 May 1996)

Accordingly, it follows that to avoid the need to argue
the point in litigation (generally without success) and
to protect the tenant in a falling market, it is recommended
that the rent review clause allows either party to trigger
the review process and that the lease does not contain
a ratchet clause which prevents the rent being decreased
on review.

Time limits

Under most market rent review clauses the landlord is
required to take steps within a prescribed time to activate
the rent review process.

Where a landlord fails to initiate the process within
the prescribed time, it becomes open for the tenant to
claim that by reason of such failure, the landlord has
lost the right to review the rent.

The courts have now provided a clear statement of the
law on this point. The position now is that a landlord
who has failed to observe the time limits specified in
the rent review clause will lose their right to raise the
rent only if such time limits are of the essence of the
contract and that, in the absence of any indication in
the lease to the contrary, the presumption is that the
time limits prescribed by such a clause are not of the
essence of the contract: United Scientific Holdings
Ltd v Burnley Borough Council [1978] AC 904.

In United Scientific Holdings, the House of Lords allowed
a review by the landlord out of time. Lord Diplock observed:

It is not disputed that the parties to a lease may provide
expressly that time is or time is not of the essence
of the contract in respect of all or any of the steps
required to be taken by the landlord to obtain the determination
of an increased rent, and that if they do so the court
will give effect to their expressed intention.
...

… the best way of eliminating all uncertainty
in future rent review clauses is to state expressly whether
or not stipulations as to the time by which any step
provided for by the clause is to be taken shall be treated
as being of the essence.

The importance of making time provisions of the essence
is well illustrated by other judicial decisions where time
was not made of the essence, and the court held the landlord
was entitled to a review of the rent out of time, and in
some cases, even though the fixed term of the lease had
expired.

A well drafted lease will make time of the essence, so
a landlord in a rising market will lose their right to
activate the review process three months after the review
date.

Criteria to be taken into account on review

It is strongly recommended that rent review clauses should
contain valuation criteria for the review, including assumptions
which should be made by the valuer, matters which must
be taken into account, and matters which should be disregarded.

As valuers have a very wide discretion in applying valuation
principles it is important, to ensure an objective review
process, that they are made to take into account certain
criteria. This can be achieved by giving certain directions
and by specifying such criteria in the rent review clause
and requiring the valuer to follow those directions and
apply that criteria in determining the rent.

Current market rent

The valuer should first be directed as to the type of
rent to be determined, and so the lease must refer to the
type of rent to be determined, for example, current market
rent.

The term 'current market rent' has been expressed
in various ways, such as 'open market rental value', 'current
annual market rent' and 'current annual open
market rent'. These terms are effectively identical
in their meaning. The preferred term is current market
rent, which is well established in valuation practice and
poses no legal or valuation difficulties or ambiguity:
Burns Philp Hardware Ltd v Howard Chia Pty Ltd (1987) 8
NSWLR 642.

The expressions 'reasonable rent', 'fair
rent' or 'fair market rent' are generally
considered to be different from ' current market
rent' and take into account what is reasonable between
the actual parties to the lease. That introduces subjective
considerations into the rent review process: Wickham
Properties Pty Ltd v Astor Motel Pty Ltd (1991) ANZ ConvR 440; Ricciardello
v Caltex Oil (Australia) Pty Ltd (1991) ANZ ConvR 445.
This is considered undesirable and presents difficulties
for valuers.

Another expression, 'best rent', requires
a rent at the top of the rent range and on the basis of
the highest and best use of the premises, which may not
be its actual use by the tenant. This distorts the valuation
task unfairly against the tenant, which is unjustified
and should be resisted by the tenant when the lease is
being finalised.

A well drafted lease will adopt the expression 'open
market rental value' which has been held to be the
equivalent of 'current market rent'.

The distinction between 'market rent' and 'open
market rent' was the subject of consideration by
Harman J in Sterling Land Office Developments Ltd v
Lloyds Bank plc [1984] 2 EGLR 135 at 137:

I do not believe there is any difference between an 'open
market rent' and a 'market rent'. I
am convinced that the words 'market rent' are
not by themselves apt to refer to a rent within a closed
or circumscribed market to which only certain bidders
are admitted.

Accordingly it is important to correctly describe the
type of rent to be determined. From a tenant's point
of view this will ideally be the 'current market
rent' or 'open market rental value'.

Assumption of vacant possession

The expression 'vacant possession' was the
subject of consideration by Donaldson J in FR Evans
(Leeds) Ltd v English Electric Ltd (1977) 36 P&CR 185. The
valuer was instructed by the rent review clause in that
case to ascertain the rent at which the premises were 'worth
to be let with vacant possession on the open market … disregarding … any
effect on rent of the fact that the lessee or its tenant
has been in occupation of the demised premises'.
His Honour said at 189:

It is implicit in this instruction, and is expressed in
[the rent review clause] that the tenants are to be deemed
to have moved out or never to have occupied the premises.

This assumption ensures valuers do not determine (as they
may otherwise be inclined to do) that tenants would pay
more than market rent for premises they occupies which
they may otherwise do to avoid the cost of relocating.

Accordingly, the rent review clause should direct the
valuer that vacant possession must be assumed in assessing
market rental value and a clear expression of that requirement
should be set out in the rent review clause.

Lease incentives

During periods of economic downturn when commercial premises
are more difficult to lease, landlords frequently grant
lease incentives to tenants, and sometimes very substantial
incentives usually in the form of a rent-free period or
a contribution to the cost of the tenant's fitout.

In many commercial leases it is provided that lease incentives,
in respect of the particular lease and other premises,
should be disregarded. This should be strongly resisted
by the tenant as it will result in a review of 'face
rent' (rent shown in a lease which is artificially
higher than market because of incentives provided and allowed
for in the rent shown in the lease) and a comparison of
other 'face rents', again ignoring that they
are inflated because of the incentives provided under the
other leases used as comparisons.

A well drafted lease will require incentives to be taken
into account by the valuer which will result in an objective
review of 'effective rents' rather than 'face
rentals'.

Willing landlord and willing tenant

The assumption of a willing seller and a willing buyer
is central to valuation principles for the valuation of
the freehold. There should be an assumption of a willing
landlord and a willing tenant for the purpose of the rent
review. The assumption involves a landlord who is not forced
to lease the premises, but could not afford to wait until
the rental market improved, and a tenant who is actively
seeking premises such as those under the lease but is not
under pressure to lease those premises: F R Evans (Leeds)
Ltd v English Electric Co Ltd (1977) 245 EG 657.

The nature of this assumption was discussed in Alcal
Australia Ltd v Scarcella & Ors [2001] NSWCA 401. The principle
issue was whether the valuer should or can have regard
to the market when determining a market rent, even where
there was no potential market for the hypothetical lease,
or there was no other likely bidder to lease the premises.
Stein JA said that the 'valuer must envisage a hypothetical
willing lessor and willing lessee and determine the rental
at which they would reach agreement'. His Honour
held that the trial judge was correct in making his orders
and declarations, and that to make the assumption that
a market for the hypothetical lease did not exist, as the
tenant contended, would be inappropriate and have the capacity
to lead to a subjective determination.

Challenging the determination

Although there have been many attempts to challenge the
validity of rent review determinations in the courts, few
have succeeded.

It is generally only 'speaking valuations' that
may be open to challenge, and although a challenge may
not be made for mistake, it may be made where the valuer
does not follow the process required under the lease (that
is, the valuer has regard to some matters and disregards
other matters in a way that is inconsistent with the direction
given in the lease).

A well drafted lease will require the valuer to produce
a 'speaking valuation', and accordingly that
valuation should be examined to see that it follows the
process the lease requires. If the valuation does not do
this it may be open to challenge.

With a 'speaking valuation' the method of
arriving at a valuation and reasons should be stated. Detailed
reasons and conclusions are not essential. It is not necessary
that the reasons given be as detailed or as comprehensive
as judgments of courts or awards by arbitrators. The test
is whether they are sufficient for the parties to understand
that the terms of the engagement have been satisfied and
how the valuation was arrived at.

The most important factor is that the valuer addresses
the matters required by the lease. If that is not done
then the valuation is liable to be set aside by the courts
on the ground that it does not comply with the lease.

Process

The procedure to implement a rent review involves correspondence
(and communications), including:

  • the rent review notice
  • correspondence between the parties
  • correspondence relating to the appointment of the
    valuer.

In general terms care should be taken to ensure that the
rent review notice and other correspondence is:

  • in the correct form
  • addressed to the correct person or persons
  • served on such person or persons in accordance with
    the terms of the lease.

Judicial decisions indicate that the parties need to exercise
certain precautions. First, if each party appoints a valuer
who acts independently, the appointment should be advised
to the other party before that valuer commences to act
or completes the task: Gollin & Co Ltd v Karenlee Nominees
Pty Ltd (1983) 57 ALJR 711.

Secondly, some care needs to be taken in communications
between the parties (or their representatives) and the
valuer. Representations can only be made to the valuer,
if the rent review clause authorises it. This allows written
submissions to be made, and also rent valuations submitted
(by valuers employed by each party).

Conclusion

It is important for agencies to be aware of the process
of a market rent review, who may initiate the review, and
the importance of timing provisions, proper directions
and criteria to be included in the rent review clause to
ensure the valuer is required to make, from the tenant's
point of view, a fair and objective determination.

There are limited grounds for challenging a determination
and few challenges have been successful. Therefore it is
suggested that particular care be taken in agreeing to
the provisions in the first place.

From an agency's point of view it is essential to
get the market rent review provisions right, at the time
the lease is negotiated.

Mark Sheridan has extensive experience in advising
on commercial and property matters, having acted for
both private sector and government clients, and is also
an accredited mediator with the Australian Commercial
Disputes Centre.

CURRENT LEASING ISSUES FOR COMMONWEALTH PROPERTY MANAGERS

Robert Claybourn

Robert Claybourn Senior Executive Lawyer
T 07 3360 5767 F 07 3360 5797
robert.claybourn@ags.gov.au

This note examines three current leasing issues for
agency property managers:

  • providing for and managing building outgoings in
    the context of a net rent lease
  • warranties of fitness given by the landlord, and
    remedies for breach
  • options for the tenant in dealing with make-good
    obligations at the end of a lease.

Providing for and managing building outgoings in the
context of a net rent lease

A net rent lease differs from a gross rent lease in that,
in addition to the rent, the tenant pays the whole or a
proportion of:

  • statutory or building outgoings (or both), or
  • increases in statutory or building outgoings (or both)
    over a base period.

The challenge for the parties is to comprehensively define
outgoings in the lease. Although this task is difficult,
if it is approached by specifying both the outgoings included
and those excluded, a better outcome is likely to be achieved.
Effective management of the tenant's outgoings obligations
assumes a comprehensive outgoings definition in the lease.

Statutory outgoings

The following issues are relevant in defining statutory
outgoings:

  • Municipal rates which are recurrent impositions and
    usually form part of statutory outgoings should be confined
    to the land on which the leased premises are located.
  • If taxes are included, they should be specified, confined
    to those which relate only to the leased premises, and
    defined to exclude future taxes and taxes which require
    a one-off capital payment.
  • Outgoings should be calculated on the discounted amount
    for early payment, exclude fines and penalties for late
    payment, and be assessed as if the land is the only land
    owned by the landlord.

Building outgoings

In defining building outgoings, the following issues should
be considered:

  • determination of items to be included or excluded
  • whether the outgoings are relevant to, and of benefit
    to, the leased premises
  • whether any outgoings should be subject to a limit
    in each accounting period (for example, it might be possible
    to cap management fees and repairs and maintenance).

Expenditure of a capital nature, contributions to a sinking
fund, the cost of replacement, refurbishment or redecoration
not reasonably attributable to fair wear and tear, the
cost of effecting works of a structural nature, costs recoverable
under a policy of insurance, interest charges, fines and
penalties, charges on amounts owed by the landlord and
amortisation of capital costs should be excluded.

Structuring the tenant's liability for outgoings

In negotiating how best to structure the tenant's
liability for outgoings, the tenant may be required to
accept the landlord's approach to outgoings in other
leases within the building.

The tenant's liability may be structured so that
they pay the whole or a proportion of outgoings or increases
in outgoings over a base period. Matters which are relevant
in structuring the liability of the tenant include:

  • When the tenant pays a proportion of outgoings or
    a proportion of increases in outgoings over a base period,
    that proportion should equate to the proportion that
    the net lettable area of the leased premises bears to
    the net lettable area of the building.
  • When the net lettable area of the building changes,
    the landlord should provide a surveyor's certificate
    which identifies the new net lettable area of the building
    and the date of effect of that change.
  • When the tenant's liability is based on increases
    in building outgoings over a base period:
    • the lease should assume that for the whole of the
      base period the building was completed, fully occupied
      and operational, the landlord received no benefit from
      guarantees or warranties and that all contracts for
      servicing and maintenance were in place and operational
    • the base period and the frequency of updating that
      base period during the term of the lease need to be
      established or alternatively, the parties could agree
      that, to simplify the process, outgoings will be deemed
      to increase by a fixed percentage at the commencement
      of each accounting period under the lease.

Determining how tenants might discharge their liability

When determining how tenants might discharge their liability
for outgoings, and how that liability might be confined,
property managers should be alert to the following:

  • Consider if the tenant could pay annual or monthly
    instalments in advance based on the landlord's
    estimate, with an adjustment at the end of the outgoings
    period having regard to an audited statement, or in arrears
    based on an audited statement of outgoings for the accounting
    period.
  • Do not deem statements provided by the landlord in
    relation to outgoings as conclusive. The tenant should
    have a right to dispute amounts and to require the landlord
    to provide relevant assessments, invoices and receipts
    for payment to permit the tenant to determine whether
    expenses have been properly incurred.

    In the event of the parties being unable to agree, the
    dispute could be settled in accordance with the dispute
    resolution provisions of the lease or a dispute resolution
    provision which applies only to outgoings.

  • Base all calculations on the assumption that the only
    land owned by the landlord is the land on which the leased
    premises are located
  • Consider whether it is preferable to update the base
    accounting period or provide for outgoings for the base
    accounting period to increase by a fixed percentage in
    each subsequent accounting period.
  • Ensure that outgoings exclude amounts payable by other
    tenants or occupiers of the land or building.
  • Consider whether outgoings should exclude amounts
    payable by the landlord to perform certain obligations
    under the lease. (For example, if the landlord incurs
    expenditure of a capital nature because of the need to
    replace one of the building services, that expenditure
    should be excluded from the outgoings.)
  • Ensure that if their outgoings liability is overpaid,
    the tenant has a right to set off that overpayment against
    future outgoings liabilities or rent.
  • Include only those outgoings which benefit the tenant's
    premises. For example, if the tenant occupies ground
    floor premises, it is reasonable that outgoings exclude
    the cost of servicing and maintaining the lifts.

Assuming liability under a net rent lease

The following issues need to be considered by a tenant
in assuming liability under a net rent lease:

  • Landlords generally prefer net rent leases, however,
    that preference sometimes assumes that outgoings are
    defined by example rather than by a comprehensive schedule
    of inclusions and exclusions.
  • Each party may incur significant management and administrative
    costs over the term of the lease in resolving whether
    expenditure is an outgoing or whether that expenditure
    has been incurred, was necessary, and is reasonable in
    quantum.
  • The tenant risks paying for costs included in the
    rent payable by third parties or for the landlord's
    capital improvements in the event that outgoings are
    not properly defined.

A net rent lease provides little incentive for the landlord
to rein in outgoings and therefore potential for dispute
is always present.

Warranties of fitness given by the landlord and remedies
for breach

The law implies no warranty that premises to be leased
are fit for the purpose for which they are let. It follows
that in the absence of an express warranty by the landlord,
the tenant has no remedy if the premises are not physically
or legally fit for the use permitted by the lease.

It is common for the lease to provide that the landlord
does not warrant the suitability of the premises for any
purpose.

If the tenant wishes to secure warranties in relation
to fitness and in particular, the standard and performance
of the building services, those warranties must be expressed
in the lease.

A prudent tenant will seek to secure warranties by the
landlord that at all times during the term of the lease,
the leased premises:

  • are fit for use and occupation for the use permitted
    by the lease
  • comply with standards specified in the lease or alternatively,
    all relevant Australian Standards and industry standards
    at the commencement of the lease term
  • comply with all laws
  • do not contain hazardous substances.

To give effect to the landlord's warranties the
tenant should consider whether the lease might provide
for the landlord to comply with related obligations to:

  • keep and maintain the building services and structure
    in good repair and condition and, subject to the tenant's
    obligations, keep and maintain all other parts of the
    leased premises and the building in good repair and condition
  • effect service contracts for the maintenance and repair
    of specified building services and provide evidence of
    those contracts when required by the tenant
  • provide certificates, including certificates by the
    maintenance contractors, that the performance of certain
    building services complies with the standards required
    by the lease and that those building services have been
    maintained in accordance with the service contracts the
    landlord must effect in accordance with the lease
  • ensure that the landlord is responsible for structural
    faults and defects and the removal of hazardous substances
  • comply with all laws.

Remedies for breach of warranty of fitness

The lease should provide the tenant with practical remedies
if the landlord breaches a warranty of fitness or a related
covenant. In addition to specific performance and termination,
remedies could include:

  • abatement of rent, or a rent holiday, if the landlord
    fails to rectify a breach within a specified time following
    notice from the tenant of that breach
  • a right to rectify the failure at the landlord's
    cost if the breach is not rectified within a specified
    period and to set off that cost against rent
  • a right to liquidated damages which may be set off
    against rent.

Ideally, the lease should provide the tenant with remedies
which do not require the tenant to seek the intervention
of the courts or to terminate the lease, as those remedies
are generally costly, delay rectification, and provide
no guarantee of success.

For these reasons, it is important for tenants to have
rights to abate rent and to rectify a breach of warranty
or a related covenant at the landlord's cost. To
avoid the need for the tenant to recover its costs through
the courts, the lease should permit the tenant a right
to set off those costs against rent.

Options for the tenant in dealing with make-good obligations
at the end of the lease

An obligation on the tenant to remove its fittings, make
good and restore the leased premises on or before the expiry
or termination of the lease or any holding over is, like
rent and outgoings, a valid consideration in determining
value for money. Due to the make-good obligation being
deferred, the cost to the tenant is difficult to assess
and therefore the tenant should consider the alternatives.
Initially, the tenant could seek to avoid a make-good obligation
and insist on an arrangement as follows:

  • the tenant has a right, but not an obligation, to
    remove its fittings during or after the term
  • the tenant rectifies damage caused by that removal
  • ownership of fittings not removed vests in the landlord.

Where the tenant is unable to avoid a make-good obligation

If the tenant is unable to avoid a make-good obligation,
matters to be considered in settling that obligation include
the following:

  • Whether the removal and make-good should be confined
    to the term of the lease and any holding over, or extend
    to a period after that time, and if so, at what cost.
    For example, does the tenant remain liable for rent if
    the removal and make-good take place after the expiration
    of the term?
  • When determining the extent of the make-good, the
    level of make-good should be no higher than the standard
    existing at the commencement date of the term, after
    making due allowance for fair wear and tear during the
    term.

    As it will be difficult for the parties to achieve consensus
    in relation to the level of make-good (having regard
    to fair wear and tear during the term), it may be preferable
    to agree that the tenant's obligation will be satisfied
    if the tenant makes a payment to the landlord of a specified
    sum, or a sum which is agreed, and failing agreement,
    determined in accordance with the dispute resolution
    provisions of the lease.

    The lease may need to provide some guidance on those
    matters which will be taken into account in determining
    the amount to be agreed.

  • It may be preferable to vest ownership of the tenant's
    fittings in the landlord in order to reduce the tenant's
    make-good obligation. The tenant's fittings may
    have value only while in place, and if the cost of removing
    those fittings is likely to exceed that value, the tenant
    might decide that ownership of those fittings should
    vest in the landlord on installation.

    The landlord may accept ownership if it is entitled to
    depreciation benefits or if those fittings add value
    to the building. In those circumstances, the tenant will
    not be responsible for fair wear and tear or the risk
    of damage to, or replacement of, those fittings.

    However, if the lease provides for rent to be reviewed
    to market, the tenant should attempt to exclude the value
    of those fittings in determining that market rent.

Tips for clients

Tenants should consider the following matters in determining their make-good position:

  • Physical make-good
    will be difficult to satisfy and provides potential
    for dispute. Accordingly,
    it
    may be preferable to provide for make-good
    to be satisfied by a payment taking into account
    the
    standard of the premises at the commencement
    date, and the impact of fair wear and tear over
    the term.
  • It
    may be helpful to include in the lease a condition
    report of the premises at the commencement date
    of the term if that condition is relevant to the
    make-good
    obligation.
  • If the tenant is unable to avoid a make-good
    obligation, it might be possible to negotiate
    that the make-good
    obligation does not apply if the tenant exercises
    the option to renew the lease.
  • If ownership of the
    tenant's fitout vests in
    the landlord on installation, consideration could
    be given to a payment by the landlord to the
    tenant if for any reason the lease does not run
    its full
    term.
  • Care should be taken to address liability for
    rent or for use and occupation if the tenant
    is permitted to satisfy its make-good obligation
    within
    a specified
    time following the expiration or earlier termination
    of the lease.

Robert Claybourn practises in the areas of property,
leasing, construction and procurement law. He specialises
in project delivery advice and documentation.

AGS contacts

AGS has national teams of lawyers specialising in property
and infrastructure. For further information on the articles
in this issue, or on other property and infrastructure
matters please contact the authors or any of the lawyers
listed below.

Canberra

Andrew Miles
Terry De Martin

02 6253 7100
02 6253 7093

Sydney

Simon Konecny
Mark Sheridan

02 9581 7585
02 9581 7569

Melbourne

Jo Ziino

03 9242 1312

Brisbane

Robert Claybourn

07 3360 5767

Perth

Lee-Sai Choo

08 9268 1137

Adelaide/Darwin

Mary Hannigan

08 8205 4287

Hobart

Peter Bowen

03 6220 5474

ISSN 1443-9549 (Print)
ISSN 2204-6550 (Online)

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The material in these notes is provided for general
information only and should not be relied upon for
the purpose of a particular matter. Please contact
AGS before any action or decision is taken on the basis
of any of the material in these notes.