Guaranteed headache

While the recent financial downturn has seen the retail industry severely affected, its property market is beginning to see an increase in activity. However, while prime opportunities are being snapped up, the incentives for buyers to purchase mid-sized and small retail units are hugely lacking. One way that sellers can hope to entice buyers is through a rent guarantee.

A rent guarantee is a term of a property sale contract which requires the seller to make payments to the buyer equal to the rents which would otherwise be generated from empty premises if they were let, such as vacant units in a shopping centre. The seller will receive a higher headline price on the sale (since, in effect, the buyer will receive income from the vacant premises), but will be required to make payments during the guarantee period.

Often such arrangements are agreed when there are vacant premises which either the seller believes the buyer will be able to let soon after completion, or were let at the time the buyer made its offer, but have since become vacant or the tenant has entered into some form of insolvency (which may or may not mean that it is still paying the rent at the time the sale contract is exchanged).

While providing a suitable incentive for purchase, rent guarantees are on the whole, complicated. They require a large number of issues to be considered, which ultimately will have to be addressed at heads of terms stage. The inherent tensions that result between the seller and the buyer in dealing with vacant premises are frequently difficult to resolve. As a result, parties should consider if rent guarantees are sufficiently important to warrant the negotiations and need for ongoing monitoring.

Vital heads of term
Commonly, heads of terms contain little or no detail as to the precise terms and details of a rent guarantee that has been agreed. If the parties address in the heads of terms as many of the issues as possible, the time required to negotiate the guarantee should be vastly reduced.

However, the contrary is also true. In instances where issues are not considered at an early stage, negotiations can become protracted, delaying completion of a sale. Therefore, both parties should always bear in mind how much time and effort will be necessitated in operating the guarantee, as well as properly monitoring it. The primary question for all parties concerned should be whether a guarantee is in both of there interests.

When agreeing heads of terms, there are a multitude of issues to consider. One pressing question is if the guarantee should include rent, service charge, insurance and rates liabilities? If a service charge is included, does the seller need to consider including a cap on the amount recoverable? This could potentially be a particular concern if the guarantee covers a large proportion of the sale property and/or major works are envisaged during the guarantee period.

The guarantees duration will also likely to be a stumbling point. Will a guarantee last until the premises are let, or until they are let at a rent equal to or higher than the amount payable under the guarantee? If so, the buyer will almost certainly want it to be until the latter.

Technicalities may then arise in the decision. Does the guarantee fall away upon re-letting at a sufficient level of rent, or is it merely suspended while the new tenant pays the rent? The buyer will always be keen to ensure that the seller starts picking up the tab once more if the new tenant stops paying rent, exercises a break option or becomes insolvent. The seller will however argue that if it is the buyer selecting the new tenant then the buyer should bear that risk.

In any case, buyers will now be even more cautious about the identity of any new tenant of the premises, thus potentially prolonging the guarantee. The seller may prefer to agree more buyer–friendly “re-activation” provisions in the guarantee and taking on these risks.

Further issues that could also arise is the instance of what happens if a capital contribution is required to bring in a new tenant, who pays for this? And on what terms can or must the buyer let the empty premises? The seller will be keen to see as short a rent free period as possible; the buyer will on the other hand be happy with a rent free period equal to the length of the guarantee, if this secures a higher rent immediately after.

Finally what happens if the seller wants to use the premises while it is making payments? The potential lies for the seller to consider the unusual steps of taking a lease itself and then seeking to assign or underlet.

Likely tensions
What the above list of concerns demonstrates (and it is by no means a comprehensive list of all issues which arise), is the inherent tension that can manifest between the interests of the seller and the buyer, particularly in relation to letting the empty space. Fundamentally, this Is why negotiating rent guarantees can be such a challenge.

Once all of these issues have been considered, it often becomes apparent that the seller and the buyer usually have extremely different expectations as to how any guarantee should operate.

The seller will want the guarantee to fall away at the earliest possible date and on terms which are as simple as possible to satisfy. The buyer will want to keep the seller on the hook until it has found a tenant it is completely satisfied with the terms which epitomise the best deal available. In addition, the buyer may feel that from completion of the guarantee, it is the owner of the property, no-one (including the seller) should have the ability to force it to agree new leases on any terms.

A regular solution to this issue is the appointment of an independent adviser, such as a letting agent, who owes a duty of care to both buyer and seller. The buyer could be obliged to let the property on terms which the agent certifies are reasonable market terms. Although, what ‘reasonable market terms’ mean in this context is another point for discussion.

From experience, it is on the whole preferable (dependent on the level of rent, length of the guarantee and likelihood of the premises being let) to agree an adjustment to the price rather then the obligatory lengthy negotiations which may require the seller to monitor the ongoing management of the property when their efforts could be put to better use elsewhere.

Yet if a guarantee is to be put in place, it has to address all possible scenarios which may arise in connection with its operation, the release of the seller, and the letting of the empty premises. Rent guarantees therefore are a tricky business, yet remain another tool for those who wish to try and make the best out of a tough market.

Nathan Rees is Senior Associate at Nabarro Email: n.rees@nabarro.com