Many investors purchase retail and commercial properties for investment, such as retail shops, warehouses, shopping centres and childcare centres. The value of these properties largely depends on whether they are tenanted, and the quality of the leases. Most owners also rely on rent to meet their mortgage repayment obligations. It is therefore vital for landowners to conduct due diligence on the existing leases before purchasing commercial properties or on the new tenants before entering into leases.
Risks for not conducting due diligence
If landowners do not conduct due diligence on leases or tenants, the following may happen:
- The tenant may not hold any substantial assets under its name, and there may not be adequate securities under the lease （such as bank guarantee or personal guarantee）. If the tenant ceases to pay rent, abandons the premises or is otherwise in default of the lease, it will be difficult for the landlord to recover the arrears from the tenant.
- The terms and conditions under the lease may be ambiguous or may not address the specific issues of the premises or the parties. As a result, it is common for landlords and tenants to have disputes in relation to:
- liabilities for repair and maintenance;
- tenant’s make good obligations;
- is the landlord responsible to carry out any fitout works and the scope of such works;
- is the landlord responsible for a particular defect or condition of the premises or the fitout contained therein.
If there is a dispute, the landlord may incur substantial time and costs in order to resolve it.
- If the tenant is in dispute with the previous landlord in relation to defects in the premises, it will be harder for the new landlord to defend its position as it may not have the full knowledge of the facts.
- When the landlord tries to enforce its rights under the lease, it may find that the validity of the lease document is in question due to inadequate execution or failure to comply with the landlord’s statutory obligations.
When should you conduct diligence
Landowners shall conduct due diligence before entering into a new lease or before signing a contract to purchase a commercial property.
Before entering into a new lease
Landlord shall usually consider the following when deciding to accept a prospective tenant’s lease offer:
- the tenant’s business background, including any prior experience in conducting similar businesses (supported by references);
- the tenant’s business plan;
- the tenant and the personal guarantor’s financial position, usually supported by an assets and liabilities statement certified by an accountant.
If the tenant’s does not have adequate assets to meet its rent obligations (e.g. the tenant may be a newly incorporated company holding no assets under its name), the landlord may consider requesting personal guarantors (usually the tenant company’s directors) and/or increase the security deposit/bank guarantee required under the lease.
Experienced managing agents are usually able to conduct the above investigation and make recommendation to the landlord.
If the landlord decides to proceed with the tenant, it is then important to have an experienced lawyer to prepare proper lease documents to address any issues found in the due diligence and protect the owner’s rights as much as possible.
Before acquiring a commercial property with leases
When deciding to purchase a commercial property, it is not enough to only look at the rent figures and lease term. The lease documents shall be reviewed by a lawyer together with the contract of sale of property. The lawyer will usually review he following:
- whether the lease documents are complete, valid, and properly executed;
- whether the commercial terms (such as rent and lease term) of the lease are consistent with the agent’s advertisement;
- whether the leased area are clear;
- do the tenant and its guarantors’ information appear correct;
- are the lease terms compliant with the law and are they industry standard;
- are lease terms defective, ambiguous or have other issues;
- does the lease appear genuine;
- what rights and obligations do the landlord and tenant have under the lease;
- based on the tenant’s business type, are the terms sufficient to protect the landlord’s rights；
- is the tenant in breach of the lease, such as not paying rent or outgoings;
- are the tenant and the current landlord in dispute;
- is the tenant obliged to provide a new bank guarantee upon change of owners.
Summary
If the landlord does not conduct due diligence on the tenant or leases, the landlord may be exposed to significant loss when the tenant breaches the lease or when the parties are in dispute. It can be much more costly and complicated for landlord to enforce its rights or resolve the issue retrospectively.
How can we help?
If you have any queries or need assistance with retail or commercial leases, please contact us.
This article is for general information only and does not constitute legal advice. Reader should seek legal advice before making any decisions.
How can I learn more?
David Wang.
Special Counsel.
David specialises in commercial and property law. He has extensive experience assisting clients with commercial transactions and negotiations, property acquisition & development, retail & commercial leasing, structuring investments & conducting legal due diligence, foreign investment related issues and trade marks.
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