Businesses need commercial property to generate profit through their sale of goods or services. However, for businesses to rent that property, they need to sign a commercial lease agreement. A commercial lease is a legally binding contract made between the company (the ‘tenant’) and the commercial landlord. Since commercial leases are different from residential leases, it is important to understand how to negotiate such a contract such that you do not get into an undesirable lease, and that the agreed terms between the landlord and tenant are reflected on the final lease.
Here is everything you need to know about commercial leasing.
How does a Commercial Lease differ from a Residential Lease?
Commercial and residential leases are governed by different sets of rules.
In most jurisdictions, residential leases receive a higher level of protection than commercial leases. This is because to secure a commercial lease and confirm the lease term(s), prospective tenants must go through rounds of negotiation. In contrast, the average consumer signing a residential lease does not. As such, residential leases offer additional protection for security deposits and rules for residential leases protecting the tenant’s privacy. Commercial leases are also typically more flexible, which will help ensure that the commercial spaces (e.g. office space)in question are fit for the specific purposes they are rented for.
An agreement for commercial lease is more complicated because of the legal terminologies used in it. A copy of the commercial lease can be found here and you can customize it as per your requirements.
Relevant Hong Kong Laws
The principal legislation governing commercial and residential leases in Hong Kong is the Landlord and Tenant (Consolidation) Ordinance (Cap. 7). It deals with matters relating to the rights and obligations of landlords and tenants; and Part V of the Ordinance covers non-domestic tenancies.
Another relevant legislation is the Land Registration Ordinance (Cap.128). It provides that any deed or instrument in writing which affects an immovable property can be registered in accordance with the provisions of this Ordinance. As regards a tenancy agreement, it provides that the tenancy agreements with a term more than 3 years must be registered with the Land Registry. Otherwise, it will lose its priority over other documents registered after it. The importance of registration is explained in detail in this article.
There are two types of arrangements:
· A lease – Lease is for a term exceeding 3 years and the parties must execute a deed in order to create a legal estate in land; and
· A tenancy agreement – Tenancy is for a term not exceeding 3 years and it need not be in writing. However, it is recommended that the parties have the tenancy agreement in writing to prevent any dispute in future
There are no legislations governing the terms of the lease agreed by the parties in the contract. They are open to negotiation and this article will help you understand the common terms and conditions for lease and how you can negotiate them.
What are the essential elements of a commercial lease?
When negotiating a commercial lease with the commercial spaces’ landlord, it is crucial to keep in mind that the essential elements for creating a commercial lease are more demanding than creating a mere contract. Below are the essential elements of this type of lease.
The Parties
It seems obvious enough that the commercial lease should specify who the landlord and the tenant are. However, it cannot be emphasised enough that the legal names of the parties are correct and that it is clear who is involved in the lease – as companies can be structured in complex ways.
For example, you may be negotiating with a subsidiary company instead of a parent company, meaning the liabilities and the remedies would be limited. In these circumstances, companies would have to conduct due diligence to ensure that all identities of the parties are legitimate and that they are properly compensated if things do not work out under the lease.
The subject
This is the clause which details the location of the property or space that the tenant will take up. Generally, providing the address of the property will be sufficient – subject to the qualification that the land itself must be suitable for the purposes that it is rented for. For example, it may not be possible to rent a piece of land for commercial activities if that land is in a residential area. In Hong Kong, you can check with the Town Planning Board if the land is suitable for the purpose that is rented.
The lease must indicate whether the property is used for domestic or non-domestic purposes. For instance, if the property is leased for residential purpose and the tenant is using it for commercial purposes then such use constitutes a breach of contract. In case of a dispute regarding the permitted use of the property, a party can obtain a Certificate of Primary User of Premises from the Rating and Valuation Department. There are many other ways to ascertain permitted use such as the Occupation Permit (issued by the Buildings Department) and the Approved Building Plans (by the Buildings Department).
Moreover, what constitutes part of the property may also be a question to consider. For example – do air-conditioners constitute property? Some facilities might be essential for the purposes that it is rented for, but may not be considered, in legal terms, as part of the property. This should be clarified in the lease.
Rent
This clause will detail the arrangements for the rent payment. Typically, a sum of payment would be payable at the end of the month for the entire duration of the lease. However, this is subject to the market rate which parties often use to account for market volatilities.
Duration
Commercial leases are typically longer than residential leases as businesses tend to look for more permanent arrangements. Generally, a commercial lease is for more than 3 years. However, merely stating the duration of the lease is not sufficient for creating a lease – for the contract to be valid, the parties must also agree on the commencement date of the lease.
Deposit
Security deposit is payable upon execution of the lease deed. The amount of the deposit is generally equivalent to 2-3 months’ rent. The deposit is refundable upon the expiry of the lease. The landlord is entitled to deduct any loss suffered due to the tenant’s default. However, this is open for negotiation and must be looked into before a lease deed is signed.
Rates
Rates are a tax on the occupation of the property. It is charged at a percentage of the rateable value which is based on the annual rental value of the property at a designated valuation reference date. It is payable quarterly in advance.
The parties can agree in the deed as to who is responsible for the payment of rates. In absence of an agreement, the tenant will be liable to pay the rates.
What else should you negotiate for?
Besides the core legal requirements we mentioned above, parties should consider negotiating certain terms of the lease to ensure that they fit with one another. Here are some of those terms that should be considered while negotiating a commercial lease.
Sale and Redevelopment clause
Leases in Hong Kong include a ‘Sale and Redevelopment ‘ clause that allows the landlord to terminate the lease with notice in the event the landlord decides to sell, redevelop or renovate the property. Generally, the notice period generally is around 6 months. As a tenant, you may negotiate to exclude the ‘Sale and Redevelopment’ clause from the deed or limit the scope of this clause.
Repairing Obligation
Maintaining the property is a top concern for both tenants and landlords. The question of who bears the obligation to repair the property – the landlord or the tenant – should be made clear to avoid conflict.
Generally, the landlord is responsible for any external and structural repairs while the tenant is responsible for internal and non-structural repairs. Before signing the deed, the tenant must inspect the property and notify the landlord of any existing damages.
As per the Occupiers Liability Ordinance, the tenant being the occupier of the premises has duty of care in relation to any injury to any visitor, including guests, workmen, and people delivering goods to your premises. The landlords may require tenants to obtain comprehensive insurance regarding third-party liability against any person or property in the premises.
Rent Free Period
A rent-free period is offered by landlords in commercial lease. It is a period at the beginning of the lease during which no rent is payable by the tenant. This period can be used for the fitting-out of the premises. If the parties agree on a rent free period then they must specify who will be responsible for payment of management fees, rates and such other expenses during that period.
Rent Review Clause
Leases often have a rent review clause which allows the rent to be reviewed at specified intervals during the lease or at the end of the lease to determine the rental for the renewed term.
The basic purpose of a rent review clause is to reflect the market rental rate. It ensures that the rent being paid is commercially competitive. The parties must agree on the mechanism to review the rent and the review date. A rent review clause can be ‘upwards’ or ‘downwards’. An upwards rent review clause is more common as it provides that the rent will remain the same or increase (if market rents have increased) at the review date. While an upwards-downwards rent review allows for the rent to go up or down depending on the market conditions.
As a tenant, it is important to carefully understand the rent review clause as it could impact on the percentage of increase in rent by the time of review. It is recommended to take advice from experienced commercial property lawyers to guide you through the process.
Termination Clause
The termination clause will set out the circumstances in which either party can bring an early end to the lease. The lease should specify the minimum period to notice that the lease will come to early termination. This gives both the tenant and landlord time to find a replacement.
However, not all leases terminate amicably. Leases may be terminated due to unforeseen circumstances. A classic example would be a ‘material breach of contract’. The word ‘material’ is used to indicate the severity of the breach – although what constitutes ‘severe’ varies case by case. In the lease, the parties may be able to decide upon certain conduct that will amount to a ‘material’ breach of contract to provide more certainty. A typical example of a material breach would be where a tenant operates illegal activities on the premises, resulting in the landlord being entitled to bring the lease to an end immediately. The tenant may still have an obligation to pay the remaining rent under the lease.
A landlord will often stipulate that they can terminate the lease if the tenant damages the property. A landlord may also terminate the lease at any time, but it is very likely that the landlord would have to provide prior notice and pay proper compensation to the tenant.
Facilities of the property
Some tenants require special facilities to run their kind of business. For example, if a tenant wants to run a restaurant business, they would need a kitchen space, which would likely require a ventilator system. If the tenant wants to run a jewellery business, they might require a security system. A ballroom tenant might require air-conditioners as part of the lease. The tenants, therefore, need to negotiate these terms prior to signing the lease or will not be guaranteed their essential needs. If the landlord is unable to provide, the tenant may have to negotiate to make certain improvements or modifications to the property with the landlord. The tenant would also have to consult his surveyor and lawyer to understand the limits of modification.
The nature of the business
The landlord must be aware of the tenant’s business’ purpose and nature. Some landlords may only want to accommodate certain types of businesses. For example, if the building is suitable as an ‘IT’ mall, the landlord may decide not to take on a tenant that intends to run a clothes shop. This provision is not always very straightforward, as businesses can serve multiple purposes. For example, a gym can also operate as a food and beverage business to serve protein shakes and healthy foods. A landlord concerned with these matters could include a “tenant exclusive” clause to restrict the tenant’s use of premises.
Legal requirements to execute a lease
The requirements for execution of lease depends on the capacity of the parties entering into the lease agreement. For instance, if a party to the lease is:
- Individual, sole proprietorship or a partnership then it may affix a red seal next to the signature of the signing person(s)
- Limited company then it must affix the company’s common seal next to the signature(s). The lease must be executed in compliance with the company’s articles of association and supported by written board resolution authorizing the execution of lease
- Sole proprietorship, partnership or limited company then chop or the rubber stamp of the signing party should also be affixed next to the signature of the signing person.
To understand more about the execution formalities, read our article on What is the difference between Tenancy Agreement and Lease Agreement?
Stamp Duty on Commercial Property Leases in Hong Kong
Parties to a lease are liable to pay stamp duty on the document in accordance with Schedule 1 of the Stamp Duty Ordinance (Cap. 117). The rate for calculating stamp duty varies with the term of the lease. For instance, if the term of the lease exceeds 3 years then the rate of stamp duty is 1% of the yearly or average yearly rent. Any deposit paid by the tenant pursuant to the lease will not be taken into account in assessing the stamp duty.
The parties are free to mutually agree on their respective shares of stamp duty. Generally, the payment of stamp duty is shared equally between the landlord and the tenant. However, the parties to the lease must ensure that the lease agreement is stamped within 30 days after the date of execution. It is important to note that the commencement date of the lease has no bearing on the said 30 day time limit.
Non-payment of stamp duty will accrue penalties, make the lease document inadmissible in court and the document will not be accepted by the Land Registry for registration.
Lease Registration
The Land Registration Ordinance (Cap.128) requires that a lease of more than 3 years must be registered with the Land Registry. However, if the lease is of 3 years or less then it need not be registered with the Land Registry, unless such a lease has an option to renew then the option to renew must be registered in order to be binding and to have priority.
It is important to register the lease document with the Land Registry because it ensures:
- the lease document does not lose priority over other documents registered after it.
- that party’s interest in the property (especially the tenant) and the existence of the lease is notified to the public. Hence, any person who is interested in the property in future will be aware of the lease.
- That new purchaser or mortgage is bound by the lease and the tenant is not evicted.
It is important to understand that such registration will not give any validity to the document that it does not have.
Once the parties have signed the lease, then it should be registered at the Land Registry within 30 days of the date of execution. The registration only makes it possible for the people interested to deal with the property to find out all the documents that are affecting the property before making any decisions. To understand more about the Land Registry and the procedure for registration, read the Guide to Registration of Document.
Summary
Commercial leases require lengthy negotiations to ensure that both the landlord and the tenant have their interests accurately reflected. It is crucial that all interests and agreements that have been expressed orally are written on paper. Due to the complexity, we recommend that you consult a real estate lawyer who is experienced with dealing with commercial leases to avoid problems. It is also important to do your own research so that you understand what options are available to suit your business needs.
Please note that this is a general summary of the position under the Laws of Hong Kong SAR and does not constitute legal advice.