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Managing Partner, Head of Real Estate & Construction, ARZINGER
Associate, Real Estate & Construction, ARZINGER
Negotiating Lease Property — Need-to-Know the Basis
“The fight is won or lost
far away from witnesses —
behind the lines, in the gym, and out there on the road, long before I dance under those lights”, — Muhammad Ali
Concluding lease transactions can be a rather slippery path, so every step should be carefully evaluated in order one could actually reach its final destination on the most profitable terms. The first and one of the major circumstances that should be taken into account is the situation on the market, particularly the demand/supply balance and respectively distribution of bargaining power between landlord and tenant. In fact one is blowing hot and cold, so it’s very important to get an adequate understanding of your own position on the market and only after highlighting the key priorities, needs and goals is it safe to dive into negotiating a lease.
Negotiations: Stakeholders and Strategies Involved
Let’s meet the participants involved in lease negotiations. While everything is clear with a lessor and a lessee, who are often introduced not only through lease departments managers and in-house lawyers, but through financial officers, technical departments, CEOs and owners as well, the participation of external legal councils and property brokers is inevitable. Consequently, it turns the deal-making process into a Champions League final where everyone is trying to get the ball from another player’s possession and where every ball should be fiercely fought over as every goal leads to victory.
Property advisory firms are professional services providers specializing in real estate search and property management. They act as intermediaries between the parties, helping them to sort out the best property, find the best commercial solution, match the interests of the parties involved and make deals happen.
Unlike in, for instance, the USA or UAE, this kind of business is not regulated in Ukraine yet, therefore there are no strict requirements on the professional and ethical standards for brokers. This is the reason why we sometimes see situations where a broker being retained by one of the parties to a transaction is actually trying to shop on both sides, which prompts collusion of interests and should be avoided.
Legal counsel can be involved in a lease transaction for various reasons. Some companies seek additional advice while their in-house lawyers take the principal lead of the transaction. For some others getting a lawyer from outside means two heads are better than one, for the rest it’s prescribed by internal company policies. But whatever the reason might be, everybody’s interested in dragging into the deal an experienced team of lawyers capable of keeping up with the constantly changing real estate market environment.
At the very outset of a transaction it is efficient for both parties to a deal to set their key issues, rank the order of their priorities and determine the walkaway points and terms. Based on these arrangements it’s safe to dive into the savage world of the negotiation process.
So, basically, negotiations cover these two stages:
1. Negotiations of the transaction basis, followed by a term-sheet (head of terms, MoU).
2. Negotiations of the agreement’s draft and supplementary documents.
On reaching an agreement with the counterpart on the principal commercial terms, the risk of having second thoughts on the issues discussed still remains. Therefore, all significant commitments should be finalized in writing at the very initial stage of the transaction by means of signing a term-sheet.
As a matter of fact, there’s hardly a serious transaction with commercial real estate (a retail property where there’s a yield, or an office where there’s a company budget above all else) when time has little value. Every retailer knows that the quicker a business is launched, the sooner the cash flow will follow. So, at the very start of any negotiation process every party should outline the anticipated timeframes within which the company is able to enter into the lease without jeopardizing the project’s implementation. In practice, a situation exists quite often when time is used as a weapon against an opponent; when there are no other arguments to be put on the table, one of the parties starts playing the opponent’s deadlines, leaving the other party in nowhere land.
When business interests are at stake, the parties may fall back to a great variety of strategies, so negotiation tactics may be pursued in a rather insidious manner. Some of them involve outbursts of emotions followed by walkaway actions with the intention of forcing the other party to stick to certain imposed terms, while others prefer endless rounds of negotiations, wasting lots of time reviewing the documents (that have already been reviewed hundreds of times), introducing new decision-makers into negotiation sessions. In cross-border real estate transactions with regard to Ukrainian property assets involving local and foreign companies, it’s often extremely difficult for the latter to get the picture. And the difference is not only in cross-cultural issues, but in the specifics of doing business abroad. In such case the only remedy is to rely upon your counsel, who takes the lead in a situation acting as your primary spokesman by pursuing the overall client’s strategy and needs, discussed in advance. So, whatever the situation one should keep a cool head and be ready to demonstrate unlimited patience.
A rather effective tool during negotiations can be exploiting the opponent’s vulnerable points, including some related to the premises itself. Our experience reminds us of a situation where there were problems with the title to a land plot and pending related litigations, while in another situation we observed some issues with title on the property after it had been detached into several objects. So despite the fact that it actually entailed no major risks for the lessee and the potential lease, those flaws served as weighty arguments against the lessor helping gain a winning solution in that hard-bargaining scenario.
The commercial terms are the top-priority issue for both parties in negotiations. Law firms are rarely involved in the very initial commercial talks (rental fee and its calculation, OPEX, rent-free period, fitting-out investments, commencement of lease etc.) as these terms are to be agreed by the parties with the help of the brokers. Our experience has however proven that the involvement of a trusted and experienced lawyer at this very early stage can contribute to significant savings and optimization of the entire transaction. While taking the first steps in the lease deal, one of the common mistakes made by lessees lies, for example, in neglecting to negotiate the amount of rental fee and operating expenses in detail, its nature (whether it consists only of the lease payments or there’s an additional turnover fee), some accreditation and openings payments (which, in fact, can sometimes be not completely excluded, but significantly lowered), etc. So the bottom line is that the prospective property user should be very aware of the situation on the property market or consult an external legal counsel who has a good feel for the market pattern, whether there’s a policy space.
But is the essence of commercial terms limited only to talks about price issues and payments while negotiating the lease transaction? Definitely not. Alongside the terms of the price and OPEX, importance should be given to these key commercial issues:
— Rent fee structure (fixed vs. turnover fee, indexation, etc.), rent free period (if agreed by the parties) and all other obligatory payments;
— Currency adjustment clause and fluctuation range, setting the principal percentage framework, the exceeding of which shall be deemed as ground for rent review;
— Security deposit or sinking fund, namely its use due to tax implications and after-payment order;
— Condition of transferring the property both into lease and backwards (whether the property is accepted in shell & core condition, but painted afterwards, should be ’washed away’ and some additional temporary walls installed need to be removed), which entail additional expense, etc.);
— Walkaway terms with regard to the initiating party, possible sanctions for doing so.
By setting profit-making interests above all, the potential property user doesn’t pay proper attention to the existing realities of the local real estate market, its peculiarities and any risks arising from it. Investors around the globe often face pitfalls from land plot issues, including title and designated purpose, legitimacy of construction, pending court cases related to target property. In order to avoid possible long-term, costly litigation in future and other post-transaction surprises, it’s imprudent to rely solely on contractual provisions which may be baseless. So, skimping on due diligence as a key step in real estate transaction is not safe at all, and could lead to serious repercussions for an investor.
The scope of due diligence varies depending on the country where it takes place. For example, in Ukraine there are no mandatory requirements for conducting environmental due diligence, and on-site investigations rarely take place while legal issues are being probed.
Sometimes one may overlook certain imperative provisions, according to which major lease deals presuming receipt of control over real estate objects, need to be precisely considered from the antitrust point of view. Given the very low merger control thresholds in Ukraine, major commercial mono-leases of stand-alone properties are often subject to preliminary merger clearance.
Failure to notify a transaction can trigger a fine of up to 5% of (global) annual group turnover. Therefore, it could be worth carefully evaluating the transaction from this rather unusual angle.