Leasing Incentives and ‘claw-backs’

Leasing Incentives and 'claw-backs'

Leasing Incentives and ‘claw-backs’

If you are a tenant or an owner of commercial or retail premises, you will be familiar with the idea of leasing incentives provided to secure tenant commitments.  Leasing incentives are a relatively modern device designed to induce prospective tenants to sign leases for rentals higher than they might otherwise have been prepared to agree to.

There is an upfront capital cost to the owner, but the higher rental lifts the value of the property and helps to support borrowings secured against the property.

Over the past few decades leasing incentives have become a permanent part of the market for commercial and retail leases, with the value of the incentive dependent on local market conditions and on the length of the lease term commitment, among other things.  The market, and the law, now recognises ‘face rent’, being the actual rent paid by the tenant under the lease, and ‘effective rent’ being the net amount paid after factoring in the value of the incentives.

Incentives can be provided ‘up front’ – such as paying for a tenant’s fit out or providing a rent-free period at the beginning of the term – or ‘spread’ over the term, such as by way of an equal monthly rental discount for the duration of the lease.

Over the years a practice developed of drafting clauses that provided for a ‘claw-back’ of incentives, where the lease was terminated as a result of the tenant’s default, or insolvency.  Lawyers justified this by arguing that the incentive was consideration for the tenant agreeing to pay the higher rent for the full term, and if that did not happen, the ‘consideration’ should be returned.  Many leases and incentive deeds include language to this effect.

This approach has modified over time and most leases and incentive deeds today provide only for a ‘pro-rata’ claw-back of incentives paid up front.  For example, if an upfront incentive of $300,000 was paid for a 5-year term and the lease was terminated after year 3, then the repayment liability would be $120,000.  Sounds reasonable.

But this approach was rejected by the Queensland Supreme Court in 2014 (GWC Property Group Pty Ltd v Higginson & Ors) which was followed earlier this year by the NSW Supreme Court in Alamdo Holdings Pty Limited v Croc’s Franchising Pty Ltd (No 2).  In each case the claw-back was held to be a penalty and unenforceable.

Two questions need to be asked:

  • Can the claw-back requirement be characterised as a threat against the tenant failing to comply, or a punishment for permitting that circumstance to arise?
  • Does the requirement guard the legitimate interest of the owner, or is it out of all proportion to that interest and not reflective of a genuine pre-estimate of the damages that would be suffered as a result of the default?

In each of these cases the landlord was entitled to recover damages for breach of the lease.  These damages would have included lost rent (subject to the normal obligation to minimise losses by re-letting the property as soon as possible) and other costs associated with the breach and termination.

The damages would have taken into account prevailing market conditions at the time (such as market rent and leasing incentives) and other circumstances, such as the need – if there was one – to remove the prior tenant’s fit out to maximise the chance of securing a new tenant at a reasonable rent.

These damages would compensate the landlords for all the loss they suffered, and the right to an additional amount by way of claw-back went beyond what was necessary to protect the landlord’s legitimate interests and was a penalty.

On the basis of these decisions, it seems that claw-back provisions – even those based on a pro-rata calculation, will be unenforceable.

Furthermore, if the lease or incentive deed is covered by the unfair contracts’ regime in the Australian Consumer Law, due to commence operation on 9 November 2023, there is also a risk that inserting clauses of this kind, even if unenforceable, may contravene those laws and expose the owner to penalties and other sanctions under those laws.

The issue does not arise in the case of incentives that are ‘spread’ through the term, as there is no claw-back requirement in those cases.

Reach out to Steve Aitchison ([email protected]) or Peter Huang ([email protected]) from our Melbourne Property team to clarify any questions or if you need assistance with leases.

Property Laws in Australia are generally state specific, so please contact your nearest Hunt & Hunt Lawyers office for legal advice.

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