Issues with fit-out works

Fit-out works are an important consideration for both landlords and tenants, especially when negotiating heads of terms and entering into a commercial lease.

Fit-out works, in the context of a commercial lease, are often categorised into two types:

• Cat A – works undertaken by a landlord to provide a lettable space that a wide range of tenants could utilise. This could include installing essential infrastructure, basic electrics, lighting, plumbing etc. as well as flooring and wall finishes. Essentially, creating a blank canvas for an incoming tenant
• Cat B – the customisation and interior fit-out undertaken by a tenant to meet their specific business requirements, look and feel. This could include constructing partitioning, upgrading the services, installing specific equipment and the installation of corporate branding.

In this article we look at the various considerations both landlords and tenants need to be mindful of when fit-out works are intended.

Licence for alterations

A licence for alterations is likely to be required and this is essentially a formal agreement in which a landlord provides written consent to the fit-out works, and details conditions that the tenant will need to comply with when undertaking the fit-out.

A landlord can utilise a licence for alterations to control elements of the fit-out and they are likely to include provisions to ensure that a proposed fit-out will:

• Not affect the structure of the building
• Not interfere with any other tenants use and enjoyment of the building
• Be completed with good skill, workmanship and good quality materials
• Be undertaken in accordance with all necessary consents (planning etc.)
• Be insured by the tenant
• Be undertaken within permitted hours
• Not use prohibited materials.

The licence can also provide that all costs are to be borne by the tenant, it can grant temporary rights (such as rights to access a plant room to make connections) and specify whether the works are to be removed and the premises reinstated when the lease comes to an end.

A licence for alterations is often required because leases typically allow for non-structural alterations of the interior of the premises with the landlord’s written consent, on the proviso that such consent cannot unreasonably be withheld. It is also common for leases to state that detailed plans and specifications need to be approved by the landlord, and these are often then annexed to the licence for alterations to define the permitted fit-out. Agreeing a licence of alterations will therefore involve input from other professionals, such as surveyors and architects and the associated costs will need to be budgeted for.

In addition, both landlords and tenants should be aware that if planned alterations require works to be undertaken outside of the demised premises, usually, the landlord will not have to act ‘reasonably’ when considering whether to grant consent for such alterations by the tenant. If the tenant thinks such work may be required, it  would be prudent to request consent before entering into the lease.

Consents

Fit-out works will require various consents, licences and approvals, such as:

• Planning permission, building control approval, listed buildings consent and potentially, if the premises are in a “higher-risk building”, the approval from the Building Safety Regulator (BSR)
• Consent in respect of covenants on the legal title
• Consent of any superior Landlord
• Lenders consent
• Consent from the insurer of the building.

Access

The tenant’s ability to access the premises and the wider building to undertake fit-out works needs to be carefully considered, as this is often needed before the lease is granted/taken.

Where a tenant is not already in occupation of the premises and needs to enter before a lease is in place, access can be granted via a licence to occupy or tenancy at will. The parties need to carefully consider such arrangements to ensure they do not create a formal tenancy, which could give rise to security of tenure for the tenant. Any agreement will need to detail the specific limited purposes that access is granted for. The tenant may be given limited access for a set number of days, be required to provide a security deposit, cover the landlords costs and even return the keys for the premises at the end of each day. Tenants who take possession during the course of negotiations for a lease for the purpose of a fit-out will often be regarded as a tenant-at-will and this offers very little security.

Where there is an agreement for lease, both landlords and tenants should be aware that if possession of the whole premises (or substantially the whole) takes place before completion, this could trigger substantial performance of the contract. For the tenant, this has Stamp Duty Land Tax (SDLT) implications because the ‘effective date’ of the transaction will be the date on which the contract is substantially performed. If there is no agreement for lease, occupation of the premises by the tenant before the lease completes may still result in an SDLT liability, as they may have temporarily acquired a different ‘chargeable interest’ in the land. Therefore, early access for fit-out works, either by the tenant or someone connected to them, could trigger the tenant’s SDLT liability before completion has taken place.

If a tenant is already in occupation, they will need to consider whether they have the necessary rights in their lease to undertake the works or access relevant parts of the building. It may be that temporary rights need to be granted to enable works to proceed.

Insurance

Insurance arrangements are a key issue when it comes to fit-out works. Consideration needs to be given to the insurance of the whole building and what effect the fit-out may have on that policy, as well as insurance of the fit-out works themselves.

The usual position is that the tenant will be responsible for ensuring that the fit-out works are insured and the landlord will insure the works once they are complete and once they have been given notice by the tenant of the amount the completed works should be insured for. The tenant will be required to pay any increase in the insurance premium or additional premium arising as a result of the fit-out.

A landlord could insure the fit-out works whilst they are ongoing and arrange for both the tenant and contractor to be added to the landlord’s insurance policy. However, the tenant and contractor will want a waiver of the insurer’s rights of subrogation against them and the landlord and insurer may not be willing to proceed on this basis. Insurance options may also be limited for a landlord if they have a block policy and most landlords will not want the additional administrative burden of insuring the ongoing works.

Therefore, under the terms of the fit-out works contract, the contractor will usually insure the works. The contractor could also obtain additional insurance to cover the reinstatement of the building but such liability could be significantly disproportionate to the value of the works and there are also subrogation issues to consider. If the contractor agrees to insure the works, it may use its own third party liability insurance policy to cover any damage to the building but coverage may be insufficient.

Landlords, tenants and their contractors therefore need to ensure that appropriate insurance is in place, that they are not under any onerous or unnecessary insuring obligations and that any existing policies are not invalidated as a result of the fit-out works.

Most licences for alterations will require the contractor to have in place public liability and employer’s liability insurance. Landlords will want to see that the appropriate policies are in place and that premiums have been paid before works are commenced.

Construction (Design and Management) Regulations 2015 (SI 2015/51)

Commercial fit-out works are subject to the Construction Design and Management Regulations (“CDM Regulations”). Nearly all leases and licences for alterations will require the tenant to comply with the CDM Regulations and to ensure that any person involved in the management, design and construction of the works complies with their respective obligations under the CDM Regulations.

Landlords must ensure that tenants are fully aware of their obligations under the CDM Regulations, which apply no matter the size or scale of the works carried out. If the landlord is also carrying out works at the same time they must coordinate with the tenant to avoid any safety risks.

The landlord may want to include provisions for the tenant to indemnity the landlord against any loss caused by any breaches of the CDM Regulations and a requirement that on completion of the works a copy of the health and safety file relating to the works will be handed over.

Building Safety Act 2022 and Building Control

The Building Safety Act 2022 (BSA) introduced changes to the Building Regulations 2010 for all buildings.

The BSA  brought in the dutyholder regime, requiring anyone carrying out ‘building work’ or associated in the design and construction process of ‘building work’ to be competent and compliant with building regulations. Dutyholders include principal designers and principle contractors, so both landlords and tenants must take reasonable steps to ensure that those appointed by them to undertake fit-out works meet the competency requirements.

Landlords and Tenants will also need to establish whether the building falls within the regime for ‘higher-risk buildings’ because the procedure for obtaining building control approval is more onerous and involves obtaining approval from the BSR. Significant delays are currently being experienced where consent is required from the BSR, so the parties will need to factor this in when negotiating terms.

Rent Free Period

Tenants may want to seek a rent-free period or rent reductions to offset the costs of fitting out the premises, especially if the works are substantial and result in a long period of time before the tenant can benefit from being in occupation. Tenants should therefore carefully assess their fit-out costs and ensure that these are factored into the lease negotiation, including requesting rent-free periods to help cover the financial burden.

Landlords should be mindful that agreeing to rent-free periods or other incentives may impact the long-term value of the lease and set unwanted precedents. Other tenants of the landlord may request the same incentives, which could reduce landlord cash flow and profit and limit their negotiating position. However, if a tenant is investing heavily in the premises, the landlord may be inclined to offer such incentives, in exchange for a longer lease term or other commitments.

Rent Review

Rent review clauses in a lease can specify that something will not be taken into account when determining the new rent. These are referred to as disregards.

• Fit-out works – the lease is likely to contain provision that the premises’ rental value is to be decided without taking into account works carried out by the tenant (other than those which it was obliged to do under the lease). If the works were included in the valuation, the tenant would end up paying a higher rent as a result of the premises being in better condition due to the works they undertook and paid for
• Rent free – in determining the new rent, any rent free period is usually disregarded so that the ‘market rent’ will be the rent that would become payable after the end of any rent free period or concession.

Therefore, where there are fit-out works and associated rent free periods, as well as addressing this in any licence for alterations, the rent review provisions in the lease will need to be drafted/checked to ensure that these are correctly taken into account on any rent review.

Energy Performance

The Landlord will want to make sure that the tenant’s fit-out works do not have a negative impact on the energy performance rating for the premises. This is because a reduction in the rating could affect their ability to let the premises, due to it not meeting the minimum standards. A lower rating may also suggest that the premises will be expensive to run and therefore commanding a lower rent.  In addition, most landlords will have climate change and environmental social and governance (ESG) policies which include commitments to reduce the environmental impact of their building(s).

A tenant’s fit-out could reduce the energy performance rating for the premises if, for example, it included changes to glazing, lighting and the removal of internal walls. Tenant’s works could also result in the requirement for a new Energy Performance Certificate (“EPC”) to be obtained and modern technology and differing approaches taken by EPC assessors could result in a new EPC having a lower rating.

Summary

Considering the effect of fit-out works when negotiating, drafting and entering into a commercial lease is essential. The impact fit-out works have is far greater than just the works themselves. Failing to fully consider fit-out works when drafting commercial lease documentation can have significant consequences. Both landlords and tenants should take specialist advice when considering fit-out works and commencing negotiations.

If you require advice about a lease, licence for alterations or assistance negotiating heads of terms, please get in touch with Thomson Snell & Passmore where our experienced Real Estate team will be able to assist.