“Risk comes from not knowing what you're doing." - Warren Buffett
This Warren Buffett quote is somewhat confronting, for no one likes to admit to an uninformed decision that results in a negative outcome. The favourable implication of this statement is that risk can be mitigated when one knows what one is doing. This truism applies to lessee make good obligations where insight and expertise can contain make good costs and lessen the negative impacts of the make good obligation.
Direct and indirect make good obligations and costs
“Risk is the absence of control." - James Clear
It is commonplace for office, retail, and industrial tenants to incur unexpected make good costs and obligations. While elements of the make good costs and obligations are explicitly set out in the lease, tenants incur additional indirect costs that may well be more onerous than the direct costs. The lessee impacts are always unwanted and include increasing the accounting provision for make good, unplanned legal costs, dual occupancy costs, the drain on management time, and the resources needed to oversee the required works.
Reaching an agreement on the make good scope may necessitate legal advice, property surveys, and professional services to assess and negotiate make good obligations. The extent to which professional services are required is inextricably tied to the efficacy of the lessee's make good negotiations before lease execution, for ambiguous and open-ended make good obligations disadvantage the lessee and give rise to protracted negotiations and the need for professional advice.
When the lessee is required to execute make-good works (as opposed to payment in lieu of works), indirect costs may include appointing a project manager to oversee the make good works and confirm landlord acceptance. Furthermore, make good works create added work for the lessee's administrative and management team while also giving rise to concurrent rental obligations for the stay and the go premises. The potential for management distraction and business disruption is increased in these circumstances, negatively impacting revenue and profitability.
Mitigating make good obligations and costs
“I seek as much as I can to mitigate risk.” - John R Allen
Mitigating the risk of unexpected make good obligations and costs starts with understanding what causes these unwanted outcomes.
The root cause is a tenant (or their representative) not paying enough attention to the detail of the make good provision during lease negotiations, resulting in an executed lease with make good terms that work for the landlord whilst disadvantaging the tenant. This neglect is often a by-product of too great a focus on negotiating the starting rent and the incentive, with too little emphasis on future obligations and risks that may impact the tenant’s utility of the leased asset during the lease term. It can also result from accepting typical make good clauses (which emanate from the landlord and protect the landlord) as normative and non-negotiable. Whatever the cause, tenants can improve their leasing arrangement and derisk their lease terms through intentional negotiation aimed at achieving a make good provision that is as close as possible to cleaning and handing back the keys. With this goal in mind, the following negotiation guidelines are helpful for tenant-side lease negotiations relating to make good:
- The tenant (or their representative) can make more headway with make good negotiations when the rent and incentive are near finalisation and the landlord is seeking to close the deal. In these circumstances a landlord (or their representative) is concerned about losing the deal and will be more open to accepting a make good provision that works for the tenant.
- In situations where an option term, or multiple option terms, are negotiated, then a reducing make-good provision can be linked to the exercise of an option term. As with point 1, a landlord is more accepting of terms that benefit the tenant when the benefit is in the future and does not impact the landlord’s return on investment in the short and medium term.
- It is useful for the tenant’s representative to negotiate an option to pay a pre-defined make good settlement option at the tenant’s election. This option can mitigate the indirect risks (including management time, dual occupancy, disputes) tied to the tenant carrying out the make good works pending landlord approval.
- When a walkaway provision cannot be negotiated, it is in the tenant’s best interests to ensure the make-good scope and standard are clearly articulated, together with an approval regime that mitigates the risk of dispute.
- In all instances, the tenant should obtain a condition report at the lease's start and end. Ensure that both parties understand the expectations and include detailed descriptions of the required condition at the end of the lease.
Regrettably, tenants don't always start with the end in mind and often find themselves exiting a lease that has onerous make good terms. These guiding principles are helpful for the tenant in such circumstances:
- Appoint an astute tenant representative to undertake make good negotiations and manage the make good process with the landlord. This minimises the opportunity for legacy relationships and emotion whilst adding expertise and formality to the make good process.
- Get to the make good requirement early, as time is leverage in make good negotiations and execution. This will facilitate clarity around make good expectations and the scope of works if a settlement and walkaway has not been negotiated. This will minimise the potential for disputes, legal action, dual occupancy costs, and an unwanted drain on management time.
- Seek to negotiate a settlement and walk away, even if the lease does not provide for this option. Getting to this early enables an informed offer constructed to benefit both the tenant and the landlord and facilitates negotiation around existing fit-out and improvements.
- It is important to note that ongoing condition reports during the lease term that are acknowledged by the landlord, or their representative can be helpful in laying the groundwork for the final make good scope.
Concluding comments
‘There are risks and costs to action. But they are far less than the long-range risks of comfortable inaction’ - John F Kennedy.
It takes time, effort, and expertise to challenge the long-standing lease norms relating to making good that result in a tenant incurring more cost and trouble than expected. In hindsight, far too many tenants regret the impacts of not giving more attention to mitigating make good impacts.
Who is LPC, and how do we help futureproof your accommodation arrangements?
LPC is a conflict-free advisor to commercial tenants across Australia and New Zealand. We facilitate strategic review of accommodation strategies, represent occupiers to secure best-fit accommodation arrangements, provide lease management services to multi-site occupiers, and oversee client fit-out and relocation.
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