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The Importance Of Your Covenant In A Commercial Office Lease

Proving your commercial office lease covenant is a step in the leasing process that landlords may take to ensure the financial stability of a new tenant. Whilst not only limited to proving financial obligations, but landlords may also scrutinise the business itself, its industry and how it operates on a day-to-day basis before agreeing to it leasing space within its building.

The following information is provided to assist businesses in understanding the task and processes associated with proving their covenant and how to select a building in which it will have the most success finding a landlord that will best accommodate it as a tenant.

Alongside staff wages, a lease agreement presents itself as one of the largest overhead costs required of a business across its lifetime. With this commitment comes a legal obligation to fulfil the financial requirements expected of the business during the course of the lease.

On the other hand, a lease commitment is in equal measure a significant commitment for the landlord. Building owners are required to continually service the ongoing needs of their tenants throughout the duration of their lease, which in turn requires tenants to uphold their obligations which at a core requires them to pay rent. Landlords also bear the risks associated with committing funding towards fit out for new incoming tenants and ongoing maintenance and capital works on the asset. For this process to be successful it is absolutely essential landlords retain the necessary securities to ensure their investment is protected, including ensuring new business covenants are reliable and fit well within the already existing tenancy mix.

Fundamentally, proving your covenant is a process that the landlord may require prior to executing an agreement. The proper execution of this component will satisfy the following three (3) items:

  • Landlord – satisfy their expectations that the tenant/business is able to pay its rent and other financial duties throughout the lease;
  • Tenant – it may provide the tenant with a greater scope for negotiations, given their sound financial history;
  • The tenant and its business are able to operate within the building without the disturbance to both the landlord and other tenants.

Based on the strength of your covenant, it will have a large effect on the security period of your bank guarantee. The bank guarantee can be reduced to a shorter period, however, is only applicable on a case-by-case basis.

Scrutiny of Industry and/or Business

In many instances, before even looking at the financials of a business, landlords will assess whether a business is the right type of business for its building. This is important as certain business may operate in ways that causes disruption to other already existing tenants, which may cause friction with existing tenants. A key example of this is Education providers as they often have a higher than average, often large and loud groups, flow of client facing customers or students frequently entering and exiting a building. This not only adds extra pressure on the buildings’ elevators, potentially causing longer wait times, but also may cause other tenants (existing or prospects) choosing not to take space in a building. For this reason, certain landlords may flat out refuse to allow such tenants take space within an asset even if they may be financially viable.

In order to best assess which buildings will permit your business occupy within, you may look at what types of tenants are currently within the building. If your business is in Education, a building which is full of Lawyers may not be the best bet.


Proof of Financial Performance

In order to prove your covenant, financial statements for the preceding two (2) years are usually required as the nominated practice to show recent business performance and must be ATO approved documents. In differing circumstances, the landlord reserves the right to request a longer statement period of authenticity to ensure that their expectations and reservations have been met in specific circumstances. Should your financials not meet the requirements of the landlord, the tenant may be liable to put in additional Directors guarantees or increased bank guarantee lengths – this is subject to each lease.

Businesses that are start-ups or subsidiaries will not be able to negotiate certain terms without authentication of performance for previous financial years – which for the former is largely unachievable, leaving them with little room for flexibility. Subsidiaries, however, may rely on parent companies acting as a guarantor for their liabilities by presenting the same documents of proof.


Bank Guarantee

The Bank Guarantee acts as the sole form of security a landlord has against the business during the lease. The Guarantee is provided by the tenant to the landlord with a number of conditions to ensure it meets the fair representation required to establish confidence between parties. These conditions for the Bank Guarantee include:

  • The Guarantee is to be made out in favour of the landlord;
  • Illustrates the agreed period of security;
  • Certified by a recognised Australian Bank; and
  • The Guarantee may be actionable in the event a business is unable to fulfil the following:

– Meet its financial obligations (e.g. pay rent) and/or;

– Unable to cover damage/make-good costs post lease expiry.

On average, businesses can expect a 6-month Bank Guarantee as standard although depending on both covenant and the landlords specific requirements, this can often be shortened or lengthened (it is uncommon for a Guarantee to be less than 3 months or more than 12 months).

Additionally, substantiating the financial competency of the business will play a significant role in determining a successful applicant for office space. In the event that there are multiple interested parties in one (1) tenancy, the landlord will scrutinise each aspect of the following criteria to choose the best-suited party:

  • Competitive deal parameters (i.e. agreeable rates, suitable commencement date);
  • Historically financially sound;
  • Responsiveness to the execution of documents, and;
  • Business industry or general community perception of the business.

Furthermore, businesses that perform well in their first term within a building will have greater say in discussions and possible negotiations when lease expiry or renewal occurs. Should the business intend on remaining within the current building and foregoing a relocation to another asset, the landlord will consider the performance in the initial term and seek to improve the business’s lease parameters within the asset on a secondary lease term to retain the tenant.

In essence, proving your covenant as a sound and robust entity is not only of benefit to the landlords’ interests but also to that of the business going forward. The process creates a line of transparency between the two entities that acknowledge their abilities to perform their duties in full, and subsequently develop a foundation of trust. The landlords’ concerns are satisfied, and the tenants’ scope of negotiation is expanded. As a result, both parties are therefore more amiable in discussions and are able to establish a relationship that will better suit their combined interests going forward.

Not sure how much office space you need? Our calculator could help.