Have you identified the ideal space for your office, workshop or retail use, and are ready to negotiate a lease with the owner? Here’s a complete guide on the contractual terms of a commercial lease that you need to know for negotiating the best deal with the landlord.
There are three general definitions for the area of commercial premises, namely, Gross(G), Lettable (L), and Net (N).
Net Area (similar to saleable area) is the floor area exclusively allocated to that unit including balconies and other similar features but excluding common areas such as staircases, lift shafts, lobbies and communal toilets. It also includes the full thickness of external wall and half thickness of walls shared with other units. All internal partitions and columns within the unit shall be included.
It is the clearest presentation of premises size for comparing unit occupation cost on apple for apple basis.
However, there is only less than 1% of office buildings using net area as the basis in calculating rent, which includes Hong Kong Land’s properties like Exchange Square, Jardin House, Chater House, The Landmark, etc.
Lettable Area of a unit is its net area (area exclusively allocated to that unit) plus a proportionate share of the communal areas including toilets, lift lobbies and passageways but excluding staircases, lift shafts and plant room among the units on that floor. Its efficiency to net area varies from 75% to 90%.
Gross area is mostly used in commercial premises of Hong Kong. It is the total square footage of the premises including the common areas such as staircases, lift shafts, lobbies and communal toilets. Though it doesn't show exactly the exclusive area of the premises, it may reflect whether the building has common facilities or not. An old walk-up building with very few communal areas may have over 90% efficiency to net area when comparing to 70% or less for a modern building with club house, decent lobby and toilets.
Efficiency rate is a ratio to convert gross or lettable area to net area. Though there is no standard in Hong Kong and varies very much from building to building, efficiency rate for lettable area is usually around 75-90% and 65%-75% for gross area.
Not like residential properties in Hong Kong whereas owners are required by law to use saleable area to market their premises, no restriction is imposed on non-residential properties. Despite gross area is mostly used by commercial premises in Hong Kong, its definition is not standardised by law and therefore it is not difficult to see units on the same floor of many strata-titled buildings having different gross to net efficiency ratio. Area inflation is a phenomenon in many strata-titled buildings like Lippo Centre, Admiralty Centre, etc., tenants must be clear minded when doing cost comparison on their targeted premises.
Tenant should not trust on the quoted gross area and its associated estimate of efficiency rate totally. They should derive the true net area by measurement on site or on a scaled floor plan by themselves or with the help of a trusted real estate agent or space auditor before they can compare the occupation cost of their targeted premises on a like-for-like basis.
For purchasing a commercial premises which has not yet been built or subdivided, investor should try to request the vendor to provide a certification from an authorized person (AP) to confirm the true saleable area.
2. Lease Term
Tenancy vs. Licence
Lease term varies very much in leasing different property types and sizes in Hong Kong. It is generally on yearly basic but in some cases on month for leases of flex office, kiosk in a shopping mall or popup retail shops. For short-term leases on monthly basic, the terms “License” instead of “Lease/Tenancy”, “License period” instead of “lease term” and “License fee” instead of “rent” may be used in the contract. Thought similar in nature, tenancy and licence are different in legal implications on the possession right of the space in concern.
Duration of Lease
For commercial properties (i.e. office, retail or industrial premises) in Hong Kong, the typical lease terms are two to three years for sizes below 10,000 sq.ft.. The larger the size, the longer the lease term may prevail. Larger occupiers tend to secure longer lease because they are usually more mature and capable than small or startup companies in planning their business growth and size requirements over time. Shorter lease term gives greater flexibility in this dynamic market but shorter amortization period for decoration cost. When it comes to an uptrend market or a successful retail brand, double up rentals upon lease renewal are not uncommon in Hong Kong. So, tenants must weigh the pros and cons from their own business in negotiating the ideal length of the lease term.
Lease with Renewal Option or Rent Review
For leasing spaces involving tens of thousands square feet or huge set-up cost, the tenant would tend to secure an even longer term exceeding three but less than ten years (It is very rare for Hong Kong landlords to accept a lease term of 10 years or more). As leasing market is unpredictable and highly dynamic in nature, long leases are usually incorporated with a rent review clause which determines the time of revising the rent at the end of a mutually agreed year, says, the third, the fifth or the sixth year, at the then open market rental with or without rental caps. In additions, these long leases may also be structured with a mixture of “rent review” and “option to renew”, for example, a fixed lease of 6 years with rent review at the end of the third year plus a tenant’s option to renew for a further 3 years at the expiration of the 6 years’ lease. In short, larger occupiers are always in a better position to negotiate with the landlord for a more tailored lease term.
The Real Case
“Best Glory Holdings Ltd, an international medical centre, took up 7 floors in One Chinachem Central with a fixed lease of 5 years from 2016 plus an option to renewal for a further 5 years after expiry.”
3. Option to Renew
Option to renew clause provides the option right to the tenant to renew the lease for a further term, usually 1 to 3 years, upon the natural expiry of the lease at the then open market rent with or without rental cap. The deadline of such execution (usually 6 months before lease expiry) and the method of determining the open market rental (by arbitration or by independent expert for determination) in case of dispute between the parties are stipulated in the tenancy agreement.
Thought this clause seems mostly beneficial to the tenant, there are still some trick points for the tenant to aware. When it comes to the deadline of executing the option, the landlord may intentionally delay to agree on the renewal rental with the tenant, and the tenant may be forced to execute the option without it. Once executed, the tenant is bound to renew and it will become a case similar to a rent review scenario. In case there is no mutual agreement on the renewal rental, it will be left for arbitration or third party determination as stipulated in the tenancy. Since the landlord tends to register only those latest lease transactions in favor of themselves, the ultimate open market rental determined by the independent expert may be based on those rental evidence which may not reflect the truth of the market. In additions, the tenant has to beware of any potential conflict of interest between the landlord and the expert. The expert can be the sole marketing agent or the property management company of one or more of the landlord’s properties which may possibly lead to a decision inclined to the landlord.
Tenant should plan and act at least one to three months earlier before the execution deadline and force the landlord to agree on the renewal rental before the execution of such renewal option by leveraging every feasible alternatives in the market with the help of a trusted leasing expert.
4. Rent Review
For long leases above 3 years, it is common for the landlord to request for a rent review clause, which determines the time of revising the rent at the end of a mutually agreed year, says, the third, the fifth or the sixth year, at the then open market rental with or without rental caps. It is different from “Option to Renew” as the tenant cannot opts to terminate the lease for whatever reasons. In case of dispute on the renewal rental, it will be left for Arbitration or Expert Determination as stipulated in the tenancy.
Arbitration vs. Expert Determination
Expert Determination is the more commonly adopted approach in the market as it is less costly and complicated than Arbitration. It is a process in which an independent third party, usually a surveyor firm, acting as an expert rather than judge or arbitrator, is appointed to provide a confidential and binding determination of the open market rental. Such appointment is governed either by the original contract between the parties, or by a post contract agreement. Such agreements often provide for appointment and rules prescribed by a nominating body, such as the RICS. The cost will usually be shared equally by the parties.
Unlike expert determination, arbitration is a process of appointing an arbitrator to judge on the evidence and argument provided by the parties, and both parties will need to make representations. Apart from the cost of appointing the arbitrator, both parties may also be required to appoint its own representative, usually a surveyor firm, to gather and submit rental evidence in favor of themselves. If the rent review clause is extremely complex, the rental involved is huge or the type of property is unique, arbitration may be preferred by the parties.
Large and portfolio landlord usually have more control in manipulating the rental evidence by registering only lease transactions in favor of themselves or for some cases putting those leasing terms unfavorable to the landlord into a separate agreement, for example, a long rent-free licence period or a large decoration allowance. The ultimate open market rental determined by the independent expert may be based on those rental evidence which may not reflect the truth of the market.
In additions, the tenant has to beware of any potential conflict of interest between the landlord and the expert. The expert can be the sole marketing agent or the management company of one or more of the landlord’s properties which may possibly lead to a decision inclined to the landlord.
Small vs. Big Surveyor - The tenant must pay attention when compromising with the landlord on which independent expert to be chosen. Some smart and experienced tenant may tend to choose those small but renowned surveyor firms with limited or no businesses in the leasing and property management sectors.
Rental Caps - Rental caps is a mechanism put in place to limit the percentage of rental increment. Success in including a rental cap into the rent review clause can greatly reduce the risk during the rent review exercise.
Rent Review vs. Option to Renew – For the sake of the tenant’s interest, “Option to Renew” is always better than “Rent Review” in terms of flexibility and the leverages that the tenant can utilize during the rental negotiation process. With the help of an experienced agent, a timely and effective tactic can be applied to pressurize the landlord by leveraging all feasible alternatives in the market. So, when it comes to structuring the initial offer to lease, the tenant may try the former first. If the later is finally inevitably, rental cap can be a resolve.
5. Break Clause / Sales & Redevelopment
Break clause is a clause that allows either the tenant or landlord to terminate the tenancy before its natural expiry usually without penalty as clearly stated in the contract. For commercial leases in Hong Kong, break clause mostly applies to tenant whereas the tenant is entitled to give not less than 3-6 months’ notice in writing to the Landlord to terminate the lease after the end of a minimum period of occupation, says, the end of the second year of a 3-year fixed lease. For the side of commercial landlord, break clause usually takes form as Sales and Redevelopment Clause which appears in most of the single landlord buildings in Hong Kong.
Most of the commercial landlords in Hong Kong tend to accept only a lease with at least two years fixed. For those SME or start-up companies requiring shorter lease term to cater for possible changes in expansion plan or unpredictable business performance, they may try negotiating this clause and it can become a form of compromise on the length of the lease between the tenant and landlord.
Sales & Redevelopment Clause
Most leases involving buildings owned by portfolio landlord may include the Sales and Redevelopment Clause which grants the right to the landlord to serve a specified period of months’ notice, usually six months, to terminate the lease if the landlord decides to redevelop, renovate, refurbish, redesign or sell any part or whole of the Building.
Generally, it is rare for the landlord of a single titled buildings to exercise this clause as planning to redevelop a building takes years hence enough time for them to schedule their leases. If it is a sale, the new owner is usually an investor purchasing the building for rental yield with no reason to execute this clause.
Despite of this, there are still cases for such execution which have given hard blows to those tenants just spent huge investment on the setup and decoration. Therefore, tenant has to weigh its potential risk before accepting this clause and should do market research and seek experts’ advice for any redevelopment news of the targeted building already spread out in the market.
Once the Sales and Redevelopment Clause has been adopted in a single-tilted buildings, it is seldom to see any room for its cancellation in any new leases. The only mitigation measures the tenant may take is to negotiate a longer length of the notice period or seek for a remedy to recover part of the decoration cost if such clause is executed before a specified point of the lease term.
6. Sublet Right
Though explicitly prohibited in most leases, large space tenant may be able to obtain a sub-letting right of a certain percentage of the leased space to cope with unpredictable changes in market conditions or their partnership structure in the future. Its execution is used to be subject to landlord’s approval but depending on negotiation, such approval can or cannot be withheld unreasonably by the landlord. Any profit rental derived from such a subletting will be fully entitled by Landlord solely or shared on a predetermined ratio between the parties.
7. First Right of Refusal
First right of refusal, also known as right of first refusal, is a priority right to enter into a lease on a specified unit or space before anyone else can. Should the landlord receive a bona fide offer from other parties on such specified space, the landlord is obliged to serve a written notice to the tenant with this right to confirm their intention to decline such offer and lease such space themselves or not. Apart from first right of refusal, there can be second or third right of refusal in the queue.
Portfolio landlords of single-titled buildings always create the so-called buffer zone between multiple-floors occupiers in their leasing strategies and grant the right of first refusal on the units of these buffer floors to such big occupiers for their future expansion needs. Therefore, tenants on such buffer floors have to aware of the potential risk of being forced out upon lease expiry.
Rent in Hong Kong is payable monthly in advance, which can be fixed (commonly adopted) during the whole lease term, or escalated at a predefined rate upon a specified point(s) of the lease, or based on turnover.
For retail premises in a shopping mall, turnover rent, derived from the percentage on a tenant’s retail turnover, is generally applied in addition to the fixed base rent. It is generally assessed as an amount on top of a specified turnover threshold within a particular period. Such threshold can be the base rent or a fixed figure mutually agreed by the parties.
Effective Rent / Net Effective Rent
For comparison of different premises options on a like-for-like basis, effective rent should be used for averaging out the monthly rental with the account of the rent-free period. For a more precise comparison, net effective rent should be used with the additional account of the efficiency rate of the premises.
9. Management Fee
Management fee is payable monthly in advance and subject to revision from time to time by the management company. It generally includes central air-conditioning charges, common area cleaning and all other outgoings related to the common areas. Its rate on net square footage should be standardized throughout every unit in the building except those units requiring additional services, for example, longer air-conditioning services or security services for a retail unit.
Though non-negotiable in nature, it maybe adjustable for retail tenants with different usage of central air-conditioning, and the landlord may even have different packages for different tenant to choose from.
10. Government Rates & Rent
Rates applies to all properties in Hong Kong and is assessed at 5% of the rateable value of a property. It is levied on property owners but is generally passed to the tenant for commercial leasing.
Rates Concession – In connection with different economic conditions, different degrees of rates concession may be given by the Government periodically. For example, there will be a rates concession form April 2022 to March 2023. For each non-domestic rateable tenement, the ceiling will be $5,000 per quarter for the first two quarters (April 2022 to September 2022) and $2,000 per quarter for the following two quarters (October 2022 to March 2023). No payment will be required for the quarter if the quarterly rates payable do not exceed the corresponding rates concession ceiling.
Government rent applies to properties located in the New Territories and New Kowloon north of Boundary Street or those properties located on Hong Kong Island or Kowloon which are held under a land lease granted or extended on or after 27 May 1985. It is levied on property owners but in most cases passed to tenant for commercial leasing. It is assessed at 3% of the rateable value of a property and is adjusted in step with any subsequent changes in the rateable value.
11. Rent Free Period
Rent free period is one of the key elements in a lease to affect the total occupation cost. It is an incentive to the tenant not just for the fitting-out work but a way to discount the rent. Its length varies very much during different economic conditions and relates very much on lease term, premises size and lease commencement date. For large floor plate offices up to tens of thousands square feet in buildings or new developments with high vacancy, smart tenant with the help of a knowledgeable leasing expert may be able to achieve a rent free of well over 12 months spitted into phases to commence over the lease term.
Rent Free Licence Period
Rent free can take form in “Rent Free Licence Period” which nature is virtually the same as rent free with the major difference of its falling outside the tenancy agreement. It can provide more flexibility for portfolio landlords to consider unfavourable offers during economic downturn on the one hand but to maintain an overall better-looked rental level on the other hand. Such better-looked rental level has its real significance during lease renewal of all leases in the same buildings and so do the valuation of the asset.
Since data of incentives like rent free period are not easily accessible to tenant from market news, seeking help from a trusted leasing expert with full market coverage can help to understand the true landlords’ offerings, and to structure an effective negotiation tactic before the submission of the offer to lease.
12. Fit-Out Subsidies
Fit-out subsidies, also known as tenant improvement allowance, is a maximum amount of incentive money paid by landlord to the tenant for covering up the cost directly related to physical improvements to or alterations of the premises carried out by tenant, but not include furniture or other moving or start-up costs. Tenant must still use their own funds to initially cover construction. After completion of work, such allowance will be payable upon proof of completion, which have to include receipts, lien waivers, etc.
Despite not quite common for office leasing in Hong Kong, some landlords of single-titled buildings have used it as one of their marketing tools during economic downturn. As for new shopping mall, this allowance is sometimes on the table for the landlord to negotiate deals with anchor brands which may draw foot traffic and speed up overall leasing progress.
13. Stamp Duty & Legal Cost
Once the formal tenancy agreement is signed, the stamp duty is due to be paid within 30 days or the parties may face fines if they present it for stamping in the later days. However, it is not compulsory by law that all tenancy agreements are required to be stamped but stamping is actually to protect the landlord and tenant by legitimating the agreement for the use as evidence in court for dispute.
Stamp duty of commercial lease is normally shared by both the landlord and tenant in equal share and is calculated according to the lease term as follows:
Infinite lease: 0.25% of average annual rent
Lease <= 1 year: 0.25% of average annual rent
Lease > 1 year and <= 3 years: 0.5% of average annual rent
Lease > 3 years: 1% of average annual rent
There is an extra photocopy cost of HK$5 for each stamping.
Late Payment Penalty
For late stamping over 30 days as mentioned above, the following corresponding fine will be applied:
For late <=1 month: 2 times of the deemed stamp duty
For late > 1 month and <= 2 months: 4 times of the deemed stamp duty
For late > 2 months: 10 times of the deemed stamp duty
It is common for the landlord and tenant to bear their own legal cost in preparing and reviewing the tenancy agreement. For many cases involving single-titled buildings, however, big landlords like Chinachem Group, Sino Group and the like may require tenant to pay half share of their legal cost even the tenant may engage another firm of solicitors to act for them.
14. Security Deposit
Tenants are typically required to pay a security deposit equivalent to three months' rent, management fees and government rates for leasing any premises from portfolio landlords or single-titled buildings. For premises from strata-titled building, it is sometimes negotiable down to two months. This deposit will be held by the landlord without interest throughout the lease and is refundable upon lease expiry after the tenant has fulfilled all their obligations including restatement and settlement of all rent and bills.
For new companies or companies with low paid-up capital, landlord may ask for more security deposit of up to 6 months. For some cases, the landlord may accept part of such deposit being paid by a bank guarantee. It is a type of financial backstop offered by a lending institution whereas the bank will cover such deposit in the event of default by a tenant. Since deposit held in the landlord’s account is interest free, bank guarantee, if possible, should be better from the tenant’s point of view as cash held at own bank can earn interest.
Most landlords would require the tenant to take out property insurance of a certain amount to cover third party liabilities arising from fire, flooding, breaking glass of curtain wall and the like.
16. Decoration Deposit and Vetting Fee
Decoration deposit is a deposit paid to the property management by the tenant before the start of the decoration work. It is refundable after deduction, if any, to the Tenant after completion of fitting out works. There is no standard of its base but usually in relation to the building grade, premises size and the respective landlord’s policy.
Approval of decoration plans from the landlord or management company is required in most commercial buildings before starting works. There may be a vetting fee, if not waived, charged on the tenant for such approval.
Tenant may be required to take out a decoration Insurance of a certain amount to protect losses or damages arising during the decoration of the premises. It covers both injuries to someone else and damage caused to others.
Despite unfriendly to most limited companies, more and more landlords of single-titled buildings in Hong Kong may ask for personal guarantee from the director(s) of the tenant’s company especially for those small and new setups to secure the lease. The guarantor will be held liable to the tenant’s default on paying rent or breaking the lease.
18. Handover Condition & Reinstatement
Handover condition varies from building to building and from grade to grade. For Grade A offices of those single-titled buildings, screeded floor and installed full ceiling system with suspended ceiling, light boxes, sprinkling system and central air-conditioning ducting are normally provided. Some newer buildings may also provide raised floor system. As for retail shop or strata-titled office buildings, bareshell with screeded floor or “as is” condition with decoration left by outgoing tenant are common.
Upon earlier determination or expiration of the Tenancy, the Tenant shall upon the Landlord’s request, at the Tenant’s own costs, remove all the fittings, fixtures and furniture within the Premises, and reinstate the Premises to a predefined condition in the lease. It can be a good and tenantable “bare-shell” condition or its original handover condition. For single-titled building, landlord may ask for reinstatement to a “bare-shell” condition with standard landlord’s provision like full false ceiling system even the original handover condition has decoration left by the outgoing tenant. As reinstatement work may cost up to HK$150 per square foot net for a grade A office, tenant should have a clear understanding about the predefined condition which they have to deliver back to the landlord upon lease expiry.
To save up this reinstatement cost or from environmental protection angle, tenant may market their space to real estate agents few months before the lease expiry and keep proactive and helpful in assisting real estate agents or landlord to prepare marketing materials like photographing or VR filming on the site. If there is a new tenant willing to take up the existing decoration and enter into a new lease with the Landlord, the incoming tenant will take up the reinstatement obligation as well.
19. Car Parking
Car parking space in core business districts are generally inadequate with not every office tower having its inhouse parking facility. For those single-titled buildings with such facility, large space occupier may ask for, if available, a reservation of a limited number of parking space (fixed or floating) with terms and conditions of various packages covered in a separate license agreement.
20. Form of Tenancy Agreement
For single-titled buildings, the tenancy agreement prepared by the landlord is typically using fairly standard terms and conditions applied to all leases in the buildings. It has little room for the landlord to accept major changes as it is the only protection to the landlord after handover and has to cope with too many possibilities and too many tenants amongst which there must be some troublesome.
For strata-tilted buildings, the tenancy agreement is in a much simpler form, which may be prepared by the leasing agent, the landlord’s solicitor, or just purchased from the bookstore nearby. Since Hong Kong is well known of its supremacy in contract law application, both landlord and tenant are well protected under the related ordinances.