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What to look for in a franchise lease

Sarah Stowe

Inside Franchise Business: Get advice on your lease before signingA franchised business is generally operated from commercial premises and it is common for these premises to be leased directly to the franchisee from a third party landlord.

The alternative is for the franchisor to take the lease and then sublease it to the franchisee.

For existing franchises, a franchisee may be taking over an existing lease, while new franchisees may be negotiating a new rental agreement.

Regardless of the structure, ultimately the franchisee will be taking on certain obligations under the lease or sublease that  need to be carefully considered before signing.

The franchisee’s obligations under their lease are separate from the franchisee’s obligations under their franchise agreement.

However, in many cases a franchisee will have an obligation under their franchise agreement to secure premises to operate the franchised business.  So getting the lease right up front will be a vital part to the successful operation of a franchised business.

As a tenant, a franchisee will have various rights and obligations to the landlord under the terms of the lease.  Most franchisees will be aware of the basic ones such as the payment of rent and outgoings, the obligation to repair and maintain the premises, the ability to assign or sublet the premisesand otherwise in relation to the use of the premises.

This article will identify some of the key lease provisions a franchisee tenant should be aware of when either reviewing an existing lease or negotiating a new lease with a third party landlord.  It is not an exhaustive list of all issues and we recommend franchisees obtain legal advice before signing a lease of commercial or retail premises.

Outgoings

A gross lease is a lease where the landlord pays for the outgoings for the premises other than consumables (which are paid for by the tenant).  A net lease is a lease where the landlord recovers the outgoings for the premises from the tenant.

If a franchisee is signing a net lease, they should review what outgoings are payable and how they’re calculated, e.g. if it’s based on a proportion of the total outgoings within a shopping centre or large building. Each State and Territory has its own legislation with respect to leases of retail premises which specifically exclude certain outgoings (e.g. management fees, some legal costs, key money)

Timing of rent reviews and renewals

Rent review provisions usually include timing obligations on market rent reviews.

In most cases the landlord will be entitled to give the tenant a notice of the new rent following a market rent review and the tenant will be entitled to dispute the new rent within a certain time frame, but time is of the essence with respect to the tenant giving the landlord notice.

Similarly there will be a timeframe in which the tenant is able to give the landlord notice of their intention to renew the lease. This timeframe may also be of the essence.

Franchisees should pay particular attention to the words “time is of the essence” or “time being of the essence” in rent review and renewal provisions. These phrases have a specific legal meaning which may result in the franchisee losing their renewal rights should they fail to act within the specified time.

It is also important for franchisees to try and ensure market rent reviews line up with the deadline for exercising renewal options. If not, they may find themselves committed to a lease and hit with a market review for far higher than they had budgeted for, even after any independent determination of that rent.

End of lease and make good obligations

A franchisee buying an existing business which operates with a lease becomes an assignee of the existing lease and will need to carefully consider the tenant’s end of lease obligations.

This is particularly so where the tenant and the landlord have agreed to the landlord taking ownership of the tenant’s fixtures, fittings, plant and equipment at the end of the lease at no cost, but the purchaser of the franchised business has paid for those items from the tenant as part of the purchase of the franchised business.

In this situation, the assignee franchisee will only have ownership of these items during the life of the lease.

It is also fairly common for a lease to contain an obligation on a tenant to return the premises back to the state it was in when leased. An assignee of an existing lease should consider the cost implications of returning the premises to its original state when negotiating the purchase of the franchised business as the costs of the de-fit of the premises may be substantial.

The existence of any property condition report can become vital to any end of lease dispute about the condition of the premises at the start of the lease.

Term and security

It is important to ensure that the term of the lease and any renewal options match up with the term of the franchise agreement otherwise a franchisee may find themselves in a difficult situation where the franchise term has ended but the lease payment obligations continue or vice versa.

Any personal guarantees or bank guarantee obligations under the lease should not continue beyond the term of the lease and should end upon an assignment or the expiry of the lease.

Most jurisdictions in Australia do not allow landlords to pursue personal guarantors of a lease following an assignment but this is a matter franchisees should seek legal advice on before agreeing to such obligations.

Liaise with the franchisor

There are several other matters franchisees need to carefully consider before entering into a lease that may be specific to their type of business or the jurisdiction they are in.

It is also important for franchisees to liaise with their franchisors on the terms of the lease – while many franchisors like to have step in rights for the lease to avoid losing those premises within that territory, if such a clause has not been negotiated upfront, a franchisor may not be willing to take on an overly onerous lease.

Authors: Lawyers Patrick Thaung, partner, and Mitchell Spurge, senior associate, Mills Oakley.