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Improvements in Rental and Earthquake Prone Buildings

My fellow Harmans partner Brian Burke and I were recently favoured with the opportunity to present a workshop at the Association’s Wellington conference. In the time available, we touched on an issue that may give rise to concern for tenants of those motels, especially older motels that may require earthquake strengthening.

The liability for such work may always have been a possible issue, but the recent swarm of Canterbury earthquakes has put an immediate focus on the problem in two ways. First, they have increased the concern of many people in the field of commercial property, including bankers, engineers, purchasers and owners. Secondly, they have caused officials, both in central and local government, to review their respective plans and procedures for determining what are earthquake prone buildings and how such buildings should be treated. These reviews are not confined to Canterbury, but are taking or, I imagine, will take place throughout . Even now I suspect that many buildings used as motels fall short of the present standards imposed by the Council in their region, but this group may grow as more demanding standards are adopted. Furthermore, the timeframes allowed for the repair of susceptible buildings, which are now often quite generous, may be shortened. All in all, these changes may place an obligation on the owners of such buildings to spend appreciable sums of money to strengthen those buildings and to bring them up to a higher level of compliance.

Given that 70% of MANZ members are tenants, I think it is useful to consider what liability tenants might have in this situation.

As any lawyer will tell you, it all starts with the lease. It is often said that the law in relation to commercial leases follows the lease. Having said that, and while seldom are two leases the same, provisions around improvements rent are surprisingly standard. Most, if not all, leases contain an improvements rent clause and typically it would provide as follows:

  • That the tenant be bound to comply with any local or central government requirement.
  • But that the tenant’s liability would not extend to structural maintenance.
  • That the landlord may do such structural maintenance. In some cases, and if the work required is significant, the landlord may also be entitled to determine the lease without compensation.
  • Should the landlord carry out the work required, they may charge interest on the sum expended as additional rent, the lease would set an interest rate for that charge normally somewhere between 8% per annum and 12% per annum.

In a post earthquake environment, a hypothetical example of the application of an improvements rent clause might be as follows:

Bill and Sandy own the Triple Brick Motel business. They have a 30 year lease of the land and buildings from Goneril who has owned the freehold for over 20 years. The motel premises were first constructed in 1963 when 10 units were added to a converted character building, formerly a triple brick stable now used as an office and laundry. The premises were extended by the addition of 10 more units in 1987.

The local Council has recently updated its building code and has begun a 2 year programme of inspections for commercial buildings constructed before 1965. The Triple Brick Motel was one of the first to be inspected by the Council and has been found to be earthquake prone. The Council have found that although the additions built in 1987 exceed minimum requirements, the first block of 10 units built in 1963 requires earthquake strengthening, while the old stable used as an office and laundry would in a moderate earthquake be potentially dangerous. The Council have therefore required Goneril to carry out strengthening and rebuilding work to the first 10 units within 10 years and to bring the office and laundry up to minimum code requirements as soon as possible and not later than in 2 years.

The quote for the immediate earthquake repairs and strengthening obtained by Goneril came in at $247,000.00. In reliance on the lease, Goneril had the work completed and immediately on the completion of the work has imposed a rental increase of $24,700.00 plus GST on the basis that the improvements rent percentage stated in the lease is 10% per annum.

In this hypothetical lease, there is no sunset date for the additional rent, although it is worth noting that in the current ADLS lease, the additional rent is payable only until the next rent review.

The consequences of this scenario are severe for Bill and Sandy. The repairs for which they are indirectly paying add nothing to their business. Because there is no sunset date applying to the additional rent and because their rental is typical ratcheted, it may be years before their additional burden is watered down by subsequent rent reviews. Even that assumes that Bill and Sandy are able to convince Goneil or an umpire on rent review to take account of the additional costs they are meeting. On top of that they or a subsequent tenant will face a further imposition of improvements rent when the second stage of the work is required to be done.

Not only has Bill and Sandy’s profit been reduced by $24,700.00 per annum, but the value of their business has also been reduced by a factor of that amount and the potential future liability further limits the saleability of their business.

In an ideal world, every problem would have an answer. Here I am not sure that I can see one. However, if the clock were to be turned back and Bill and Sandy were able to negotiate around this clause, for example by including a sunset date to their liability for improvements rent, then their loss would be mitigated. It may be possible for them to introduce such a limitation when they are making other concessions such as in a rent review and at a time before Goneril realises the possible costs to which she is exposed.

I would therefore encourage any tenant who might feel that their premises or a part of their premises could be potentially earthquake prone, to adopt a risk management strategy. This might include negotiations with the landlord at the next available opportunity. At the very least, I would encourage them to ascertain what their local Council’s policy is for determining earthquake risk and for dealing with that risk. I would also encourage them to make themselves aware of what their particular lease provides for in these circumstances.

 

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