Commercial Condition Reports. Valuable or a waste of time?

Unlike residential condition reports which have been in use for many years and are needed if a dispute arises with a tenant, there is no requirement in the Victorian commercial leasing market. There is no standard report format, no reference to a report in any of the current commercial leases and no mention in any tenancy legislation. The standard form R.E.I.V. authority lists a condition report as a service requirement in the residential authority but not in the commercial one.

What happens at the end of a commercial lease if there is no condition report? That would depend on the terms of the lease. In the R.E.I.V. 2016 lease this is dealt with in clause 10 and the L.I.V. 2014 lease in clause 5. Both require the tenant to remove its fixtures and fittings and make good any damage. The R.E.I.V. lease requires the property to be returned to the condition as at the initial commencement date whereas the L.I.V. lease emphasises a clean condition. If the parties do not agree on the state of the premises then further action may be initiated in court or at V.C.A.T. All the more reason to have some sort of record.

What type of condition report should be used? That would depend on the type of property. A small shop would generally be satisfied with external and internal photos, a list of the owner fixtures and fittings and any general items that are a feature of the property such as fitout, air conditioning or those found in item 1.4 of a standard disclosure statement. Videos can be useful if the premises are substantial and there are companies that can prepare detailed condition reports on HVAC, electrical distribution, data cabling and the like if the intention is to have a corporate office for example returned to its original condition at lease end or if the tenant intends to make substantial alterations.

When would you not want to prepare a condition report? Often this is not needed if the premises were leased as a bare shell and is to be returned as such or the premises are in poor condition and agreement is made for the tenant to renovate. Be sure to amend the lease so that the tenant is not obliged to return the premises to its original condition if the landlord wants to retain the improvements made by the tenant. Often when a building is slated for demolition, there is no need to prepare a report however, as often occurs, the premises do not end up being demolished, are re-let and the tenant and landlord are in dispute over how the property was left. If a report is made, it can always be discarded if demolition proceeds.

When is a condition report useful other than at the end of a lease? Unlike residential properties, commercial properties are often modified by tenants such as new or amended fitouts, particularly food related. A condition report and subsequent recording of the changes after the tenant has moved in and refitted will assist tracking alterations to the premises. This could evolve over many years with the same or new tenants following the sale of a business.

In the residential context, a tenant acknowledges the state of the premises and a report is agreed to by both parties. It is up to the individual owner if they want to seek agreement from the tenant or merely keep a copy for their own records for commercial premises. I have had tenants ask for a condition report at the commencement of a lease but it is rare. Property owners also rarely ask for this unless a problem arises.

A thorough condition report can catch out changes that have been made without consent or where the tenant asserts on vacating the premises that the premises were taken in poor condition and that their changes actually constitute an improvement. That may or may not be the case. Undocumented changes without permits may actually be illegal and require expensive restoration. Landlord’s fixtures and fittings such as floor coverings are often contentious. Were they in good condition at commencement  and can the landlord prove it? Was there pre-existing damage or is it fair wear and tear? Without good photographic evidence the proof required may not exist, leading to dispute.

Condition reports may eventually find their way into standard leases or legislation but in the meantime a report with basic photos and a description of the state of the premises and fixtures and fittings should be on every agents file.

Would You Let A Tenant Insure Your Building?

No is the obvious answer, but it is worth looking at the obligations of both parties under the R.E.I.V. and Law Institute Leases and what they mean in practice.

With the R.E.I.V. 2016 Lease, the owner is allowed to recover insurances premiums under clause 2 (h) of the lease which is fairly encompassing. The landlord can pretty much insure whatever they like at whatever sum they see fit. The landlord is prevented from recovering insurance charges if the Retail Leases Act 2003 applies generally if it is not disclosed in a disclosure statement, covers part of a premises not used by a tenant, the calculation is not on a percentage of floor area and the like. The landlord also has an obligation to provide insurance details to a tenant under clause 21 if requested to do so. There is no requirement on the landlord to actually insure the building so after production of documents, the landlord could merely cancel the policy. This is unchanged from the 2003 version of the lease.

The tenant also has obligations to insure under clause 4 covering public risk, additional premiums by way of the tenant’s occupancy, claims excess payment and tenants fixtures and fittings. Whilst there is an obligation on a tenant to replace glass in clause 5.5 (f) interestingly, there is no obligation on the tenant to insure glass. The tenant is also not required to insure in the joint name with the landlord or note the landlord as an interested party.

With the Law Institute of Victoria 2014 Lease, the owner can recover insurance premiums under clause 1.1(d) and the type of cover is strictly defined and not as broad as the R.E.IV. lease. Public risk premiums are for $10 million as a default so ensure that schedule item 12 is for example $20 million. The same applies to Loss of Rent cover listed in schedule item 13. If you require a loss of rent period of say 18 – 24 months you need to make the appropriate insertion in the schedule as the lease has a default period of 12 months only. The owner has a further obligation to ensure that the  premises are insured under clause 6.2 during the term of the lease unlike the R.E.I.V. lease. The tenant also has obligations under clause 2.1.6 to pay any premium increase due to the basis of occupancy and to insure for public risk for an amount listed in the schedule (the same basis as the landlord noted above) but for not less than $10 million in clause 2.3. The landlord in this case must   be noted on the tenant’s policy. There is no requirement for the tenant to insure their fixtures fittings or stock. Clause 3.2.3 requires the tenant to replace any broken glass but there is no requirement for the tenant to insure glass. The tenant is also required to pay any claims excess under 1.1(d).

Some of the tenancy problems which are encountered with insurance (a topic in itself) include:

1. Under or over insurance. With under insurance the insurer applies averaging to the claim so the landlord will be well out of pocket. With over insurance, the tenant will pay excessive premiums. The lease has no mechanism to rectify either of the above situations although a retail lease may lead to a mediation to resolve the matter. Generally, if the tenant receives an invoice from the landlord which it considers to be excessive, quotes are sought from competing brokers and compared upon which the parties negotiate a settlement. Advice should be sought as policies can be a premium type or bare bones form of cover only and not always like for like. The sums insured are normally arrived at by a valuation if in dispute. You cannot take an educated guess when assessing the quantum of cover.
2. Glass cover is often a basis of dispute wherein the tenant who is paying the landlord’s insurance premium has an expectation that if the glass in the shopfront is damaged, that the landlord has glass cover. Landlords should always have cover to avoid this problem.
3. The noting of a landlord on the tenants policy is also problematic. Will the insurer actually cover the landlord in the event of a claim? The landlord is a third party, has not completed a proposal with the underwriter and may not be an insurable risk let alone that they have seen or read a copy of the policy noting the exclusions of cover.
4. Landlords who also demand copies of tenants insurances as a basis to sleep well at night are unrealistic. The landlord cannot contact the tenant’s insurer to see if a policy is up to date during the period of cover due to privacy legislation and there is nothing to stop the tenant cancelling the policy the day after production to the landlord.
5. Some landlords allow the tenant to take out the cover thinking they are doing the tenant a favour or if it is a large corporation, that the premium will be vastly cheaper. In the event of a substantial or total loss if proper cover is not in place the landlord may be bankrupted or face an appearance in the coroner’s court in several years time. Why would you risk that?
6. Something to consider, If you have just leased to a new tenant in a property that was hard to lease, the tenant is under resourced, a first timer, an extensive fit out is involved or the rent is high, consider loss of rent cover (not loss of income in the event of say a fire) for 12 or 18 months if the tenant gets in financial difficulty. If the tenant survives the first year or so of a new lease their chances of success are much higher and you may not renew the cover. Either way, If you have a large mortgage or are really going to rely on the income then without insurance you may put yourself in jeopardy. The premium is most likely recoverable anyway.

The golden rule is that each party must maintain and control their own insurance cover.