What is covenant strength of a tenant?

As a landlord or tenant, you often hear agents and other professionals talk about the ‘relevant covenant strength’ of a tenant, but what does that mean?

The Landlord and Tenant (Covenants) Act 1995

Before delving into the concept of covenant strength, it’s essential to understand the legal framework that governs landlord-tenant relationships in the UK. The Landlord and Tenant (Covenants) Act 1995 is a crucial legislation significantly impacting commercial leases in England and Wales.

The Act was introduced to address issues with the previous system, where tenants remained liable for the covenants in a lease even after assigning it to someone else.

Key features of the Act include:

• Automatic release of tenants: When a lease is lawfully assigned, the outgoing tenant is automatically released from future liability under the lease covenants.
• Authorised Guarantee Agreements (AGAs): Landlords can require outgoing tenants to enter into an AGA, guaranteeing the incoming tenant’s performance of the lease covenants.
• Limited liability for guarantors: Guarantors are also released upon assignment, unless they enter into a new guarantee for the assignee.
• Application to “new tenancies”: The Act applies to leases granted on or after January 1, 1996.

This legislation has significantly impacted how landlords assess potential tenants’ financial stability and reliability, making the concept of covenant strength even more crucial in commercial property transactions.

Covenant strength 

In the simplest terms, covenant strength refers to a tenant’s ability to comply with and observe the covenants outlined in their lease. The majority of the drafting in a lease is made up of tenants’ covenants. As most tenants (and landlords) will know, most of the lease is made up of various obligations, covenants and warranties given by a tenant to their landlord.

Most commercial leases these days follow a fairly similar format, which has assisted property professionals and the market over the years. On the other hand, commercial leases are still very much weighted in a landlord’s favour. It is the role of a tenant’s lawyer to try to rebalance some of these obligations (and in some cases reflect the heads of terms) and to ensure a fairer bargain is reached.

Factors affecting tenant covenant strength

To better understand the concept of covenant strength, let’s compare factors that landlords typically consider when assessing potential tenants.

This table provides a quick overview of what landlords might consider as indicators of strong or weak covenant strength. It’s important to note that these factors are often considered in combination, and the specific thresholds may vary depending on the landlord’s risk tolerance and the local market conditions.

Preparation before negotiation 

As you will imagine a lot of the negotiations that happen regarding the finer points set out in a lease are dictated largely by supply and demand, the bargaining strength between the parties, and to a large extent the tenant’s covenant strength.

From a landlord’s perspective, you can have the best-negotiated lease you have ever seen with your tenant, but if your tenant is a party or company without any viable means, poor covenant strength, then the lease itself may not be worth the paper it is written on. It is all well and good having comprehensive obligations for your tenant to observe, but if your tenant cannot comply with them or defaults when it matters then how effective is that lease then?

Rent deposit deed 

Landlords commonly look at the tenant’s wherewithal to comply with the terms of their lease and will usually ask for a guarantor to be provided by the tenant and/or a rent deposit deed. There are different considerations to be made as a tenant when being asked this question by the Landlord or their agent.

The advantage of a rent deposit deed is that you are not either personally liable, or the parent company is not liable, and at a practical level liability can effectively be capped to the amount of the rent deposit deed. If the tenant has no assets a landlord will usually cut his losses and take the rent deposit monies (well that is the theory anyway).

The downside of the rent deposit deed is that you are tying up valuable working capital. You need to consider when you get your money back, and ordinarily, as a tenant, you would seek an early release of the rent deposit money. Perhaps when the tenant company can show three years of consecutive accounts showing net profits exceeding three times the rent reserved under the lease. Again, these points need to be negotiated from day one. If you do not ask you most certainly will not get.

Personal guarantor 

A common situation we find is acting as a personal guarantor under the terms of the lease for your newly formed limited company. You need to consider the obligations in the lease very carefully, as well as carefully consider the position where you are no longer in control of your company or you perhaps take on another shareholder with a minority interest. If you lose control of your company, you potentially have no say in how that company operates and you may be left exposed under the guarantee. If you decide to sell your company at any point you must consider the guarantor provisions. You need to get a release, it sounds obvious, but often is simply forgotten. A release is usually not automatic and it must be negotiated at the time when the document is entered into.

It is worth bearing in mind that the guarantor provisions do commonly provide for a guarantee by the guarantor of all the obligations of the tenant’s covenants in the lease (not just the rent) and further where that tenant ceases to exist or has gone insolvent the landlord will be entitled to turn to the guarantor and ask them to take a new lease of the premises for the remainder of the contractual term. Guarantees and leases are not to be entered into lightly.

How we can help 

If you are a tenant of commercial property and want to talk about the covenant strength of a tenant in further detail then Julian Pyrke in our commercial property team will be happy to help.