ESG (Environmental, Social and Governance) has become a familiar phrase and, in practice, the component parts of it are developing at different rates.

ESG in leasing models: focus on the ‘social’

ESG (Environmental, Social and Governance) has become a familiar phrase and, in practice, the component parts of it are developing at different rates.

The “E” has been taking shape for years and, after some initial debate between landlords and tenants an accepted position is developing. The “G” is already a key part of leases setting out responsibilities of each party. The “S” is increasingly coming into focus.

In March, Nathan Rees from Shoosmiths LLP wrote in EG “Community-led development can future-proof our town centres” and set out how community-led developments might future proof town centres. He highlighted Platform: a town centre innovation programme.

Lease structures have been a hurdle to many wanting to engage in such innovations but they should not be a barrier.

Rent

From a landlord’s perspective, each building is an investment. An obstacle to initiatives such as Platform is the need to achieve a commercial yield as a landlord will not want an ESG scheme to affect the entire portfolio detrimentally.

A key means of avoiding this is to ensure that the rental evidence created by letting at a lower rent to a Socially Trading Organisation (STO) cannot be relied upon as comparable evidence for other transactions. This can be achieved by:

1. The landlord having a formal management policy for the scheme that allocates an area for STO use only. This policy needs to be robust and be clear that only organisations that fit defined criteria can let units within that area. This should have the effect of excluding the evidence as a comparable for occupation by anyone other than an STO;
2. The lease needs to have a defined user provision which states that the tenant must be “socially trading”. How this is defined will be important. STOs are businesses that deliver social benefits but they often trade commercially too. They are not limited to any particular legal form and may include community businesses or land trusts, social enterprise, cooperatives and/or family businesses and local ventures who demonstrate social purpose through their actions and behaviours. Depending on the length of lease, the permitted use might be limited to the particular STO tenant in question or the lease may adopt a wider definition but still have the social mission as its basis. Focusing on the use of the property in this way, and so triggering the criteria set by the landlord, the evidence should be excluded from comparables in the market and so ring fenced to protect the remainder of the portfolio.

Lease terms

Usual lease terms may differ between STOs but it is likely to be important that they are flexible for both parties. Such an initiative will often be new to both parties and each needs the chance to exit if it does hot work in a particular location.

• Term: this may be shorter for a pilot STO. For example, at the Legal & General scheme at Kingland Crescent in Poole the leases were granted for an initial period of two years with no rent or business rates. This gave the tenant a period of time to build up its business, by the end of which it is hoped it will be in a position to pay some form of rent/rates or, if not, demonstrate to the landlord that the increased footfall to the neighbouring shopping centre means retaining the tenant is fundamental to that scheme.
• Rent: there are many ways this could be dealt with in the lease. The desire is to achieve a fair rent. This may start with an initial rent-free period but move to turnover type once the STO gets up and running. It will be important not to place an onerous administrative burden on the STO. Many turnover provisions require periodic statements, signed off by accountants. This will be an additional cost for an STO. Instead, annual statements would ease this burden and still give the landlord the information it needs to assess whether the STO is working for it within its portfolio. If the STO is not going to trade commercially but the aim is an increase in footfall, this needs to be measured. There are a variety of tech solutions to this but it needs to be clear how this is to be measured so there is no doubt as to the metrics the STO needs to meet.
• Repair: this is a concern for STO tenants. Full repair leases can be onerous, depending on the condition of the property. A landlord will want to ensure it has the ability to require removal of any tenant’s fit out and that any damage, beyond fair wear and tear, is made good. Collaboration is key. If the property is to be improved, the landlord may be willing to contribute towards the costs of works. The tenant, taking a property in an improved condition, may then be willing to take on some repair obligation.
• Breaks: we expect breaks to be included with no or limited conditions. STOs will not necessarily understand how strictly conditions need to be complied with so should not sign up to anything more than payment of the principal rent and giving up occupation. Landlords should not need to meet any criteria to break the lease if it is not working out and we expect these leases to exclude 1954 Act protection.
• Alienation: due to their short -term nature and narrow user clause, it is likely alienation will be irrelevant but landlords wish the lease to state expressly that it cannot be assigned or underlet.

The key to an STO letting is that the lease must work for both parties on a fair basis. The landlord needs to see reward, whether that be financial or social, and the tenant needs to commit to meet the metrics set. The lease itself does not need to change drastically, but the approach to reaching agreement on its terms does.

This article was first published in EG on 18 June 2022.