Leases and underleases - Code for Leasing Business Premises

Learning Outcomes

This article examines the fundamental principles of commercial leases and underleases, including the distinction between leases and licences, key lease covenants, and the structure of underletting. It also introduces the Code for Leasing Business Premises and its relevance. For the SQE1 assessment, you will need to understand the creation, key terms, and implications of commercial leases and underleases, recognise the purpose and status of the Code, and apply these principles to practical scenarios involving business premises. Your understanding will enable you to answer SQE1-style single best answer MCQs effectively. In particular, be able to identify the formalities to create legal and equitable leases, the registration position for longer terms, the typical institutional lease structure (including FRI repairs, insurance and rent review), how consent mechanisms for alterations and alienation operate in practice and under statute, how underleases fit within the landlord–tenant chain, and when and how security of tenure applies or can be excluded.

SQE1 Syllabus

For SQE1, you are required to understand the practical aspects of commercial leases and underleases, including their structure, key terms, and the impact of the Code for Leasing Business Premises, advising on leasehold transactions and understanding landlord and tenant obligations, with a focus on the following syllabus points:

• the distinction between a lease and a licence
• key leasehold covenants typically found in commercial leases
• the structure and implications of granting an underlease
• the purpose and status of the Code for Leasing Business Premises
• the concept of security of tenure under the Landlord and Tenant Act 1954 (Part II) for business tenancies.
• formalities to create leases: when a deed is required (s52 LPA 1925), short leases without deed (s54(2) LPA 1925), and equitable leases under s2 LP(MP)A 1989
• registration of leases and underleases exceeding seven years and the use of prescribed clauses in registrable leases
• remedies for breach of covenant (including forfeiture, s146 notices, the Leasehold Property (Repairs) Act 1938, and commercial rent arrears recovery)
• statutory modification of covenants on alterations and alienation (LTA 1927 s19, LTA 1988 s1) and typical conditions under s19(1A)
• privity of contract/estate for assignments and the effect of the Landlord and Tenant (Covenants) Act 1995, including authorised guarantee agreements (AGAs)
• rent review mechanics (assumptions/disregards, review frequency and upward-only conventions) and how the Code influences negotiation of these terms
• energy efficiency minimum standards (MEES) as a practical constraint on lettings of sub-standard premises.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the key legal test established in Street v Mountford [1985] AC 809 to distinguish between a lease and a licence?
2. True or false? The Code for Leasing Business Premises is legally binding on all landlords and tenants negotiating commercial leases in England and Wales.
3. Can a tenant grant an underlease for a term that is longer than the remaining term of their own lease (the head lease)?
4. Which Act primarily provides security of tenure for business tenants in England and Wales?

Introduction

When advising clients on occupying business premises, understanding the nature of leasehold agreements is essential. Commercial leases form the backbone of property occupation for many businesses. This article focuses on the core principles governing commercial leases and underleases, differentiating them from licences, outlining common obligations (covenants), and introducing the influential Code for Leasing Business Premises. Familiarity with these concepts is essential for advising clients and tackling SQE1 questions effectively.

Creating a legal lease ordinarily requires a deed (s52 Law of Property Act 1925). An exception exists for short terms not exceeding three years taking effect in possession at the best rent without a fine (s54(2) LPA 1925), which may be created orally or in writing without a deed. Even where the deed requirement is not met, an equitable lease may arise from a written, signed contract incorporating all expressly agreed terms (s2 Law of Property (Miscellaneous Provisions) Act 1989), enforceable by specific performance. Longer leases (and underleases) exceeding seven years must be registered to take effect at law; registrable leases use Land Registry prescribed clauses and attract first registration rules and timelines. These formalities sit alongside commercial drafting norms (institutionally acceptable terms, repairing and insuring structure, rent review) and standard due diligence (title, searches, consents).

Key Term: Lease
A legal interest in land granting exclusive possession for a fixed or periodic term, usually in return for rent. It creates an estate in land.

Key Term: Licence
A personal permission granted by a landowner (licensor) allowing someone (licensee) to do something on the land that would otherwise be a trespass. It does not grant an interest in land or exclusive possession.

Key Term: Covenant
A promise contained in a deed. In the context of leases, covenants are legally binding promises regarding the property made between the landlord and tenant.

Key Term: Underlease
A lease granted by a tenant (who becomes the 'intermediate landlord' or 'mesne tenant') to a subtenant. The term of the underlease must be shorter than the term of the head lease.

Key Term: Head Lease
The original lease granted by the freeholder (head landlord) to the first tenant (who becomes the mesne tenant if they grant an underlease).

Key Term: Code for Leasing Business Premises
A professional statement issued by RICS setting out mandatory requirements and best practice recommendations for RICS members (like surveyors) involved in commercial lease negotiations in England and Wales.

Leases vs Licences

A fundamental distinction in property law is between a lease and a licence. This distinction carries significant practical implications, particularly regarding statutory protections available to occupiers.

The essential test for distinguishing a lease from a licence was set out in Street v Mountford [1985] AC 809. If an agreement grants exclusive possession for a term certain in return for rent, it creates a lease, irrespective of the label the parties attach to it. Exclusive possession means the right to exclude all others, including the landlord (subject to limited rights reserved in the lease, e.g., for inspection or repair).

Courts look at substance, not form. Labelling an agreement a “licence” will not prevent it being a lease if the substance is exclusive possession for a term at rent. Conversely, some arrangements fall outside the lease category despite occupation, for example genuine service occupancies (e.g., caretakers required to live on the premises for duties), transient hostel-type arrangements, family or friendship arrangements, or where the grant is a sham or pretence. In addition, the “term certain” element requires a fixed or periodic term; an indefinite right of occupation may not satisfy this unless properly construed as a periodic tenancy arising by implication from rent payments and possession.

Short leases can be created informally under s54(2) LPA 1925, but they still confer an estate at law if the criteria are met. Where formalities are not complied with, equity may step in to recognise an equitable lease if there is a compliant signed contract under s2 LP(MP)A 1989.

Worked Example 1.1

A start-up company, Innovate Ltd, occupies an office suite under a document titled 'Licence Agreement'. The agreement grants Innovate Ltd the sole use of Suite 101 for 12 months, requires monthly payments, and prohibits access by the property owner except for emergencies or agreed maintenance. Does Innovate Ltd have a lease or a licence?

Answer:
Innovate Ltd likely has a lease. Despite the document's title, the terms appear to grant exclusive possession (sole use, restricted landlord access) for a fixed term (12 months) in return for periodic payments. Applying Street v Mountford, the substance suggests a lease, not a licence.

Worked Example 1.2

A café operator agrees verbally to take immediate possession of a ground-floor unit for 18 months at market rent, with no premium payable. No deed is executed. Is there a valid legal lease?

Answer:
Likely yes. A lease for three years or less may be created without a deed where it takes effect in possession, is at the best rent, and without a fine (s54(2) LPA 1925). An 18‑month letting meeting those criteria can take effect at law despite the absence of a deed.

Key Lease Covenants

Commercial leases contain numerous covenants imposing obligations on both the landlord and the tenant. These regulate the use, maintenance, and management of the property.

Common tenant covenants include:

• Paying rent and other sums due (e.g., service charge, insurance premiums).
• Repairing the premises (the extent varies depending on whether it's a lease of whole or part).
• Using the premises only for permitted purposes (the 'user' covenant).
• Not making alterations without landlord's consent.
• Not assigning or underletting without landlord's consent ('alienation' covenant).

Common landlord covenants include:

• Granting the tenant quiet enjoyment (undisturbed possession).
• Insuring the building (often recovering the cost from the tenant).
• In leases of part, repairing and maintaining the structure and common parts (often recovering costs via service charge).

Two overarching common law principles run alongside express covenants: the tenant’s right to quiet enjoyment and the landlord’s duty not to derogate from grant. Quiet enjoyment protects the tenant from interference by the landlord in the tenant’s lawful use; non-derogation prevents the landlord acting in a way that substantially defeats the benefit of the lease (for example, blocking the only access that was essential to the letting).

Repairing obligations require careful reading. “To keep” in repair generally requires the tenant to put into repair and then maintain that standard, subject to any schedule of condition limiting liability to the property’s documented state at grant. For older or imperfect premises, a schedule of condition is often negotiated to cap exposure. For breach of repairing covenants, remedies include damages (subject to s18(1) LTA 1927, which caps damages by reference to the diminution in value of the reversion) and, rarely, specific performance; leases sometimes contain “Jervis v Harris” self-help clauses allowing the landlord to enter, carry out works, and recover costs as a debt.

Alterations covenants are commonly absolute for structural/external works and qualified for internal non-structural works. Statute modifies some qualified covenants: under s19(2) LTA 1927, where a covenant is qualified against improvements, consent cannot be unreasonably withheld and may be subject to reasonable conditions (e.g., reinstatement, payment of legal/surveying costs). Alienation covenants are frequently fully qualified; s19(1)(a) LTA 1927 upgrades a simple “no assignment without consent” to a “consent not to be unreasonably withheld”, and s19(1A) permits landlords to specify reasonable pre-conditions in modern leases. Separately, s1 LTA 1988 imposes a duty on landlords to deal with consent applications within a reasonable time and not to unreasonably withhold consent, reflecting the reasonableness obligation.

Insurance covenants typically provide that the landlord insures the fabric against defined risks (and recovers the premium), with rent suspension while premises are unfit for occupation due to an insured risk and reinstatement provisions. Rent review clauses commonly adopt open‑market rent, with assumptions and disregards to ensure fairness (e.g., assume a willing landlord/tenant, vacant possession, that covenants have been complied with; disregard the tenant’s occupation/goodwill and voluntary improvements).

Worked Example 1.3

RetailCo leases a shop unit under a commercial lease. The lease contains a covenant stating the tenant must "keep the premises in good and substantial repair and condition". The shop front window is cracked due to vandalism. Is RetailCo likely responsible for the repair?

Answer:
Yes, most likely. A covenant to "keep" in repair generally implies an obligation to put into repair if necessary. Even though the damage was caused by a third party, the repairing covenant usually places the obligation on the tenant, unless the damage falls under an insured risk for which the landlord is responsible for reinstating (which vandalism might not be).

Worked Example 1.4

A tenant proposes internal layout changes (partitioning and new cabling). The lease prohibits structural or external alterations but permits internal non‑structural alterations with landlord’s consent. Can the landlord refuse?

Answer:
Consent to internal non‑structural works must not be unreasonably withheld under a fully qualified covenant. For “improvements”, s19(2) LTA 1927 reinforces that consent cannot be unreasonably withheld, though the landlord may impose reasonable conditions (e.g., reinstatement at lease end, payment of reasonable legal/surveying fees, compliance with building regulations). A blanket refusal without reasons is vulnerable.

Remedies for breach of covenant should also be in view. For non‑payment of rent, landlords may sue for debt, consider forfeiture (if a right of re‑entry is reserved), or use the commercial rent arrears recovery procedure (CRAR) to seize goods for pure rent arrears. For other breaches, forfeiture requires a s146 LPA 1925 notice specifying the breach, requiring remedy (if capable of remedy) and compensation; tenants may seek relief. For repairing breaches in long leases with sufficient unexpired term, the Leasehold Property (Repairs) Act 1938 may require the landlord to obtain court leave, limiting immediate enforcement.

Underleases

A tenant holding a lease (the 'head lease') may grant a lease of part or all of the property to a third party. This creates an underlease (or sublease).

The grant of an underlease creates a new landlord-tenant relationship between the mesne tenant and the subtenant. However, the mesne tenant remains bound by the covenants in the head lease to the head landlord. There is typically no direct contractual relationship (privity of contract) or landlord-tenant relationship (privity of estate) between the head landlord and the subtenant.

To be valid, the underlease’s term must be shorter than the residue of the head lease. Practically, this avoids the underlease outliving the grantor’s title. Most modern leases require landlord consent to underletting; the consent is ordinarily documented by a licence to underlet. The licence serves multiple functions: it evidences consent, sets conditions, and frequently introduces a direct covenant by the undertenant to the head landlord to observe the head lease covenants so far as they relate to the demised premises (other than paying head rent). This creates privity of contract between head landlord and undertenant on those obligations, helping the head landlord enforce compliance. The licence also commonly requires formal notice of the underlease and undertakings to pay the landlord’s reasonable costs of processing the application.

Registration matters mirror leases: underleases for more than seven years must be registered; shorter underleases should be noted as appropriate in title or notified to the landlord under the head lease provisions.

Worked Example 1.5

TechFirm holds a 10-year head lease of an office building from LandlordInvest plc. TechFirm grants a 5-year underlease of the top floor to DesignStudio Ltd. DesignStudio fails to pay its rent to TechFirm. Can LandlordInvest plc sue DesignStudio directly for the unpaid rent due under the underlease?

Answer:
No, generally LandlordInvest plc cannot directly sue DesignStudio for the rent due under the underlease. There is no privity of contract or estate between the head landlord and the subtenant regarding the underlease obligations. LandlordInvest plc's recourse for rent is against TechFirm under the head lease. TechFirm must pursue DesignStudio for the underlease rent. (Note: Sometimes a direct covenant is created via a licence to underlet).

Worked Example 1.6

A tenant with 4 years left on its head lease proposes a 5‑year underlease to a subtenant. Is that term permissible?

Answer:
No. An underlease must be for a shorter period than the residue of the grantor’s term. A 5‑year underlease cannot be validly granted out of a 4‑year residue; the underlease term must be reduced accordingly.

The Code for Leasing Business Premises

The Royal Institution of Chartered Surveyors (RICS) publishes the Code for Leasing Business Premises. It sets out expectations for fairness and clarity in negotiating commercial leases.

While the Code is not law and does not override lease terms or statute, its mandatory provisions must be followed by RICS members, and departures from best practice require justification. Non-RICS members are encouraged to follow it.

Key objectives and provisions include:

• Negotiations: Must be constructive and collaborative.
• Heads of Terms: Should be comprehensive, clear, and cover key points like premises, term length, rent, rent review, repair, permitted use, alienation rights, and break options. The landlord is responsible for ensuring heads of terms contain specified details before issuing a draft lease.
• Information for unrepresented parties: RICS members must advise unrepresented parties of the Code and recommend they obtain independent professional advice.
• Rent Reviews: Should ideally allow for upward or downward review based on market conditions, not be restricted to upwards-only reviews unless specifically negotiated, and should include fair assumptions and disregards (e.g., assume tenant covenant compliance and vacant possession; disregard tenant’s occupation, goodwill and voluntary improvements).
• Break Clauses: Conditions attached to break rights should be reasonable and solely within the tenant's control—typically limited to payment of rent up to the break date and delivering vacant possession, rather than broad “material compliance with all covenants”.
• Assignment/Subletting: Landlord's consent should not be unreasonably withheld or delayed. Reasonable pre-conditions should be specified where possible (s.19(1A) LTA 1927), and s.1 LTA 1988 duties (to act within a reasonable time and give reasons) should be observed.
• Repairs: Obligations should be appropriate to the lease length and property condition. Schedules of condition are recommended for older properties, limiting tenant exposure to pre-existing defects.
• Insurance, service charge and other outgoings: The Code encourages transparency on how these sums are calculated and managed.
• Use and compliance: Heads of terms and drafting should take account of planning and regulatory constraints, including energy efficiency standards (MEES), where relevant.

Worked Example 1.7

A tenant’s draft break clause is conditional on “material compliance with all tenant covenants” and “payment of all sums due”. Does this align with the Code?

Answer:
Not well. The Code promotes break conditions limited to matters within the tenant’s control, typically payment of rent up to the break date and delivering vacant possession. Broad “material compliance” and “payment of all sums” (which could include disputed service charges or insurance reconciliations) risk making the break ineffective and are discouraged as best practice.

Revision Tip

Remember the Code's status: it's a professional standard, primarily for surveyors, not statute. However, its principles often reflect what courts consider reasonable, particularly regarding landlord's consent for alienation or alterations.

Security of Tenure

Many business tenancies benefit from 'security of tenure' under the Landlord and Tenant Act 1954 (Part II). This grants tenants the right to remain in occupation after the contractual term ends (the “continuation tenancy” under s24) and the right to apply for a new lease, unless the landlord can establish specific statutory grounds for opposing renewal (e.g., tenant breach, landlord intends to redevelop or occupy).

Eligibility generally requires occupation for the purposes of a business carried on by the tenant (s23). Security can be excluded (“contracted out”) by following the statutory procedure: the landlord serves the prescribed warning notice and the tenant makes the appropriate declaration (simple or statutory/advanced declaration, depending on timing) before the lease is granted. A valid contracting‑out clause is then included in the lease.

Renewal mechanics operate through two principal routes:

• Landlord’s s25 notice proposing terms (and indicating whether renewal is opposed) to terminate the tenancy on a date between six and twelve months after the notice; or
• Tenant’s s26 request proposing terms, to begin a new tenancy from a date six to twelve months after the request.

The tenant may serve a s27(1) notice to end the tenancy voluntarily, or a s27(2) notice to vacate at term end (with specified timing). Where renewal is contested, the landlord must establish a ground under s30(1):

• Discretionary grounds (a) persistent delay in paying rent; (b) other substantial breaches of covenant; (c) substantial repairs at tenant’s expense that remain undone; and (e) suitable alternative accommodation. Even if proved, the court retains discretion to grant a new tenancy.
• Mandatory grounds (d) tenancy created by subletting of part; (f) landlord intends to demolish or reconstruct and could not reasonably do the works with the tenant in occupation; and (g) landlord intends to occupy the premises. Ground (g) is subject to the five‑year ownership rule, with exceptions; ground (f) requires firm, settled intentions and capability to carry out the scheme.

Where renewal is refused on grounds (e), (f), or (g), statutory compensation is payable based on the rateable value of the premises; “double compensation” applies where the tenant’s business has occupied the premises for 14 years or more. The court fixes terms of any new tenancy, capped at 15 years, usually at open market rent and having regard to the existing lease’s structure (not necessarily replicating every clause).

Worked Example 1.8

A landlord wishes to exclude security of tenure on a five‑year lease. What must be done to contract out validly?

Answer:
The landlord must serve the statutory warning notice in the prescribed form. The tenant must give a declaration acknowledging the consequences—either a simple declaration (where completion is at least 14 days after service of the warning notice) or a statutory/advanced declaration (if completion is sooner). The lease must contain a clause recording the parties’ agreement to exclude security and the notice/declaration details. These steps must occur before grant.

Key Point Checklist

This article has covered the following key knowledge points:

• A lease grants exclusive possession for a term certain, distinct from a licence which is mere permission.
• Street v Mountford established the test based on substance (exclusive possession, term, rent) not label. Genuine service occupancies and transient arrangements may fall outside the lease category.
• Legal leases ordinarily require a deed (s52 LPA 1925); short leases up to three years can be created without a deed if the statutory criteria are met (s54(2) LPA 1925). Equitable leases may arise under s2 LP(MP)A 1989.
• Leases contain covenants outlining landlord and tenant obligations (e.g., rent, repair, user, alterations, alienation), with quiet enjoyment and non‑derogation from grant supporting them.
• Repairing obligations can be heavy; schedules of condition, s18(1) LTA 1927, and Jervis v Harris clauses are key risk controls. Enforcement of repairs in long leases may be constrained by the Leasehold Property (Repairs) Act 1938.
• Alterations and alienation covenants are modified by statute: s19 LTA 1927 upgrades qualified covenants and permits reasonable conditions; s1 LTA 1988 imposes duties regarding consent applications.
• Rent review clauses typically use open market mechanisms with standard assumptions and disregards; the Code encourages fair, transparent reviews and challenges overly harsh terms.
• An underlease is granted by a tenant out of their own lease (head lease) for a shorter term; consent is usually required and documented by a licence to underlet, which may introduce a direct covenant to the head landlord.
• The Code for Leasing Business Premises promotes fairness and clarity in commercial lease negotiations, setting mandatory standards for RICS members and strong best‑practice guidance on heads of terms, break clauses, repairs, alienation and transparency on outgoings.
• Business tenants often have security of tenure under the Landlord and Tenant Act 1954, providing rights to renew the lease unless validly contracted out or opposed on statutory grounds; compensation may be payable where renewal is refused on certain grounds.
• Registration rules apply to leases/underleases over seven years and prescribed clauses must be used in registrable leases; failure to register within time limits affects legal status.

Key Terms and Concepts

• Lease
• Licence
• Covenant
• Underlease
• Head Lease
• Code for Leasing Business Premises