Most people assume that the critical moment in a retail lease transaction is when they sign the lease itself. Often, however, it is not.
By the time a formal lease document is in front of a tenant, most of the terms that will govern their occupancy for the next three, five, or ten years have already been settled. The document is largely a legal formalisation of what has already been agreed.
The real negotiation happens earlier, in the heads of agreement stage. This is the point at which the landlord and tenant agree on the commercial terms of the lease before any formal documentation is prepared. It is also the point at which tenants most commonly give away leverage they did not know they had.
This article explains what the heads of agreement stage involves, which terms matter most, and why involving a retail leasing lawyer before those terms are finalised is so important.
What Is a Heads of Agreement?
A heads of agreement, sometimes called a letter of offer or commercial terms document, is a summary of the key commercial terms that the landlord and tenant have agreed on before the formal lease is drafted. It is typically prepared by the landlord's leasing agent and covers the basics: rent, term, options, outgoings, any rent-free or fit-out period, the required security, and sometimes make good obligations.
In many cases the heads of agreement is not a legally binding contract in the strict sense. But that does not mean it can be ignored once signed. Once both parties have agreed on those commercial terms, whether in writing or by exchange of emails, changing them is very difficult. The landlord's solicitor will draft the lease on the basis of what has been agreed, and pushing back on terms at that stage is treated as a renegotiation. Landlords do not always accept it.
The window to negotiate is open at the heads of agreement stage. Once it closes, a tenant's options narrow significantly.
When to Get Legal Advice
The most common mistake tenants make is engaging a lawyer only after the heads of agreement has been signed. At that point, a lawyer can review the formal lease document and identify clauses that are inconsistent with the Retail Leases Act or unfavourable on their face. What they cannot easily do is reopen the fundamental commercial terms.
We strongly recommend that tenants speak to a retail leasing lawyer before finalising the heads of agreement, not after. The cost of that advice at the early stage is modest. The cost of living with a poorly negotiated set of commercial terms for five years is considerably higher.
A lawyer involved at the heads of agreement stage can flag terms that are worth pushing back on, identify things that are missing from the document that should be there, and help a tenant understand what they are agreeing to before they agree to it. That is a very different role to reviewing a completed lease document.
Rent and Rent Review Mechanisms
The starting rent and the method by which it increases over time are the most financially significant terms in the lease. Both need to be understood clearly before the heads of agreement is agreed.
Rent review mechanisms in retail leases are typically fixed percentage increases, CPI-linked increases, or market reviews at set points in the term. Each has different implications. A fixed percentage increase provides certainty for both parties but can work against a tenant if market rents fall. A CPI-linked increase tracks inflation but adds an element of variability. A market review can produce a significant jump in rent, particularly if the review occurs after several years in a strong market.
The Retail Leases Act prohibits ratchet clauses, which are provisions that increase rent to whichever of two measures is higher, such as the greater of a fixed percentage or CPI. That protection exists by statute. But tenants should still understand what the agreed rent review mechanism means for their total occupancy cost over the full lease term, including any option periods.
Where a market review is included, the lease should specify how market rent is to be determined if the parties cannot agree, including whether an independent valuer can be appointed and who bears that cost. The heads of agreement should at minimum record the type of review that will apply and at what intervals.
Rent-Free and Fit-Out Periods
Where a premises is provided as a base shell, a tenant will typically need time and money to configure it for their business before they can open. A rent-free or fit-out period is the landlord's concession of that time, during which no rent or reduced rent is payable while the tenant carries out the works.
The length of any rent-free period is almost entirely a matter of negotiation, and it is negotiated at the heads of agreement stage. Once agreed, it is very difficult to extend. A tenant who underestimates how long the fit-out will take, or who agrees to a period that is too short, will find themselves paying full rent before they have opened their doors.
Tenants should think carefully about the realistic timeframe for their fit-out before agreeing to any rent-free period. That means getting quotes from builders or fit-out contractors in advance, factoring in lead times for council or development approvals if those are required, and building in a reasonable buffer for delays. A fit-out period that looks adequate on paper often turns out not to be.
It is also worth clarifying whether outgoings are payable during any rent-free period. The heads of agreement should make clear whether the concession applies to rent only or to the full occupancy cost.
Options to Renew
An option to renew gives the tenant the right to extend the lease for a further period. Options are almost always in the tenant's favour. They are not an obligation to renew, but a right to do so. If the business is trading well and the tenant wants to stay, the option locks in that right. If the business is struggling, the tenant can simply let the option lapse.
Tenants should always push for option periods in the heads of agreement. A landlord who is prepared to grant a five-year lease is often prepared to include an option for a further five years, particularly where the tenant represents a stable, long-term occupier. The negotiating position is strongest before the heads of agreement is signed.
The terms on which the option can be exercised should also be understood clearly. Most leases require the option to be exercised within a specific window, typically several months before the end of the current term. Missing that window means the right to renew is lost. The heads of agreement should at minimum record how many options are available and the length of each.
Permitted Use
The permitted use clause in the lease defines how the tenant is allowed to use the premises. It sounds like a technical detail, but in practice it can significantly constrain a business's ability to adapt over time.
A narrowly drawn permitted use clause means that if the tenant wants to change or expand their business activities, they need the landlord's written consent. The landlord is not always required to give it. A cafe that wants to add a takeaway window, a clothing retailer that wants to start stocking homewares, a gym that wants to offer allied health consultations: each of these might require landlord consent if the permitted use clause is drawn too tightly.
The heads of agreement is the point at which the permitted use should be negotiated as broadly as the landlord will accept. A description such as "retail sales and associated activities" gives the tenant considerably more flexibility than "women's clothing retail." Tenants should think not just about what their business does now, but what they might reasonably want to do in three or five years.
Shopping centre landlords sometimes resist broad permitted use clauses because they manage the tenant mix in the centre carefully. This is a legitimate concern and the parties will need to balance their respective needs.
Make Good Obligations
Make good obligations are what the tenant is required to do to the premises at the end of the lease: removing the fit-out, repainting, replacing flooring, and in some cases restoring the premises to a bare shell. The scope of those obligations should be negotiated at the heads of agreement stage, not discovered in the fine print of the lease document two months before the tenant is due to vacate.
The cost of make good works can be substantial. We have seen make good disputes result in bills of tens of thousands of dollars that the tenant had not anticipated. In most cases, those disputes trace back to a make good obligation that was not clearly understood at the outset, or one that was agreed without anyone properly considering what it would cost to comply with.
The starting position to push for in negotiations is that make good is limited to removing the tenant's fit-out and leaving the premises in a clean and tidy condition, rather than restoring it to a particular condition that may be difficult to define or expensive to achieve. A condition report or photographic schedule prepared at the start of the lease, signed by both parties, provides a clear baseline and reduces the scope for dispute later.
Some landlords will push for the right to require the tenant to restore the premises to its pre-lease condition, which can be an open-ended obligation. Others will accept a cash settlement in lieu of make good works. Both positions are negotiable, but they need to be negotiated and understood before the lease is signed.
Security: Bonds, Bank Guarantees and Personal Guarantees
Landlords will almost always require the tenant to provide security before they take possession. The amount, type, and conditions for release of that security are all matters for negotiation.
The quantum of security is typically expressed as a number of months of rent, and it is negotiated based on the financial position of the tenant and the risk the landlord perceives. A tenant with a strong trading history and good financial statements is in a better position to negotiate a lower security requirement than a first-time business owner. That negotiation happens at the heads of agreement stage.
Personal guarantees deserve particular attention. Where the tenant is a company, the landlord will often require the directors to personally guarantee the company's obligations under the lease. This means that if the company defaults, the landlord can pursue the directors personally. That is a significant personal financial exposure that should never be agreed to without legal advice and a clear understanding of what is being signed.
It is sometimes possible to negotiate limits on personal guarantee liability, such as capping it at a fixed sum, restricting it to a defined period, or providing that it falls away after a certain number of years of compliant performance by the tenant. These are terms that need to be raised at the heads of agreement stage, before the lease is drafted.
Hold-Over Provisions
A hold-over provision governs what happens if the tenant remains in the premises after the lease has expired without having exercised an option or signed a new lease. In most leases, the tenant continues on a month-to-month basis during any hold-over period.
What many tenants do not anticipate is the rent that applies during that period. Some leases include provisions that impose a significant premium on the hold-over rent, sometimes as much as 150% or more of the last rent payable under the lease. The intention is to create a financial incentive for the tenant to either exercise their option or vacate. In practice, it can catch a tenant off guard at a moment when they are already under pressure.
The hold-over position should be identified and understood before the lease is signed, even though it may not feel urgent when the lease is just starting. A tenant who enters a five-year lease knowing what the hold-over rent will be is in a much better position to plan their exit or renewal strategy than one who discovers it for the first time when the lease is about to expire.
What the Heads of Agreement Should Cover
Not every heads of agreement is equally comprehensive. Some are detailed and cover most of the key commercial terms. Others are little more than a statement of rent and term. As a minimum, a tenant should expect the heads of agreement to record:
The rent payable in the first year of the lease and the basis on which it will be reviewed.
The term of the lease, including any options to renew and the term of each option.
Whether outgoings are payable and on what basis.
Any rent-free or fit-out period, and whether outgoings apply during that period.
The permitted use of the premises.
The security required, including the amount and the form.
Whether a personal guarantee is required and from whom.
The make good obligations at the end of the lease, even if only at a high level.
Where a heads of agreement is silent on a point, that point will be filled in by whatever the landlord's standard lease says. Silence at the heads of agreement stage is generally not in the tenant's favour.
Getting Advice Before the Terms Are Locked In
The heads of agreement stage is not where most tenants expect to need a lawyer. It is informal, it often moves quickly, and the terms are expressed in plain commercial language rather than legal drafting. But it is precisely because of that informality that the stage is so consequential. There is no legal review of the document before it is signed, no disclosure statement has been prepared yet, and no formal lease has been drafted that a lawyer might be asked to review.
At Thornton + King, we regularly act for tenants at the heads of agreement stage. The advice provided at this point is practical and commercially focused rather than purely legal: understanding what terms are standard and what can be negotiated, knowing which concessions landlords will typically consider, and making sure that the document accurately records what the parties have discussed. Engaging us at this stage costs considerably less than trying to reopen negotiated terms after the lease has been drafted.
If you are in the process of finding retail premises and have been provided with a heads of agreement or letter of offer, give us a call or submit an enquiry to speak to a Law Society Accredited Specialist in property law.
Related articles in this series:
Retail Leases in NSW: A Complete Guide for Tenants and Landlords
What Is the Retail Leases Act 1994 (NSW) and Does It Apply to You?
Retail Lease Disclosure Statements in NSW: What Must Be Disclosed and When
Disclaimer
The information in this article is intended as a general guide only and does not constitute legal advice. Retail leasing is a specialist area and the law can change. You should obtain advice from a qualified retail leasing lawyer in relation to your specific circumstances.
