Defects: what should a tenant think about when considering a pre-let?

Author: Nick Turner, Partner, Real Estate, London

I often find I'm sitting in meetings on large office pre-lets debating the length of the period that the developer will be on the hook for its development obligations."  Is six years market?" "Is a release at the certificate of making good market?"  To my mind, on many occasions, this misses the bigger picture.   What we're really discussing here is "What are the potential tenant's rights of recourse should there be defective design and/or construction of the building in question?"

The answer to that requires a consideration of various factors and various potential avenues of recourse.

For instance, is focusing on the developer itself the key issue? In many cases this will be important, and the identity of the developer should be analysed carefully.  What is its covenant?  Are there guarantors standing behind it?  Clearly, the stronger the developer the more this line of recourse is important. If it's an off-shore fund then a legal opinion may be reassuring, but would a tenant really want to be enforcing judgements in an overseas jurisdiction it may know little about?

Equally important is the package of third party rights being provided by the contractor and professional team.  On that issue, third party rights are only as good as the underlying contracts and appointments (and may be more restrictive). Prospective tenants really need to focus on this issue early to ensure they are receiving a robust package of rights. For instance, if the employer or developer is getting a parent company guarantee from the contractor's parent, then the tenant should be looking to see its rights are similarly backed up.

Another area to consider is the lease itself.  Many lawyers seek to carve out liabilities relating to defects from the service charge or repairing covenants in the lease but are rarely successful in achieving this. That's because the effect of this is to remove development risk from the original developer to its successors in title to the asset.  Simply put, the lease won't be "full repairing and insuring" (FRI) and prospective purchasers, who are well advised, will see this as a defect and value point.  Another approach, which doesn't have this effect, is to place obligations on the landlord from time to time to enforce its rights under the building contract or appointments and credit monies recovered.

Finally, the parties should consider defects liability insurance. It's not a universal panacea and tenants will want to ensure it extends to mechanical and electrical (M&E) and not just the structures of the building. The tenant will also need to understand the limitations on claims ("imminent collapse") and excesses applicable to claims. 

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