Avoiding the renewal lease rent trap in KSA

A lesson for companies taking leases in Saudi Arabia

In England, and some other jurisdictions around the world, commercial tenants are accustomed to systems of security of tenure that mean they cannot necessarily be required to vacate premises when their lease term expires.  The degree of security varies between stronger regimes where tenants have near absolute rights to remain in occupation, to weaker systems which merely create a more level playing field in negotiations for a renewal. 

Commercial tenants in Saudi Arabia have no system of security of tenure – the contract “is the law of the parties”.  When the lease term ends, so do the tenant’s rights to use the property and, unless a renewal is agreed, the tenant has to vacate.

So where is the trap?

Saudi Arabia is not alone in shunning the tenant protectionist approach of statutory security of tenure regimes and allowing contract rather than statute to dictate what happens at the end of the term of a lease.

The Saudi Arabian Civil Transactions Law (CTL) does allow for a “holding over” by the tenant – if the landlord allows the tenant to remain in occupation without signing a renewal lease, then the lease is deemed renewed for a period linked to the period by reference to which rent is paid i.e. if the rent is payable annually, then the lease renews for a year.  That holding over will be at the rent payable under the expired lease unless, before expiry, the landlord demands a higher rent in which case the tenant has to either accept that or object.  If the tenant objects then the landlord can agree or simply bring an end to discussions and require the tenant to vacate.

As there is no restriction on how late in the lease term the landlord can demand the increase, if it does so during the last days of the term, the tenant may have no realistic option of relocating and be forced to agree the increase or be left without premises to trade from. 

In a jurisdiction where shorter lease terms are the norm, the commercial problem for the tenant may be exacerbated as capital expenditure on fit out may not have been adequately written down over the initial lease term.

The tenant may be able to buy itself a short period by simply refusing to hand keys back but, under the CTL the landlord can demand market rent, claim compensation and would still have a right to possession.  Another potential option under the CTL is to claim an extension for “urgent need” and again pay market rent. That claim is far from certain given that this “urgent need” will have arisen from failure of negotiations and legitimate application by the landlord of other provisions of the CTL.

How to avoid the trap

In recognising the trap during heads of terms or lease negotiations, a well-advised tenant can go some way towards avoiding it or ameliorating some of its consequences.

Solution 1: the CTL expressly acknowledges the principle of a contractual option to renew the lease or extend the term.  This would often be seen as the tenant’s optimal solution. In Saudi Arabia rent increases are generally fixed ratchets rather than open market reviews and comparables are hard to find given the nascent land and lease registration system.  As such, ratchetted rent calculation mechanisms in options to renew/extend can lead to higher or lower than market rents and similar commercial issues.  They are still the best solution available from a tenant’s perspective as any discrepancy between market rent and rent under the calculation in the option is likely to be more than set off by avoiding relocation costs and negative impacts on goodwill.  They also do not prevent further commercial negotiation with the landlord on rents if the renewal lease/extension rent exceeds market.

Solution 2: negotiate a longer initial term but with a tenant only right to break the lease.  A longer term with a right to break is, commercially, equivalent to a shorter term with a right to extend.  There may be other factors that make this less attractive, including costs involved with lease registration if the longer lease term triggers that and the impact of IFRS16 (an international financial reporting standards) and how lease liabilities are accounted for on company balance sheets.

Solution 3: create an early warning system in the lease.  The lease can oblige the tenant and landlord to confirm their intentions early and for the landlord to suggest a renewal rent at a time that still leaves scope for negotiation or exit.  This provides the tenant with an opportunity to negotiate whilst orderly relocation is still a viable option, thereby partially redressing the imbalance of bargaining position inherent in the provision under the CTL.  

Solution 4: provide for compensation for un-written down fit out works left in situ.  In many instances this is unlikely to be palatable to a landlord as fit out is often specific to the tenant.  In some instances, particularly in office or logistics sectors, fit out (or parts of it) can be of value to a landlord if available for future occupiers.

The CTL provides for a landlord to require a tenant to leave its fit out in exchange for compensation linked to value.  There is no reason in principle why the parties cannot agree for works to remain and fix the compensation in the lease on day one.  This is not, of itself, a solution to the renewal rent trap but it can assist in mitigating one of the harsher effects of it.