The difference between commercial lease types

Categories: commercial mortgages | guides

When investing in commercial property to let out, before applying for a commercial mortgage (if you are not buying outright), one of the key considerations is the type of lease you will offer or agree to with tenants. 

Commercial leases are typically either of the following:

1. An Internal Repairing Insuring (IRI) lease 
2. A Fully Repairing and Insuring (FRI) lease

Understanding the differences between these can significantly impact your property management strategy and financial returns. This guide will help you navigate these options.

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What is an Internal Repairing Insuring (IRI) lease?

An Internal Repairing Insuring (IRI) lease is a commercial lease where the responsibilities for property maintenance, repairs, and insurance are typically shared between the landlord and the tenant. The specifics can vary, but the general principle is that not all obligations fall on the tenant.

Key features:

• Maintenance and repairs: The landlord is usually responsible for structural repairs and major maintenance, such as the roof or external walls. The tenant may be responsible for minor repairs and internal upkeep.
• Insurance: The landlord typically arranges building insurance, covering the structure of the property. The cost of this insurance is often passed on to the tenant as part of the service charge, but the landlord remains in control.
• Service charge: The tenant may pay a service charge that contributes to the upkeep of common areas, communal services, and building insurance. However, this does not usually cover major repairs or structural work, which remain the landlord's responsibility.

Pros and cons for investors

• Pros: The lower risk for tenants can make properties more attractive and easier to lease. The landlord retains control over major repairs and insurance, ensuring that the property is well-maintained in a way the landlord is happy with.
• Cons: The landlord bears more responsibility and potential costs for repairs and maintenance. This can result in unpredictable expenses.

What is a Fully Repairing and Insuring (FRI) lease?

A Fully Repairing and Insuring (FRI) lease shifts most, if not all, of the property-related responsibilities to the tenant. This type of lease is more common in commercial property, especially for longer-term leases and larger properties.

Key features:

• Maintenance and repairs: The tenant is responsible for all repairs and maintenance, both internal and external. This includes structural repairs, routine maintenance, and any necessary refurbishments. The landlord has minimal involvement in the day-to-day upkeep of the property.
• Insurance: The tenant is also responsible for arranging and paying for the building insurance. The tenant must ensure that the property is adequately insured throughout the lease term.
• No service charge: Since the tenant takes on most of the responsibilities, there is usually no service charge. However, in multi-tenanted buildings, a service charge might still exist for communal areas, but this is less common with single-tenant properties on an FRI lease.

Pros and cons for investors

• Pros: A property leased under an FRI lease comes with a more predictable income stream and fewer unexpected expenses. The tenant’s responsibility for repairs and insurance reduces the landlord’s management burden and financial risk.
• Cons: FRI leases can be less attractive to tenants, due to the higher level of responsibility. This might result in longer vacancy periods or result in your having to reduce the rent to secure a tenant.

Key considerations for property investors

Before finalising a decision on which type of lease you want to offer, there are other factors to consider based on who you are trying to attract as a tenant. These include:

Tenant appeal and lease length

IRI lease: More appealing to smaller businesses or those with less predictable cash flow. These leases can attract a wider range of tenants, especially those who prefer lower responsibilities.

FRI lease: Often favoured by larger, established businesses that are willing to take on additional responsibilities, in exchange for potentially lower rent or longer lease terms.

Property type and condition

IRI lease: Ideal for older properties or those with high maintenance needs. The landlord retains control over the quality and timing of major repairs.

FRI lease: Suitable for newer or well-maintained properties where long-term maintenance costs are expected to be lower. This lease type also works well for single-tenant properties, where the tenant wants full control over the property.

Investment strategy

IRI lease: Better for investors who prefer a hands-on approach, with the potential for higher but more variable returns due to the maintenance obligations.

FRI lease: Suited to investors looking for a more passive income stream with minimal day-to-day management. The steady, predictable nature of an FRI lease can be advantageous for long-term investment planning.

What impact does a lease have on getting a commercial mortgage?

When you apply for a commercial mortgage, the lender will want their solicitors to review the terms of your lease. They will want to establish that it is robust, as when they are lending you money, the lender is taking on the risks associated with the security property. 

If, in an extreme circumstance, they had to repossess the property to recoup an unpaid mortgage debt, but found the lease caused them further problems in doing so, their costs would mount up.

So, when you come to apply for a commercial mortgage, have a copy of your lease to hand so you can provide it to your mortgage broker / the lender.

A commercial lender will also want to know how long the lease has remaining on it, until it expires. They will typically be looking for at least two years to be remaining, so that they know rent is (by and large) guaranteed for that amount of time. Once a lease expires, you will either renew it with the existing tenant, or have to find a new tenant.

Another key factor relating to the lease and a commercial mortgage application is the inclusion of any break clause in the terms. A break clause is a point after the start of a tenancy, where a tenant or you as the landlord can end it, without penalty. 

For example, your tenant might sign a contract for a ten year tenancy, but the agreement has a break clause at year five, in case your plans for your property change in a way you had not foreseen. Similarly, if the tenant’s position had changed, this gives them the option to terminate and leave the property.

A commercial lender will want to know if your lease has a break clause, because the rental income from the tenant is what is covering the cost of the mortgage. A break clause runs the risk of a gap in a tenancy and in rental income. Most lenders will not want to see a break clause coming up within two years of the mortgage start date. 

Final thoughts on commercial lease types

Choosing between an Internal Repairing Insuring (IRI) lease and a Fully Repairing and Insuring (FRI) lease depends on your investment goals, the type of property, and the target tenant market. 

Consider your risk tolerance, desired level of involvement in managing the property, and the specific property characteristics when choosing the right lease type for your investment.

If you prefer steady, predictable returns with less involvement in the property's upkeep, an FRI lease might be the better option. However, you'll need to ensure the property is in good condition to avoid deterring potential tenants.

If you're willing to take on more responsibility and potential costs, an IRI lease can offer greater flexibility and potentially attract a broader range of tenants, especially in a competitive market.

Always seek professional advice tailored to your specific situation, as lease terms can vary significantly depending on the property and the market conditions.

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