Understanding underleases: what are the risks?

Potential undertenants need to understand the nature of their interest and the implications this has for their liability as a whole. This article highlights some risks for undertenants and suggests ways in which these may be addressed.

What is an underlease?

An underlease is a lease that is not granted by a freehold owner but by a person who is, himself, a tenant. So it is a lease which is granted out of another lease. The parties referred to in this article are the landlord (meaning the freehold owner), the tenant (meaning the tenant under the existing lease or 'headlease' granted by the freehold owner) and the undertenant (meaning the tenant under the underlease, which is the lease granted out of the headlease).

Contents of the underlease

Undertenants are usually required to covenant directly with the landlord to comply with the underlease covenants. Sometimes underleases also require compliance with covenants contained in the headlease. Caution is needed before agreeing to this, as it effectively incorporates the terms of the headlease into the underlease. If the repairing obligations in the headlease were to be incorporated into the underlease in this way, it could allow the landlord to pursue the undertenant for dilapidations in respect of the whole of the headlease term. It is vital that such exposure is limited.

Even if the headlease obligations are not passed on to an undertenant, they still need to know what is in the headlease and what the tenant can or must do. What if the underlease lets only the internal shell of a property and the structure falls into disrepair? Can the tenant effect repairs? Is this the responsibility of the landlord? The underlease should oblige the tenant to comply with its own obligations, and enforce the landlord's obligations, in the headlease.

An undertenant should ensure that the tenant is obliged to pass on any notices that it receives in relation to the headlease and to notify the undertenant it of any variations to the headlease. Either could affect the undertenant's security or liabilities.

The underlease must expire before the headlease. If the underlease term is equal to or greater than the headlease then this will usually result in the assignment of the headlease to the undertenant, which is not what the parties intend.

What happens to an underlease when the headlease ends?

If the headlease is forfeited because the tenant has breached its terms, the underlease will end automatically. The undertenant can apply for relief from forfeiture but the court has a wide discretion as to the terms upon which this might be granted. It may impose an obligation on the undertenant to pay the tenant's arrears as a condition of relief. Complications arise when the undertenant occupies only part of the premises comprised in the headlease.

As an alternative, a tenant may be able to agree with the landlord that if the headlease is forfeited and the underlease falls away, the landlord will grant a new lease to the undertenant.

If the tenant is wound up and the headlease is disclaimed, the undertenant can stay in occupation for the underlease term but only if it complies with the headlease obligations, including payment of the headlease rent. Expert advice should be sought to protect the undertenant's position if this occurs.

If the headlease is terminated by break notice then, again the underlease will end at the same time as the headlease. Undertenants must be careful to review the headlease for any break options and take advice to protect their interest.

Getting advice

Tenants often take leases without legal advice. This is unwise but entering into an underlease without legal advice is even more hazardous. Potential undertenants should seek proper legal advice prior to entering into an underlease to ensure that:

• they are not liable for anything more onerous that the provisions of the underlease
• they are aware of the implications of the headlease ending early; and
• safeguards are put in place if at all possible to protect their interests.