Sinking and Reserve Funds in a Commercial Lease Agreement

When a landlord and tenant enter a commercial lease, they typically sign a lease agreement. This contract details the rights and obligations of both parties, such as the cost of rent and repair responsibilities. Property service charge monies are a cost to the commercial tenant in addition to the rent, which replaces the landlord’s costs. Some costs associated with a property service charge are sinking and reserve funds, which can cover major works to properties. This article will explain sinking and reserve funds in a commercial lease. 

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What is a Service Charge?

If you are part of a commercial lease, the lease agreement may contain a provision that details the tenant must pay a property service charge. This charge is in addition to the property rent. 

The property service charge covers common services by the landlord as part of the lease. It will typically occur when the lease is for commercial premises within a larger building with several business premises. For example, a large commercial building with multiple offices inside, each leased by different businesses. In this instance, the business premises may share areas such as:

• lifts;
• garden area, such as a roof garden;
• kitchen area;
• meeting rooms; and
• break-out space.

The service charge will assist the landlord in maintaining these areas and allow the costs to be shared between the individual business tenants. For example, the cost may cover the:

• cleaning of the areas;
• necessary repairs;
• heating costs;
• lighting costs;
• insurance costs;
• regulatory compliance; and 
• security costs.

Sinking Funds and Reserve Funds

The property service charge does not cover costs for all common areas, such as a one-off renovation or other significant expenses. Although similar, sinking and receiving funds are not the same. Therefore, you must be clear on which, if any, the commercial lease will contain. We explain each fund below.

What are Sinking Funds?

Sinking funds differ from the property service charge and cover substantial repair costs. Sinking funds cover repair costs a landlord and tenant believe will likely arise during the lease term. They will usually refer to repairs for expensive and possibly large equipment, for example:

• repairs to air conditioning systems; or
• repairs for the commercial property lift.

What are Reserve Funds?

A reserve fund in a commercial lease is a fund that allows a landlord to meet the costs of likely future maintenance of the common areas of the commercial property. This may include, for example:

• external cleaning; or
• redecorating the commercial property.

The reason for a reserve fund in a commercial lease is to ensure that the yearly commercial property service charge is fair. Likewise, an allocated reserve fund ensures the property service charge does not vary too much each year. Reserve funds also ensure that a commercial tenant does not suddenly have to make a large payment in the lease.

Other Considerations

Before a landlord and their tenants enter into a commercial lease with either a sinking fund or reserve fund, there are essential issues parties should first consider. These include:

• who legally owns the money in the fund;
• the exact purpose of the fund;
• the timescale of the fund;
• where the fund will go once the lease terminates; and 
• whether the tenant can retrieve any monies that remain in the fund. 

Key Takeaways

A property service charge refers to costs the landlord incurs for looking after common areas of a commercial property. However, some large and one-off common area costs may be separate from the service charge. These are in the form of a sinking or reserve fund. A sinking fund covers substantial foreseen repair costs, and a reserve fund covers maintenance costs. If a commercial landlord or tenant plans for the lease to contain a sinking or reserve fund, they should consider specific issues. These include, for example, who owns the fund and precisely what it will cover. 

If you need help understanding sinking funds or reserve funds in a commercial lease, our experienced leasing lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 0808 196 8584 or visit our membership page.