Pre-Lease Law in Russia

So near and yet so far - while standard practice in the legal systems of most developed countries, pre-leasing agreements are of doubtful validity under Russian law, one of many problematic issues stemming from the law requiring buildings to be registered by the State. The changes required to existing legislation are fairly minor, but could make a big difference to the market.

In many other jurisdictions there is an administrative regime which states that a new building may not be used or occupied until the authorities have issued an "occupancy permit" following completion. This is a means of enforcing building controls since it ensures that a building cannot be commissioned until local government representatives have inspected it and ensured that it was built in accordance with the planning permission and construction regulations.

In Russia these laws go further. Until the building is State registered, it does not officially exist. It cannot be bought, sold or mortgaged. No contracts can be entered into in relation to it, including leases.

Pre-leasing is an important aspect of property development and investment. Banks will lend on better terms to a developer who can show that income will start to flow as soon as the building is finished, because he already has legally-binding 'pre-lease' agreements. It reassures the bank that the developer has secured a source of income to service the debt.

In certain other jurisdictions there is a binding agreement to lease which subsequently leads to a lease proper being signed once the building is finished and ready for the tenant to occupy. In yet other jurisdictions, the lease is executed in advance of the building being officially commissioned subject to a condition precedent that the occupancy permit is issued or some other such similar arrangement.

But irrespective of the exact details, the important thing is that the bank and the developer know that income will flow. This obviously is also important in 'forward purchase' deals where an investor agrees to buy the complete and commercialized (i.e. income-producing) asset.

The State Registration issue is therefore a big problem in the development of a proper market in Russia, both for institutional lending and for institutional investment in real estate. If Russian law did not permit the use of 'agreements to agree' (which are void in other jurisdictions), then the obstacles would be insurmountable.

The elaborate Russian version of a simple pre-lease is a 'preliminary agreement' to enter into a 'fit-out and access agreement' which allows the tenant to take occupancy of the building when it is ready for him to fit it out to his own requirements. For this he pays a "fee" which is usually suspiciously similar to the rent he would pay if it were lawful to lease the building.

This agreement is automatically terminated when a) State registration occurs and b) the lease is signed and, finally, c) the lease is registered. At that point it is lawful for the tenant to take up occupancy and pay rent under an ordinary lease. Sometimes a short-term lease precedes the main lease to provide yet another temporary basis for income to flow. Leases less than one year in length do not need to be registered.

This whole ridiculous rigmarole allows the market to function in practice. However, there is varied legal opinion as to whether it actually works. The most conservative opinion is that the suite of agreements used to circumvent the law is simply a 'device' and less legally enforceable than a lease would be.

To cover the risk that a court might take this view, landlords require deposits, parent company guarantees or some other form of security for performance under the preliminary agreement. Often they rely on the practical device of contracting for the tenant to do more of the work between 'shell and core' and final fit-out at his own expense than would be common in other markets. 

Normally a developer completes a building to 'developer standard finish' - that is to say, the interior is decorated, carpeted and services are installed but it is not partitioned up. The tenant then pays for fitting it out to his own particular specifications. In Russia developers often try to move forward state commissioning by contracting to finish the building only to 'shell and core' state. They then sometimes require the tenant to finish his premises to developer standard finish and beyond. This commits the tenant to so much expenditure that he is unlikely to walk away from his contracts, whether they are legally enforceable or not.

Such devices only work in a 'landlord's market', where there is a real shortage of premises. Once the situation changes and supply and demand are more balanced, tenants will rightly refuse to take such risks. There is also the risk of default by the tenant. Although it may be possible to persuade the court to compel performance of the preliminary agreement, the court may also take the view that payment of damages is an adequate remedy. It is difficult to predict what the court will think is an adequate sum of compensation. But it is unlikely to be equivalent to the lost revenue of the full lease term, as the court will say the landlord still has the building and can find another tenant.

All of this complication serves absolutely no useful purpose. A few paragraphs of statute law are all that is necessary to solve a problem that will otherwise inhibit the development of the market.

This article first appeared in The Moscow Times Real Estate Quarterly, September 21, 2005.