Proposed lease law reform may soon provide additional certainty for real estate investments in Germany

April 2020 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

April 2020 Issue

The German Federal Council recently adopted a legislative proposal aimed at simplifying termination rights in case of written form defects in a long-term lease agreement. The legislation still needs to be approved by the German Parliament to be enacted. Whereas many details and effects of the new law are still unclear, it can clearly be foreseen that real estate investments in Germany will become significantly less risky if the new law is enacted. The new law will significantly reduce the risk that the tenant terminates the lease agreement before the end of the fixed term based on a breach of the written form requirement for lease agreements.

Background

Section 550 of the German Civil Code requires that lease agreements, including commercial leases, with a fixed term of more than one year, must be concluded in written form. If parties violate this requirement, the lease agreement can be terminated by either party before the end of an agreed fixed term, observing only a notice period. The intention of the legislature was to protect the purchaser of a lease asset who enters into an existing lease relationship automatically through the acquisition of real property, in accordance with Section 566 of the German Civil Code.

In practice, however, the effects of Section 550 are often used by tenants to liberate themselves from obligations under long-term lease relationships. Thereby, non-compliance of the lease agreement with the written form requirement constitutes a risk for investments in real estate, which economically rely on a lease agreement with a fixed term.

The Federal Court of Justice has widely interpreted this form requirement to mean that the entire material content of the agreement is subject to the written form. Case law, for example, requires that the pages of the lease agreement, as well as all annexes and amendments, must either be connected to each other physically or at least clearly form a unit, e.g., by continuous pagination and numbering of the stipulations, consistent layout and coherence of content. Annexes prepared after the conclusion of the lease agreement, such as specifications of a building, for example, have to be agreed upon in a formal amendment to the lease agreement.

Amendments to the lease agreement have to explicitly, and clearly, refer to the original agreement, note the date and the provisions to be amended. Otherwise, the statutory written form requirement is violated, and the lease agreement can be terminated by both parties before the end of its fixed term.

Based on this strict and complicated case law, a single amendment to the lease agreement that is not recorded properly or which does not properly take reference to the initial lease agreement, is often sufficient to infect the lease agreement with the effect that the lease agreement can be terminated before the end of its fixed period.

In the past, in order to alleviate the resulting uncertainty, many commercial lease agreements contained so-called written form healing clauses, under which the parties undertake not to invoke the written form defects or to heal a possible written form defect. However, the Federal Court of Justice declared in 2017 such healing clauses to be ineffective, intensifying risks for real estate investors, if the written form requirement was not respected.

Therefore, when reviewing existing lease agreements, checking for compliance with the written form requirement is a cornerstone of legal due diligence in real estate transactions in Germany. If a defect is identified during legal due diligence, in many cases it can only be remedied with an amendment agreement to the lease agreement.

However, this requires the involvement and cooperation of the tenant, placing considerable risks on the transaction. Tenants sometimes take advantage of this situation to renegotiate other clauses in the lease agreement in their favour or to make additional demands.

Overview of the legislative proposal

The draft legislative proposal aims to resolve these problems and contains the following main points.

First, only the purchaser of a property (i.e., the landlord) may terminate the lease agreement in case of written form defects. The new provision will apply to existing and newly concluded lease agreements. The current provisions would only continue to apply if an existing lease agreement has been terminated before the new law comes into force.

Second, the right to terminate the lease agreement because of a written form defect can only be exercised within a period of three months after the landlord became aware of the written form defect.

Third, the tenant has the right to object to the termination within two weeks following receipt of the notice of termination. In this case, the tenant must agree to continue the agreement only in accordance with the terms that comply with the written form requirement. In other words, the tenant must waive the non-written parts of the agreement for the future.

Finally, it is not possible to terminate due to violations of the written form requirement after the respective acquisition.

Outlook

The draft legislative proposal, together with the federal government’s statement, has been forwarded to the German Lower House for discussion. The federal government stated that it might not support this draft. The proposed changes, according to the federal government, would only favour proprietors in the case of commercial leases. Further, it feared that a softening of the written form requirement will reduce the overall existence of written lease agreements.

However, the federal government also announced it would further assess the problems addressed and examine what amendments to the legislative proposal might be made to improve planning security in commercial lease law while balancing the interests of tenants.

If the law as proposed by the German Federal Council or an amended but similar legislative act is enacted, real estate transactions in Germany could become significantly less risky for investors. Investors could rely on long-term lease agreements with a fixed term and would be released from the risk that income from their investment is reduced or lost due to early termination of a lease agreement by a tenant. This would also provide additional security for banks financing real estate investments. Banks in many cases ask for an assignment of the claims by the landlord under the lease agreement as security. With the new law, such security would become significantly more valuable.

Max Hirschberger is a partner, Christoph Allmendinger is a senior associate and Jianyi Wang is an attorney at SZA Schilling, Zutt & Anschütz Rechtsanwalts GmbH. Mr Hirschberger can be contacted on +49 69 976 9601 351 or by email: max.hirschberger@sza.de. Mr Allmendinger can be contacted on +49 69 976 9601 360 or by email: christoph.allmendinger@sza.de. Mr Wang can be contacted on +49 69 976 9601 536 or by email: jianyi.wang@sza.de.

Max Hirschberger, Christoph Allmendinger and Jianyi Wang

SZA Schilling, Zutt & Anschütz Rechtsanwalts GmbH