Tenants’ Right to Carry Out Improvements II 0 Comments

Tenants’ Right to Carry Out Improvements II

Proposition:  Whilst an absolute prohibition, in a lease of business premises, against redevelopment or the carrying out of structural alterations is not effective, it may be possible to allow redevelopment subject to conditions.

The first part of the above proposition was examined in detail in my earlier blog post “Tenants’ Right to Carry Out Improvements”.  To recap briefly; under Part 1 of the Landlord and Tenant Act 1927 a tenant under a long lease of business premises at a ground rent (for brevity hereon a “relevant lease”) can give notice to his landlord of his intention to carry out the alterations comprised in the redevelopment and, if the landlord fails to serve a counter-notice objecting to the work, or the landlord does serve a counter-notice and the tenant applies successfully to the County Court for a Certificate that the improvement is a proper improvement, then, under s.3(4) of the 1927 Act it is then lawful for the tenant as against the immediate and any superior landlord to execute the improvement according to the plan and specification served on the landlord, or according to such plan and specification as modified by the tribunal or by agreement between the tenant and the landlord or landlords affected, anything in any lease of the premises for the contrary notwithstanding (my italics) – though bear in mind the landlord’s option to do the work himself (rarely exercised except in the case of relatively minor improvements).

I should make the point here (as I did noSouthwark Towerst do so in my earlier post) that the 1927 Act procedure may not provide the tenant with a solution where the lease contains a restriction on use.  In theory, s.3(4) would override a user clause, but the fact that the proposed development involves a change of use may well give the landlord a reasonable ground for objecting: the obvious example would be a change from offices to enfranchisable residential apartments.

In a later blog post “Demolition and Rebuilding where the tenant is subject to an express obligation to repair” I pointed out that s.3(4) would override the tenant’s repairing covenant in a relevant lease as well as an absolute (or qualified) prohibition on the rebuilding or the carrying out of structural alterations.

This is a significant problem for ground landlords granting long leases, although one which seems to be little recognised.  Certain landowners, particularly institutions such as livery companies, are unwilling to sell a freehold property outright and wish to retain a share of the growth.  There are other ways of achieving this but the traditional (and by far the most common) way is by granting a long (it used to be 99 years but now can easily be 250 years – in fact any developer/funder would probably insist on something approaching 250) lease on an “equity sharing” basis i.e. reserving a ground rent which is a percentage either of the open market rental value of the property (unusual as it is onerous for tenants) or (more common) the occupational rents actually passing from time to time.

Leases of this kind require verSouthwark Towers Under Demolitiony careful drafting in a number of respects, for example  the need to ensure that the premises are so far as possible constantly let at the best rents available and with adequate rent review clauses, that there is provision to substitute a market rent where the tenant himself goes into occupation, and adequate reporting/accounting provisions.  I may deal with these issues (and some others in the list below) in subsequent posts; here I am solely concerned with redevelopment.

To take an example, a modern purpose built and fully equipped office building is unlikely to have a life of more than 50 years (and will almost certainly require major refurbishment, including the replacement of plant, after 25 years or less).  The best an absolute prohibition is going to achieve, even if the tenant does not use the 1927 Act route, is a deadlock, and I suggest that is in the interests of neither landlord nor tenant. And this is not a one-off problem – over 250 years there are likely to be 10 major refurbishments and at least 5 redevelopments.

What then is the answer?  It is simple in concept but complex in execution.  The answer is to permit redevelopment but to impose conditions controlling the development, including:-

a)    a requirement for the landlord’s approval to fully detailed drawings and specifications;

b)    a restriction on use (probably already in the lease);

c)    a requirement that the building is self contained and constructed entirely on the site demised by the relevant lease;

d)    a minimum net floor area; and

e)    a requirement for the developer/tenant either to pass strict covenant and financial strength tests, or to provide security for the cost to the landlord of completing the redevelopment should the tenant fail during the development period, at worst leaving the landlord with a hole in the ground (unlikely, but it has happened).

Southwark Towers Demolition SiteThere is no guarantee (or authority that I can find), but it is thought that where a lease permits redevelopment on conditions agreed between the parties, it is likely that the County Court would impose such of the agreed conditions as had not already been met as part of its Certificate (or refuse a Certificate until the conditions are met).  The reasoning is that the purpose of Part 1 is to confer a right for the tenant to compensation for improvements: in effect, s.3 is an anti-avoidance section, in that it stops landlords from blocking a tenant’s right to compensation by simply refusing consent.  The Act is not intended to enable the tribunal to re-write the parties’ bargain (and the right to compensation remains)

The type of conditions referred to above (except possibly for e), which I have known to become contentious) are relatively easy to draft, but there is another issue which it is not quite so easy to deal with: the percentage of the ground rent gearing following redevelopment.  The best solution is to include provision for a review from completion of redevelopment to a then modern ground rental market value.  That is simple to state but not so simple to draft for two main reasons:-

1)    valuers differ on what should be included in a residual valuation as deductible expenses of redevelopment; and

2)    the landlord will want to protect himself from a fall in rent i.e. will need to be sure that the review is in effect “upwards only” (it is unlikely that in market conditions favouring development this would happen but it needs to be covered as the interests of landlord and tenant will differ if only in the size of their relative shares in the equity).

The answer to (1) above is to be specific in the lease as to what can and cannot be included as development expenses (two areas which constantly cause problems are funding costs and the fees of project managers and other professionals who are wholly owned subsidiaries of the tenant company).

The Shard under constructionThere are two aspects to (2).  The first is to ensure that a “development rent” (perhaps an average of the ground rent for the three years preceding the year in which the proposed development is commenced – in the immediately preceding year the income is likely to be artificially low as the developer/tenant empties the building) is payable throughout the development period and after that until the regeared ground rent provides an income of say 120% of the “development rent”.

So far as the ongoing ground rent is concerned, the landlord should include a “viability test”.  There is a number of ways of doing this: the simplest is to provide that the tenant may not proceed with the redevelopment if the residual valuation (and of course there would need to be provision for arbitration or independent determination in the case of dispute) produced a gearing percentage which when applied to the market rental value of the new building would lead to a lower rent than – say again 120% – of the “development rent”.

As I have said, these provisions are not straightforward but I have, in conjunction with my friend and colleague, surveyor William Killick (he does not have a website but can be contacted through me), who I believe knows more about ground rents than any surveyor I have worked with and has very kindly vetted this blog post for me, have granted quite a number of leases on this basis, mostly in the City of London.

The initial reaction of the developer/tenant and his solicitors is almost invariably that the document is too long and too complicated (brevity and simplicity are considered a virtue in the property industry) but the fact is that it achieves a result which provides flexibility for the tenant with downside protection for the landlord and avoids the kind of stalemate to which I have already referred. The common practice of simply ignoring these issues is akin to burying one’s head in the sand and is in nobody’s best interests – particularly as ground leases get longer and the number of potential redevelopments/refurbishments increases.  The contingencies must be covered and not ignored.

The ShardComments from ostriches welcome!

Conclusion:  rather than seek to prohibit redevelopment entirely in a relevant lease, the landlord would be better advised to allow redevelopment whilst imposing conditions on it including a provision for a ground rent review based on a current (at the date the tenant proposes redevelopment) residual appraisal.

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