Room with a view – Mixed up in mixed use

Pressure to increase density of development in urban areas and the rise of commercial (typically office) buildings being changed into residential developments, have led to an increase in mixed use developments. Typically these comprise ground floor retail/office uses with residential units above, and possibly even additional income derived from mobile phone masts or other roof mounted equipment. Mixed use can provide potentially lucrative income streams to investors and developers alike. However proper consideration can mean the difference between ending up with a smart investment and taking on a problem lying in wait. 

You first

Our first wrinkle is the Landlord and Tenant Act 1987 (the 1987 Act). Originally designed to give long leaseholders of flats a right of first refusal to buy the freehold of their buildings, it has far-reaching (and we would argue unintended) consequences. The 1987 Act applies where there are at least two flats let to qualifying tenants (which is based on there being a long lease, rather than simply a tenant’s actual occupation of a flat).

In addition, for the 1987 Act to apply the floor area of the commercial space in the building, excluding common parts, must be less than 50% of the overall total. This is particularly worth bearing in mind if the owner plans to reduce the commercial space by converting it to residential as a building which was previously outside the 1987 Act may come within it.

If the conditions are met, then the landlord must first offer the tenants the opportunity to buy the property comprised in a ‘relevant disposal’. The 1987 Act lays down a prescribed timetable for service of notices, for the tenants to respond (and, if they wish to proceed, to nominate a purchaser/purchasing vehicle), and for the sale to either proceed under the pre-emption arrangements or for the pre-emption to lapse. During all of this process the seller cannot negotiate with another buyer (even on a conditional basis), until after the expiry of the statutory pre-emption period. Failure to comply with the relevant procedures gives rise to both:

• criminal sanctions against the seller including substantial fines; and
• the ability of the flat leaseholders to effectively undo the transaction by compelling the third party to convey the relevant interest to them on the same terms as it was sold to that third party. It should be noted in particular that there is, in effect, no limitation period on the tenants’ right to exercise that compulsory purchase power which means they can secure any uplift in value, between the date of the original transaction and the date they exercise their rights, for free.

What makes the 1987 Act particularly difficult for landowners is that, as well as there being no ability to ‘contract out’ of its effect, the meaning of the phrase ‘relevant disposal’ has been interpreted as extending not only to an outright sale of the building but also to:

• the grant of a long lease of the building as a whole
• a lease of the air space above the building. This could be to erect a mobile phone mast (something which the new electronic communications code proposes to remedy for the benefit of mobile phone operators) but could equally apply to allowing a third party to develop the air space for additional residential units
• a lease of common parts which are to be converted to residential use
• arguably, the grant of the lease of a commercial unit in the mixed use building. We say arguably as, so far as we are aware, the point is actually untested in the courts. It is unclear in practice how a right of first refusal under the 1987 Act can sit with the rights of an occupying commercial tenant who has rights to renew their commercial lease under the provisions of the Landlord and Tenant Act 1954.

Sold?!

Even if a landowner has no plans to sell, it may well be manoeuvred into having to do so under another piece of legislation, the Leasehold Reform, Housing and Urban Development Act 1993 (the 1993 Act). This gives qualifying tenants (and here the rules are different and additionally the qualifying residential floor areas must comprise at least 75% of the total area of the building) the right to come together and serve notice on the landlord requiring it to dispose of the freehold of the property to the tenants. Again there is an involved statutory process to be negotiated, as well as procedures to enable the value to be determined where it cannot be agreed between the parties themselves.

In practice, where the commercial units are let at full rack rentals, it is unlikely flat owners will exercise the right to buy, on the basis that they will have to pay full market value for the building which may well prove beyond their individual or collective means.

As well as being able to buy the building outright, under the same legislation qualifying tenants also have the right to seek a statutory extension to their leases, a right usually exercised before the lease length falls below certain thresholds that affect its mortgageability. From an investment perspective this can be lucrative, as the tenants will have to pay a premium for that extension. Nonetheless, the negotiation process, and the statutory fall-back of applying to the First Tier Tribunal (previously known as the Leasehold Valuation Tribunal) to determine disputes, are different from a negotiation on an investment/commercial lease type basis.

Are you managing?

Another provision introduced by the 1993 Act (and for practical purposes largely the same qualifying criteria apply) is the collective right for tenants to take over the management of the building from the freehold owner. There are some important points to bear in mind.

• Mismanagement is not a pre-requisite of the tenants being able to exercise the right. Provided they meet the qualifying criteria and follow the (slightly involved) statutory procedure, then they can apply to have the management vested in a tenant management company (RTM) at any time.
   
• The management rights only extend to those areas of the building let to the relevant qualifying tenants; the remainder continue under the control of the building owner. In other words, the commercial areas and any residential apartments not let on a long lease basis remain the responsibility of the freeholder of the building or its managing agents / management company. In effect this can lead to a duplication of management and problems with practical issues over who manages what.
   
• The right to collect residential service charges vests automatically in the RTM and the owner will have to hand over any on account sums that the owner or its agent is holding. Furthermore, there are no automatic rights requiring the parties to jointly agree on managing agents or to deliver services in a co-ordinated fashion.

At your service

As if the situation were not complicated enough, a final piece of legislation, the Landlord and Tenant Act 1985, also imposes statutory controls on residential service charges. There are wide ranging restrictions on matters such as levels of service charge, provision of information, duties to consult before agreeing any long term (defined as an agreement lasting more than 12 months) arrangements or incurring costs above a (quite low, particularly in smaller developments) financial limit, all of which will be new to those used to dealing with commercial properties. Sanctions for failure to follow procedure can be serious (at least in financial terms) with cost recovery from tenants being either severely capped or even disallowed completely.

Conclusion

When considering buying or developing a site for mixed use, great thought should be given to the possible impact of the issues outlined above. In some circumstances, careful planning at an early stage can mitigate many of the adverse effects. However, generally this can only be done before a development is up and running or at least has reached certain critical points in its development. Otherwise, a detailed analysis of the risk issues is key, both operationally and financially, as part of a review of the overall viability of any given project.

The content of this article is for general information only. For further information regarding mixed use developments, please contact Charlotte Wormstone or a member of the Commercial Property Team. Law covered as at July 2016.