Mike McChesney discusses the implications for lease-end negotiations of forthcoming changes to the General Permitted Development Order
The proposed changes to the General Permitted Development Order due to come into effect in spring 2013 will allow a change from B1(a) offices to C3 residential use without the need for permission (see pp52 and 94 for further detail). The move is intended to support economic growth and help to tackle the housing shortage. It is hoped that it will be a simple and effective solution, but it will also bring some interesting consequences for landlord and tenant lease-end negotiations.
Common conundrum
It is a frequent landlord challenge on secondary office buildings in locations where demand and rents are low: the occupational lease ends, leaving a vacant building. What should the landlord do with it?
Major refurbishment is often needed to maximise the chances of re-letting. However, it often isn’t viable given expected rental levels, market incentives and inconsistent demand. There will be a dilapidations claim against the outgoing tenant but it doesn’t always make sense to undertake the work because some of it may be superseded and both refurbishment and dilapidations works may be difficult to fund.
Landlords often choose to look for a tenant and offer an incentive or undertake works when one is found. Occupiers tend to gravitate to the ready-to-go options, making letting deals challenging. This strategy doesn’t help evidence the dilapidations claim against the former tenant, who, not surprisingly, argues about proof of loss. The prospect of obtaining planning consent immediately for a change of use is slim owing to restrictions on loss of employment use. As a result, the parties will usually have different views on lease-end negotiations from a one-dimensional continued-office-use perspective.
A similar situation is common on surplus occupational property where the tenant is no longer in occupation but there are a few years left to run on the lease. In discussing a surrender, the landlord and tenant can quantify outgoings until the end of the term and both are generally prepared to take a view. The sticking point, however, is often dilapidations and the landlord’s realistic options for continuing to generate income from the building in the absence of a new tenant or alternative use solution.
Change brings opportunity
Not all lease-end scenarios are this bleak, but a visit to many town centres will reveal redundant office accommodation that has little chance of being brought back into commercial use. Conversion of offices to residential is not always feasible, but the scale of supply of such buildings suggests that there will be numerous possibilities worth investigating.
In many locations, the residential demand will be for affordable housing, making housing associations an obvious contender at a time when many will have bid for and received grant funding that must be committed to completed projects by March 2015.
Where an office building is suitable for residential conversion, the proposed planning changes should help landlords and tenants to find a catalyst to bridge the lease-end negotiation gap. Mutual advantage can be obtained and shared in lease surrender negotiations. Landlords will have a clear alternative to continued office use and tenants will have a resulting reduced dilapidations liability.
Valuation
As a result, the emphasis in many lease-end dilapidations and surrender negotiations will shift from cost of works to valuation analysis of residential conversion versus continued office use differential. Section 18(1) of the Landlord and Tenant Act 1927 limits dilapidations liability in some circumstances, such that the actual landlord’s intentions and, just as importantly, a potential purchaser’s view in a hypothetical sale, are relevant in determining dilapidations liability.
Some cases will be clear-cut and will either support or have a significant impact on the dilapidations liability. In many cases, the differential will be marginal and such instances will spark an interesting debate. The starting point will be the physical viability of conversion: some buildings will more easily lend themselves to adaptation and any external alterations will need consent anyway. Then an analysis of demand, end sales values, conversion costs, and all the usual residual development appraisal inputs.
In comparing this to office values, rental levels and refurbishment costs will be important, but the most critical variable will be the realistic letting void. If a building can be let within a certain timeframe then the office value will be higher, if the void goes over a certain threshold then residential wins.
Detail
As is often the case, some of the detail on the new measures will need to be ironed out in practice.
There is the possibility of size restrictions, although it seems that this is more likely to apply to small buildings to prevent erosion of stock for small businesses, leaving larger buildings unaffected. The effect of noise and transport will need to be addressed. Any external building modifications, such as re-cladding or adding balconies, will still need planning consent.
Local authorities such as the City of London, Westminster and Kensington and Chelsea have said that they will seek an exemption. The deadline for this is 22 February 2013 and will only be granted in exceptional circumstances and on the basis of economic justification. Thus far, requests in the locations where there is an oversupply of secondary office stock have not been made, suggesting that the changes are likely to become a reality.
Moreover, there is no provision for local planning authorities to seek section 106 contributions for open space, education, healthcare and affordable housing, which will limit conversion costs and hence increase the viability of such schemes.
Early mover advantage
The change will be for a period of three years only and, consequently, any converted residential units will have to be occupied before the end of that period. Thereafter, the policy will be reviewed, but there is no certainty that it will be extended.
The opportunity will be relatively short-lived given the lead-in time for appraisals, funding, conversion and end sales/lettings. As is often the case, the first movers will maximise their advantage. Tenants may be able to persuade landlords that there is a one-off mutually beneficial exit opportunity. Owners of secondary office buildings may be able to find a solution where re-letting prospects are limited.
An early desktop review of imminent potentially vacant office buildings and residential conversion viability should be high on the to do list for both owners and occupiers.
Mike McChesney is a director at Deloitte Real Estate
