Charles Anderson and Henry Stevens present a guide for advising investor tenants on the issues raised by long leases of part of premises
Long leases of commercial properties are a common feature of the investment market for prime London real estate. Estate and institutional freeholders have typically granted 125- or 250-year leases to developers and investors, often equity sharing or side-by-side leases.
Most such leases were of whole sites or buildings. Traditionally, grants of long leases of part were relatively rare – principally shopping centres and premises over transport hubs. However, the current market is increasingly seeing the creation of separate interests for development, investment or owner-occupation, with commercial use at lower floors and residential at upper floors; examples include leisure, education and private rented sector (“PRS”) investment schemes.
Such transactions bring together commercial and residential developers, investors and occupiers, in effect “sharing” an acquisition cost and each acquiring a major interest. One party may acquire the freehold, with the other being granted a long lease of part; commercial considerations, largely based on the respective extents or values of the commercial and residential premises, determine which party takes the freehold.
Although there are many sophisticated forms of long-term commercial lease of whole, there is little by way of an institutional form of long-term commercial lease of part and there may be less appreciation of the provisions required. For example, standard forms of certificates of title will need to have bespoke provisions relating to such leases. The parties may be tempted to adapt a short-term rack rented commercial lease rather than a more appropriate starting point, such as a long lease of a valuable apartment.
Particular points to be covered in the lease include:
Premises
Generally the premises will be the internal non-structural parts of the building. There must be a satisfactory definition of the structure of the building to ensure adequate tenant rights for:
- support from the structure;
- entry to undertake repair works to the structure in the event of landlord default; and
- entry to undertake redevelopment works which may affect the structure.
Use
The user clause should be as wide as possible, but should include a tenant obligation not to cause nuisance to other occupiers. There should be careful consideration of use restrictions where commercial uses may be active outside normal business hours.
Dealings
Controls on the tenant’s rights to transfer and underlet the premises should be limited. Any requirement for freeholder consent should be subject to the
provision that it will not be unreasonably withheld.
Generally an institutional lease will prohibit a transfer of part but this might not be appropriate in a long commercial lease. Indeed, a transfer might be preferable to creating an underlease. It is possible to provide for the lease to be “split” by a transfer of part in a way that makes each resulting lease of part acceptable to a funder.
If a lease for more than 40 years is granted in consideration of a tenant’s obligation to develop the property, it might be a “building lease” under section 19(1)(b) of the Landlord and Tenant Act 1927. If so, any requirement for landlord’s consent for underletting is of no effect until the last seven years of the term.
Insurance
It is not unreasonable for the freeholder to insist that it insures the building. The critical issue for the investor tenant is for the insuring, reinstatement and frustration provisions to be in a form acceptable to a funder. It is here that residential leases of part and the Council of Mortgage Lenders (“CML”) Certificate of Title offer guidance.
There should be:
- a freeholder obligation to insure. Ideally a commercial tenant should be joint insured rather than merely noted on the policy;
- a freeholder obligation to claim under the policy, to apply proceeds in reinstatement and to make up any deficiency out of its own monies (or to claim against other tenants whose default has led to monies being irrecoverable);
- provisions to cover frustration, where reinstatement is not possible – the insurance monies and any “top-up monies” paid to cover any shortfall should be apportioned according to the respective interests in the property. The lease might provide that if the building is sold before rebuilding, the sale proceeds will be apportioned on the same basis; and
- landlord’s obligations to comply with insurer’s requirements in relation to any tenant’s contractor’s insurance covering tenant’s works.
The lease should not include provisions more appropriate to a short-term lease such as a landlord’s right to terminate after damage by insured risks.
Management
In relation to the repair of the structure and provision of communal services the investor tenant should ensure there are satisfactory arrangements for:
- freeholder/management company obligations to provide services;
- obligations on all tenants to contribute towards costs; and
- tenants’ entitlements to a shareholding and directorship in the management company.
Redevelopment, refurbishment and alterations
The lease should contain wide provisions for the tenant to redevelop, refurbish and alter its premises. These will necessitate appropriate rights to enter relevant parts of the building.
Tenants should consider the Landlord and Tenant Act 1927. Section 3 allows a business tenant to make improvements notwithstanding any provision in the lease. This is an often-overlooked fallback, though it may involve a tenant’s court application, and the landlord may elect to do the works itself and to charge rent accordingly.
Forfeiture
The forfeiture clause should contain mortgagee protection provisions covering:
- a freeholder obligation to notify a disclosed funder of any intention to take action to forfeit the lease;
- a right for any notified funder to remedy the breach within a reasonable period; and
- an obligation on the freeholder to enter into any “direct agreement” between the landlord, the tenant and its funder as required. Direct agreements create a contractual relationship between the freeholder and the funder, primarily to enable the funder to prevent forfeiture by stepping in and either remedying a breach or procuring a transfer to a satisfactory tenant.
Forfeiture should not be exercisable in the event of tenant insolvency; this would make the lease unsaleable and unmortgageable.
Statutory agreements
Prudent tenants should seek a freeholder obligation to enter into any planning, highways or utilities agreements required if the tenant proposes major works. This may be subject to the tenant indemnifying the freeholder and procuring that each agreement contains a release of the freeholder’s liability on disposal of its interest. The relevant authorities generally insist that the freeholder is a party to the agreement (even if it holds only a nominal reversion of limited value). An express obligation on the freeholder minimises any issues in this respect.
Pre-emption
The investor tenant should consider including a right of pre-emption should the freeholder seek to dispose of its interest.
Mixed-use
Where the building is mixed-use, the following legislation benefiting long-term residential tenants may affect the commercial tenants:
- the right to manage (Commonhold and Leasehold Reform Act 2002): allowing the residential tenants, using their own company, to take over management of the building;
- the right to collectively acquire the freehold (the same Act): the residential tenants’ management company may become landlord to the commercial tenant; and
- the right of first refusal (Landlord and Tenant Act 1987): if the landlord seeks to dispose of its interest the tenants may acquire it and become the direct landlord of the commercial tenant.
Each of these rights requires different criteria to be met, so the relevant legislation should be consulted in each case.
Why this matters
Capital long-term commercial leases of part are an increasing presence in the market. They are often of high value and give rise to complex issues which require sophisticated provisions to ensure they meet the parties’ expectations.
As competition for prime property grows, investors will be looking for ways to maximise returns from their assets. The creation of separate interests in a property by granting long leasehold interests of the commercial and residential parts is one way in which additional returns can be generated.
In granting long leases of part, there are a number of specific issues for the freeholder and leaseholder, including:
Insurance – it is vital that the freeholder and leaseholder insurance obligations are clearly set out in the lease. In particular, the lease should set out how damage or destruction by an insured/uninsured risk is dealt with, and the termination provisions found in short-term leases should be avoided. A leaseholder would want to ensure that the landlord or relevant defaulting leaseholder tops up any deficiencies in the insurance monies so that the property can be reinstated.
Forfeiture – any long leaseholder of part will want to limit the extent of the forfeiture provisions, ensure that the lease is acceptable to a funder, and also include the ability for the funder to remedy any breach before the forfeiture clause is invoked by the freeholder so as to preserve the value of the lease.
Tenant’s rights under a residential lease – the freeholder and commercial tenant need to be aware of the residential leaseholders’ right to manage, the right to collectively acquire the freehold of the building and the right of first refusal if the freeholder wants to dispose of its interest. These rights are subject to certain criteria; a commercial long leaseholder may want to ensure that the commercial/residential leases have been structured in a way that could mitigate the risk of the rights being triggered by a residential leaseholder.
Management of the building – care should be taken in drafting to ensure that commercial long leaseholders are entitled to play a full part in the management of the building.
Further reading
Law Society and CML Certificate of Title
City of London Law Society Certificate of Title
Charles Anderson is a partner and Henry Stevens is an associate at Farrer & Co LLP
