Dan Norris and Dion Panambalana discuss the importance of profit-share arrangements in maximising land value for sellers
On a sale of land, a seller can benefit from any future uplift in value in the site for a number of reasons. Possibly, because the purchaser obtains a planning permission or a more valuable consent, or because a development is carried out more cheaply, and/or is worth more at the end than anticipated. Additionally, the property market may be at a stage in the cycle where, within a reasonably short period, extra profit is generated for no reason other than the improvement of the market. All of these profit-share issues can be dealt with by appropriate overage and clawback provisions entered into on a sale.
Terminology
People use the terms overage and clawback interchangeably. Strictly, both overage and clawback mean the ability to share in profit from the land after its sale but, for the purposes of this article, “overage” will refer to sharing in increased value due to the development of the land and “clawback” will refer to sharing in any increased value due to events triggering or crystallising an uplift. For example:
- Planning clawback would be a share in the extra value created by obtaining planning permission for a specified use, a more intensive use or just for any use which makes the land more valuable.
- Disposal clawback could be triggered by any land sale, or change of control in the buyer or subsequent owner during the clawback period.
- A profit share based on the difference between the end value of the developed land and the costs to develop the land would be an overage payment.
Planning clawback
This could be triggered by a number of events. The first is a planning permission that intensifies the anticipated use. The seller might start off with permission for, say, 200,000 sq ft of offices. If the buyer can intensify the use and obtain a planning permission for more square footage, the grant of that consent might trigger a further payment. This is often calculated as a predetermined sum multiplied by the additional square footage.
Alternatively, there may be no prior planning permission and the planning clawback is simply based on the grant of any planning permission which increases the value. Or, the planning permission may relax the existing permitted use or change use entirely.
Some contracts define market value in detail, others simply refer to the RICS valuation guidelines. Very occasionally, contracts have no definition and leave it to the parties to agree or have the matter determined by an expert.
In all cases, you will need to decide whether the clawback trigger is the grant of the planning permission, the expiry of any challenge period or the resolution to grant – most commonly, it is the grant – and whether it requires an “outline planning permission” or a “detailed planning permission”. Usually it is the outline permission, but not always.
Planning clawback linked to the grant of a residential planning permission may be calculated by reference to the number of units (excluding social housing) for which consent is obtained as well as to the commercial element in a mixed use scheme.
Clearly, as with most profit-share arrangements, there needs to be an incentive for the buyer to maximise the value from the site.
Disposal clawback
This shares an increase in value not usually related to anything that the buyer has done. Often it is inserted for best value reasons (public sector) or shareholder value reasons (private sector) and is commonly termed anti-embarrassment. A clawback period of about five years would be normal, but there may be good reasons why this period should be longer or shorter. Similarly, it may be that all disposals for value will trigger uplift payments, or just the first disposal.
Consider carefully what sort of disposal actually triggers the payment. Obvious disposals are freehold sales or long leasehold disposals for value. Rack rental deals or disposals of land for utility occupation such as electricity substations will not usually trigger a payment. Also consider whether a change of control in the shareholding of a company should trigger a disposal payment and how you deal with disposals of interests in limited partnerships.
Overage
This is typically a payment due when the parties have a good idea of exactly what is going to be developed and have an interest in maximising the value of the scheme and minimising the cost without compromising the quality. A seller may want to maximise the short-term gain and payment, as might a buyer/developer. Conflicts may arise if the buyer has externally funded the scheme and a long-term investor or funder wants to maximise the long-term value.
There is likely to be a long list of project costs that will be subtracted from the final market value. Examples include the land price, construction costs, finance costs, unrecovered VAT and marketing and letting (but not disposal) costs. Any project income, such as from scaffolding advertising, is offset against the project costs.
Once the development is complete, it needs to be valued. Usually, this will be done reasonably swiftly after substantial completion of the scheme, often within 12 months as most of the project costs will have been agreed or determined by then. (Delays in project accounting can occur due to issues to be resolved between the developer and its contractor, eg liquidated damages, variations and extensions of time.) Similarly, the value may be more easily crystallised at that point when the letting situation has settled down.
There is usually a market valuation of the buyer’s interest in the scheme on the assumption that it has not made any disposals (other than first lettings). Typically, the project costs are then subtracted from the value and whatever profit share is being used results in a payment to the seller.
On a residential scheme, often the payment is linked to the number of completed homes and the prices achieved for them, less homeowner incentives.
Share of profit
This is to be determined by commercial factors such as the bargaining position of the parties, the state of the market and the peculiarities of the land. However, the buyer should be incentivised to enhance the land value and, as such, that should be reflected in the percentage shares. Issues that influence the percentage share include:
- the base value may already reflect either a profit for the seller, or a sale at a discounted price to the buyer;
- the buyer may have tendered for the land on a competitive tender and offered a lower percentage share than normal;
- the seller may be involved in helping to maximise the land value;
- the seller may have already achieved a base planning permission not reflected fully in the sale price, thereby assisting the buyer from day one in its ongoing efforts to maximise value.
Buyers’ ongoing obligations
The obvious ongoing obligation after sale would be to obtain a planning permission. Usually these obligations are not too onerous as it is in the interests of the buyer to maximise value, particularly where the buyer has a significant share of the additional value. However, there may be ongoing design and marketing obligations in relation to, for example, a development in which the seller will receive an overage payment. Similarly, there may be obligations to find tenants for the scheme in order to maximise the development value, or indeed to maximise any anticipated disposal value.
Seller protection
The ideal solutions for protecting clawback and overage include a charge (usually subordinated to a development funding partner’s security arrangements), a restriction and deed of covenant, a restrictive covenant, bank guarantee, overlapping headlease, joint venture structure or (if practicable) a ransom strip. To the extent that these are imposed simply to protect the overage, then, again, the size of the overage or clawback payment is relevant to the extent to which it is reasonable to fetter the land following the sale.
A common way of protecting any clawback or overage payment is a restriction on the title preventing a disposal without a certificate from the seller’s solicitor confirming that any overage or clawback payment has been made. Commercially, this is often felt to be the most appropriate way of proceeding, certainly if the buyer’s covenant status is either significant and/or of good repute.
With development funding on the increase, profit-share arrangements are set to make a comeback. They can be notoriously difficult to draft and enforce, which is why it will always be important to include a disputes clause.
Why this matters
Profit share arrangements can be an important element of capturing potential land value. This will be particularly relevant for sellers such as public sector bodies where there is accountability for obtaining best value for assets.
Without some kind of ability to share in any future uplift in value, disposals may be subject to public scrutiny as to whether the best price was obtained. No seller wants to face criticism that they have undersold assets.
Where land clearly has development potential, profit share arrangements can be a useful solution to unlocking value. However, profit sharing is not always appropriate. Documenting the arrangements can be an expensive process as the clauses can be complex and extensive. Part of their aim is to anticipate trigger events and provide for every eventuality. The more remote the potential release of profit, the more difficult it becomes to foresee and provide for the actuality.
Case law has highlighted how difficult it can be to document complex overage payments and how often disputes can occur. For example, in George Wimpey UK Ltd v VI Construction Ltd [2005] EWCA Civ 77; [2005] PLSCS 15, the Court of Appeal refused rectification of a complicated formula after one party failed to notice that a crucial part was missing.
Most disputes, certainly in relation to value and development cost, can conveniently be referred to an expert, often an expert surveyor. In Walton Homes Ltd v Staffordshire County Council [2013] EWHC 2554 (Ch); [2013] PLSCS 231, the amount of an additional payment depended on whether the property had planning permission at the date of the valuation. A dispute arose as to whether planning permission should be interpreted literally, referring only to the planning decision notice, or whether it would include the recommendation of the planning officer that permission should be granted. The expert surveyor considered that a literal interpretation was “commercially absurd”. His decision was challenged on the ground of manifest error, but the High Court disagreed. In reality, the opportunity to challenge on the basis of “manifest error” was very limited indeed.
Dan Norris and Dion Panambalana are partners at Hogan Lovells
