Rights to light ‘tax’ reimagined

Should developers revisit the rate at which they are settling rights to light negotiations? People often talk about the rights to light “industry”. They call it that because it is mostly about generating money. If you have a right to light that a nearby development is going to infringe, then you can expect to receive a payout from the developer, agreed within the framework of actual or threatened litigation. The end result is a “tax” on the development, facilitated by litigators and paid for by developers. Without major legislative reform, that situation is not going to change. But developers might want to re-visit the rate at which they are paying this tax, because it is likely they are paying it at too high a rate, based on a mistake in the conventional thinking about how to map the law of damages onto the finances of property development. Background theory The basic legal principle that underpins the rights to light tax goes like this. If the development is going to infringe rights to light, then the owner of the rights can claim an injunction to prevent it from going ahead. But the court has the power to refuse the injunction, and in many cases will do so because the adjoining landowner normally wants the payout more than it wants the light. In lieu of the injunction, the court can award damages. The basic rules for quantifying those damages are not in doubt. The court is required to envisage a hypothetical negotiation. It is taking place between two reasonable people. One of them is in the position of the owner of the rights to light. The other is in the position of the developer. The question is: what would these reasonable people agree as the price for the relaxation of the rights to light to permit the development to go ahead? The price they would agree is the quantum of the damages, and therefore the amount of the rights to light tax. So far, so good. But the problem comes at the next stage of the analysis. The next question is: what are the principles that these reasonable people would use to identify the price for the relaxation of the rights to light to permit the development to go ahead? The conventional thinking about this, endorsed in decisions like Tamares (Vincent Square) Ltd v Fairport [2007] EWHC 212 (Ch); [2007] 1 EGLR 26 and Beaumont Business Centres Ltd v Florala Properties Ltd [2020] EWHC 550 (Ch); [2020] EGLR 20, is that you begin by working out the likely profit the developer would expect to make from carrying out the development. You then reason that the release of the rights to light is the key to unlocking that profit. If the rights to light are not released, the developer cannot make the profit. But if the rights are released, the developer can make the profit. The adjoining landowner, therefore, would demand a share of that profit as the price for granting the release, and the reasonable developer would agree to that demand. They would not split the profit 50:50, because the developer is going to have to take risks that the adjoining landowner will not. So the conventional wisdom is that the adjoining landowner will ask for one third of the profit, based on the one third split first proposed in Stokes v Cambridge Corporation (1961) 13 P&CR 77, and the eventual deal will be somewhere at or around this level. Financial context Superficially, that might seem an entirely reasonable approach. But the problem is that it misunderstands the basic financial principles underpinning property development. Any developer thinking of investing in a development site will carry out an appraisal of the potential development. Development appraisals differ in their detail, but they all work along the same essential lines. You start by estimating the value of the completed development. This is termed the “gross development value”, or GDV. Secondly, you then deduct from this the costs that are going to have to be incurred in order to create that GDV: the construction costs, the costs of financing the works, and so on. Thirdly, you then deduct a sum called the “developer’s profit”. The developer’s profit is almost always a percentage, sometimes of the GDV but more usually of the construction and finance costs. The exact percentage depends on the level of risk involved in carrying out the development. In order to carry out the development, the developer is going to have to invest capital, either its own or borrowed. That capital is then being put at risk. All property development involves risk: there is a risk that the GDV will not be as high as you have predicted, and a risk that the construction costs will not be as low as you have predicted. In order to put your capital at risk, you need to make a minimum return on it. A return-free risk is not a risk that is ever worth taking. The developer’s profit in the appraisal is the minimum required return on the capital that is being invested and put at risk, bearing in mind the characteristics of the particular development. That is why the developer’s profit is usually expressed as a percentage of the capital that is going to have to be invested in the development. Finally, the sum that is then left over after these deductions have been made is called the “residue”, or “residual value”. Conceptually, the residual value is the value of the opportunity to invest your capital in carrying out the development, which will involve putting that capital at risk in the hope of achieving the developer’s profit. If the residual value is negative, then the opportunity to invest your capital in the scheme is not worth anything. But that is not necessarily the same thing as saying that the development is going to be loss-making. You can have a large amount of developer’s profit in an appraisal, and still have a negative residual value. What a negative residual value is telling you is that the development is not expected to be profitable enough for it to be worth putting your capital at risk in it. What the conventional approach in cases like Tamares and Beaumont does is to take the total profit that the development is expected to make, and then to split it between the developer and the adjoining landowner. But that fundamentally misunderstands the nature of the developer’s profit. If you take away any part of the developer’s profit, then you necessarily reduce it to a figure that is less than the minimum required return on capital. If you reduce the developer’s profit below that minimum required return, then the developer can no longer justify putting its capital at risk in the development, with the result that the development will not proceed. It is therefore a nonsense to say that, in the hypothetical negotiations for the release of the rights to light, the developer will be willing to share any part of the developer’s profit with the adjoining landowner. If the developer has to do that, then the development will not proceed and the release will not have been worth anything. It follows that the conventional approach to rights to light damages cannot be the correct one. A different approach There is, however, a different and better way of approaching this question. The fact that the developer will not be prepared to share the developer’s profit with the adjoining landowner does not mean he will necessarily be unwilling to pay anything for the release of the rights to light. One way of looking at the residual value in the development appraisal is that it is a measure of the profit that you would expect to make from carrying out the development, over and above the minimum required return that you would need to achieve in order to be prepared to invest your capital in carrying out the project in the first place. In substance, the residual value represents the excess return that you predict the development to generate, after you have accounted for the minimum required return on the capital that needs to be put at risk. The residual value is therefore, in principle, the sum that the reasonable developer would be prepared to split with the adjoining landowner as the price for the release of the rights to light. In most development appraisals, the residual value will be far less than the amount of the developer’s profit, given the highly capital-intensive nature of property development. A third of the residual value will therefore normally be far less than a third of the total profit that the development is expected to generate. It would be worth their while for developers to revisit the marginal rate at which they are paying this particular tax. Mark Sefton KC is a barrister at Falcon Chambers Photo © Teddy O/Unsplash