by Bill Simpson and Richard Reuben
In these uncertain times, the option agreement is becoming a valuable tool in enabling the landowner and the developer to work together to maximise development potential.
As a general rule, option agreements have tended to be regarded as good news for a developer and bad news for a landowner. This is generally not surprising as the word “option” indicates that a developer can walk away from the agreement, even if the conditions precedent are met. During the period of the option, the developer has control over the land in planning terms and there is, therefore, an uncertainty regarding the landowner’s mid-and long-term use of the site. Landowners are therefore rightly cautious about option agreements — there should be a government notice “Warning: options can damage your wealth!”
There are nevertheless real advantages of an option agreement for the landowner. The first is where the landowner has no resources or knowledge of development and planning processes and is content to allow a specialist in that field to have the opportunity to achieve planning permission. This will substantially enhance the value of the underlying asset. In return, the promoter can acquire the land on preferential terms which normally means at a (small) discount to open-market value.
The second key advantage is that, in the current market, an option is a more realistic method of obtaining the benefit of the developer’s skills to enhance the value of land. In this way, large tracts of land can be held by development companies, particularly residential developers, at little initial cost and often on the basis of a long-term view. Thereafter they should reap the benefits when development takes place.
Option agreements tend, therefore, to be used where there is longer-term development potential and where the landowner wishes to be a passive partner. This is particularly true when there are market uncertainties. The alternatives are a joint venture, a conditional contract or an unconditional contract. Each has implications in terms of quantum expected, risks, rewards, time-scales and tax efficiency.
The typical characteristics of an option are:
- An initial payment made to the landowner.
- The landowner has little direct involvement in the planning process, and does not carry the costs.
- The trigger is an acceptable planning permission.
- Price is determined when planning permission is achieved and is dependent upon market conditions at that time.
- Reliance upon the option holder to achieve the best planning consent.
- Time-scale depends on the likelihood of achieving planning consent, which could be from one year to 10 years.
Each agreement is unique — the nature of the parties, their financial positions, the property and the underlying planning potential will all differ from case to case. However, as the basic components of agreements are similar, we have created a hypothetical situation to illustrate the different stages of the “life cycle”.
The approach
R & S Properties has identified a development opportunity on a particular parcel of land and approached the landowner (Satanic Mill Co — SM). How should SM respond?
Before entering into any negotiations, the company must be clear on several points:
- With whom would the company be dealing?
- What are the development opportunities for the site?
- Are there other companies who would be prepared to bid on a similar or different arrangement?
- Is an option agreement the best route for SM?
- What are the valuation implications?
- What are the tax consequences?
Thorough background knowledge of the implications of the approach is the key to successful negotiations, and it is the task of the professional team to ensure that the client has all the answers.
The negotiation dance
As R&S approached SM, the onus is on the developer to make the running and put forward reasons to justify its proposals. Approaches from developers are often speculative and SM is in a position to dictate terms and make its own rules (negotiating strength should lie with the landowner).
During this early period, SM should investigate the people behind the approach, their intentions and the general implications of their proposal. There will be an opportunity to investigate thoroughly the planning potential for the site and, of course, consider the question of whether the development potential can be generated through its own development team.
These considerations will be investigated at the same time as the negotiation dance. The following points must be considered before terms of the option agreement are concluded:
- Option payment: the quantum and whether it is deductible from the eventual sale price.
- Valuation provisions: in particular, reference to the basis of valuation, and determination provisions should the parties fail to reach agreement. These are critical and must be closely scrutinised.
- Method of payment: beware of proposals for deferral or staging of payments in tranches as these can substantially devalue the capital receipt.
- Option period: this has to give R & S Properties sufficient time to achieve planning permission and trigger the option but must not tie up the property for too long (beware of provisions extending the option period beyond that already fixed).
- Planning permission trigger: R & S Properties must be under a duty to achieve the best commercial planning permission for the site, ie that achieving the highest value within the planning framework, normally defined as a satisfactory permission. The permission obtained must be consistent with any continuing interest that a landowner has in any neighbouring property. The landowner’s advisers must monitor the planning applications throughout the option period, leaving no doubt that what is achieved complies with the requirement of “best commercial planning permission”.
The engagement
The parties are happy that they can live together with an option contract. SM has been persuaded that R & S Properties can achieve a more valuable planning permisson on the site than it could, and in return for carrying the risk R&S will be able to acquire the land on the terms agreed.
The provisions of the contract must stipulate the method and terms by which the land is sold and determination of value, otherwise there are opportunities for the option contract to favour R&S.
Other considerations which could lead to problems if they are not sorted out in the early stages are:
- Taxation implications: For capital gains tax purposes the grant of an option is technically a separate disposal from the disposal of land, but the Inland Revenue often treats the grant and disposal as one transaction, particularly when the payment is small and/or the option is of relatively short duration. VAT questions also arise. If the landowner exercises the option to tax at the time when the option is granted it follows that the sale price must also carry VAT. If, however, the purchaser intends to develop the property himself and occupy it for the purpose of a VAT-exempt business, the issue is very important. Therefore, both CGT and VAT must be considered at an early date with advisers to ensure the best treatment.
- Environmental issues: If SM has operated on the site for many years, there may be deposits of materials or effluent from former use and any suggestion of warranties from the landowner should be avoided. The question of contamination surveys has become a separate issue in itself. Each situation is unique, but the point should be borne in mind as it could affect value and potentially longer-term corporate liability.
- Financial incentives: Once the planning permission is obtained there must be no delay in setting the value and the sum payable to SM. If agreement cannot or is unlikely to be reached, the sooner the matter is referred for determination the earlier quantum is fixed and payment made.
The marriage
The satisfactory planning permission enables the option to be triggered. The permission, of course, runs with the land and is of immediate value to the landowner. The marriage ceremony is the exercise of the option. As long as the landowner’s advisers have been doing their homework, they will be aware of what this means in cash terms — there should be no surprise in this final stage of the option agreement when the valuation takes place.
The sting
The valuation provisions will dictate the basis at which the price is arrived. It is at this point that the importance of the valuation provisions is realised, in particular, the approach made to section 106 agreements, infrastructure costs and other planning gain costs. For this reason it is important that the landowner’s surveyors keep a close eye on the terms of the planning applications made.
These discussions can take time to resolve, and as a last resort may require arbitration.
However, with thorough professional advice, the final net sum payable to SM should have been worth the discussions and negotiations and will have achieved a much better result in the longer term than an early sale without planning permission (assuming market conditions remain static).
Both sides are rewarded for their risk and enterprise — the basis of a good deal!
