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Exit strategies for property developers facing rights of first refusalBy: Andrew Cooper

When does the right of first refusal arise in favour of residential tenants?It is critical for developers wanting to sell all or part of a mixed-use scheme with a significant residential element to understand how and when the right of first refusal under the Landlord and Tenant Act 1987 arises in favour of residential tenants. The Act gives residential tenants of flats who qualify for a statutory collective right of first refusal to buy their immediate landlord’s interest in qualifying premises of which their flats form part at whatever price the developer is prepared to accept from a potential buyer.

The right catches disposals by an immediate landlord of the whole or part of mixed-use premises that includes two or more flats let to qualifying tenants and where the commercial parts comprise less than half the building’s internal floor area, ignoring common parts. The right will be triggered when more than 50 per cent of these flats are held by qualifying tenants.

If the right arises it will at best substantially impact on timing and delay any proposed sale by the developer. However it also has the potential to frustrate a sale entirely and at worst could result in the developer albeit inadvertently committing a criminal offence, such as contracting to sell conditionally on the qualifying tenants not accepting the landlord’s offer to sell. Critical for a developer to be aware of is that whilr there is still some legal doubt the safer view is it also catches sales and lettings of the commercial parts of which the flats form part.

Accurate measurements of the commercial and residential areas may well be required to determine whether the residential areas exceed the 50 per cent threshold and result in the relevant premises being subject to the right of first refusal. A developer can also be faced with difficult questions as to what comprises the relevant premises being disposed of on developments with contiguous and/or integrated structures and shared facilities and therefore what it should be offering for sale to the relevant group of qualifying tenants. This can give rise to the need to serve separate offer notices in respect of multiple blocks where the right has arisen.

If the right arises then the landlord must follow the potentially time consuming procedure prescribed by the 1987 Act. Only if the qualifying tenants do not accept the landlord’s offer is the landlord then free to dispose of its interest to the potential buyer on the same terms it offered to the qualifying tenants in its offer notice.
Once the right has arisen there is considerable scope for delaying a developer’s receipts from disposals and ultimately its exit from the development. Therefore the developer needs to consider putting in place a legal structure early on before sales start to ensure that disposal receipts, which may be required to service the loan facility that financed the development, become available when expected.

The need to plan early is accentuated because residential schemes are commonly marketed and sold off-plan and it is at the point of exchange of contracts that a buyer of a flat potentially becomes a qualifying tenant, not when the buyer has bought it. Disposals of the commercial space potentially run the greatest risk of falling foul of the right of first refusal because they may only get occupied long after the development has been completed and the residential elements disposed of.

Escalating ground rents in residential flat leases can generate a sizeable income stream on large developments so that the reversion to these flats can be a valuable asset. Therefore the developer’s strategic objective will be influenced by what it proposes to do with these ground rents as well as what it wants to achieve by way of sales or lettings of the development’s commercial space.

Any legal structuring will need to deal with who is to assume management responsibility for the development’s on-going repair, insurance and the provision of services between the sometimes incompatible requirements of commercial tenants, social housing tenants and private residential tenants. Is this to be passed to one of the growing number of companies buying ground rent portfolios, as well as undertaking the role of manager, outsourced to a specialist management company or is it to be undertaken by the developer through an associated management company?

The developer will have to be confident about the ability of any buyer taking on the management responsibility as part of acquiring the freehold in the development. Otherwise the developer runs the risk of incurring reputational damage for developing a badly managed development that it no longer has any control over, yet in which it is likely to retain a substantial vested interest in the commercial space. Conversely, an investor buyer who is only interested in a return on his investment could be deterred by the prospect of having to assume management responsibility.

The developer will require flexibility to respond to changes in market demand and, as circumstances dictate, carry out timely lettings or sales of the commercial units and a disposal of say the ground rents in the flats independently of each other and at different times. In the second part of this article, I will briefly look at some possible alternatives to achieve that.

About the author

Andrew Cooper, Keystone LawAndrew Cooper is a consultant solicitor at Keystone Law

Features December 2013

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