Summary and implications
As we have already seen*, mixed-use buildings are increasingly common in the commercial investment market. The potential complications associated with the residential element of such buildings mean that investors in mixed-use properties need to consider the structure and implications of any residential element before they invest.
The acquisition of a mixed-use property needs to be treated with caution even where the residential element looks to be ancillary to the main commercial use. The degree of caution required depends very much on the nature and structure of the residential elements.
There are three common structures for mixed-use buildings comprising long residential leases (generally of 99 years or more) with a commercial rack rent lease:
- the clean freehold investment;
- the developer-manager model; and
- the democratic model.
This article looks at these three structures in more detail and considers some of the statutory rights afforded to residential long leaseholders that can affect the freehold investment.
Structure
The residential element of mixed-use buildings will often comprise long leasehold interests which have been sold off at a premium, in order to strip value out of the freehold. In this case, the freehold investor's income will comprise any ground rent reserved under the long leases and rents receivable under the commercial rack rent leases. Proper structuring can reduce the potential issues around this type of investment.
a) The clean freehold investment
In order to create a clean freehold investment, the residential element, structure and common parts of the building are often let to a residential management company on a long lease at a peppercorn rent. In order to achieve a clean freehold investment, it is important that all of the common parts are included in the lease to the management company.
Modern, purpose built, mixed-use properties tend to adopt this approach, in which the long lease (or agreement for lease) in favour of the management company is put in place before any of the long residential leases are granted. You may also find this structure adopted in buildings with a large number of long residential interests where the day to day management can be more efficiently run through a specialist residential management company.
The clean freehold investment
From a management point of view, the freeholder's involvement in residential matters is limited, which is welcome news to a predominantly commercial investor with little residential knowledge. The management company can be required, by way of the covenants in their lease, to collect the ground rent and insurance rent on the freeholder's behalf and pass those sums up to it.
This structure gives a clean freehold investment because it can be sold to a third party without the need to consider the rights of first refusal afforded to residential long leaseholders under the Landlord and Tenant Act 1987 (LTA 1987) (which is considered in more detail below), making this structure an easily transferable interest. Note, however, that the other statutory rights specific to long residential leases will still apply as discussed in more detail below.
The freeholder can retain control of the commercial rack rent space by excluding it from the demise to the management company. The freeholder will then receive the rack rent direct but will need to contribute towards the service charge. However, the service charge element should, if carefully drafted, be recoverable from the commercial tenant.
b) The developer-manager model
The most common structure for mixed-use buildings is one where the freeholder itself grants the long residential leases to the residential long leaseholders, without interposing a long lease to a management company. The freeholder then lets the commercial space to the commercial tenant direct on a rack rent basis.
This structure is often used where a developer intends to build a mixed-use property and retain and manage it themselves. It is not usually the intention that mixed-use properties structured in this way be marketed as a freehold investment.
In practice, a freehold investor faced with this structure will often contract with a specialist management company to provide the services and manage the building on its behalf. Note that this is different to the clean freehold investment structure referred to above as no proprietory interest is transferred to the management company at any stage. The relationship here is purely contractual, usually by way of a management agreement. It is important in this case that both the commercial and residential leases provide for the landlord to provide or procure the provision of services to the building. This ensures full recovery under the residential service charge.
Assuming that the building qualifies and that there are sufficient qualifying residential long leaseholders, the sale of this type of freehold investment is likely to be subject to the right of first refusal afforded to residential long leaseholders under the LTA 1987. This can potentially affect investment values and inevitably creates delay and administrative costs complying with those rights on a sale or other disposal of the freehold.
c) The democratic model
The democratic model
A less common model (possibly because it is unpopular with residential long leaseholders who are generally not interested in managing the building themselves) is to form a special purpose vehicle (SPV) for the sole purpose of managing the property. A share or shares in the SPV are issued to each unit upon sale, until all of the units are occupied.
The SPV will usually be a party to the long residential leases and the commercial rack rent leases for the purposes of contracting with the landlord, the residential long leaseholders and the commercial tenants to provide the services. The SPV will have a corresponding contractual right to collect the service charge from the residential and commercial tenants.
Under this structure, the residential long leaseholders and the commercial tenants will effectively be in control of the management of the property and the freeholder investor will be left with little or no involvement. This may sound appealing to some investors but a prudent freeholder would be advised to retain a share in the management company with voting rights so all control is not lost.
Statutory rights benefiting residential long leaseholders
The significant statutory rights attaching to long residential leases which can potentially impact on the freeholder's investment are the right to first refusal, the collective right to enfranchise, and the right to a lease extension.
a) Right to first refusal
The LTA 1987 gives long residential leaseholders a collective right of first refusal. This means that if the immediate landlord of residential long leaseholders wishes to dispose of its interest in a property, it must give all qualifying leaseholders the opportunity to acquire that interest first. Note that it is not possible to enter into a contract conditional on the expiry of the notices, as exchange of contracts (conditional or not) is a disposal for the purposes of the LTA 1987.
Qualifying leaseholders must be served with a notice of the landlord's intention to sell the property specifying the intended sale price. It is only when those notices expire that the landlord is then free to contract with the third party purchaser for the sale of the property. The length of notice depends on the nature of the proposed sale. For example, a private treaty sale requires two months' notice but a sale by auction requires three months' notice. Any change in the terms of the proposed sale is likely to require fresh notices to be served and the notice period will effectively then be re-set.
Qualifying leaseholders
For the purposes of the LTA 1987, a qualifying leaseholder is a tenant under a tenancy other than:
(a) a protected shorthold tenancy as defined in section 52 of the Housing Act 1980;
(b) a tenancy to which Part II of the Landlord and Tenant Act 1954 (business tenancies) applies;
(c) a tenancy terminable on the cessation of his employment; or
(d) an assured tenancy or assured agricultural occupancy within the meaning of Part I of the Housing Act 1988.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.