This text is an extract from a booklet being produced by the College of Law for practising and trainee solicitors on the subject of the Landlord and Tenant (Covenants) Act 1995
The Act is due to come into effect on 1st January 1996 and will affect both existing leases (mainly in terms of limiting an assignor's liability in respect of an assignee's subsequent default) and new leases (privity of contract being effectively abolished).
There has been some discussion in the property investment market as to the likely effect of values of these legislative changes. This section of the booklet attempts to deal with these issues.
Timing of the legislation
Most landlords acknowledge, to a greater or lesser extent, the inequity of an original tenant being liable for the misdemeanours of an assignee (perhaps once or twice removed). Unfortunately, Parliament had chosen, as far as property investors were concerned, the worst possible period - the early 1990's - to attempt to introduce legislation limiting Privity of Contract for commercial leases. The impetus may have been a desire to protect assignors from assignee default during the economic recession, but the various proposals also coincided with the deepest commercial property recession since the war. In the event, the various Bills took so long to culminate in the Act that the economic recession had long since ended (although some individuals may have difficulty in accepting this statement) and the rate of tenant default has now been falling for some time.
In contrast, the 1988 Law Commission's report was produced at a time when interest in the subject of Privity of Contract could hardly have been lower. At that time, landlords/investors were often only too delighted to secure vacant possession by forfeiture or otherwise terminating the lease, so as to relet the property at an higher rent or to undertake development or refurbishment. Companies were generally expanding and tenant default was unusual.
Since the beginning of the 1990s, however, very little rental growth has been evident in the market. Worse than that, many properties have seen their rental values fall over the past five years - in some instances to less than half of their late 1980's value. The capital values of these properties have come, in particular, to rely heavily on the provisions of the typical institutional lease which ensures that the rent cannot fall at review and also on the covenant of the tenant or its predecessor in title.
Without such protection, investors' suffering in the property recession would have been greater. It is therefore not surprising that, despite the sympathy that many of them felt towards smaller tenants (particularly those individuals not in business anymore), they were very reluctant to give up their historic rights. An even greater initial worry was, of course, that legislation might have had a degree of retrospectiveness, possible removing Privity of Contract for all leases, whether new or existing. In no small part due to the lobbying by various bodies representing landlords' and investors' interests, the final legislation represented a generally acceptable compromise.
Underlying this is the expectation by investors that there will not, in the foreseeable future, be a repeat of the falls in rental values which occurred in the most recent five years and the properties which experienced a loss in value at the time were, by definition, let on pre-legislation leases and are therefore unaffected. (Those properties which were either unlet, or had their leases expire at an untimely point, could not benefit Privity of Contract anyway).
What should be clear from the above few paragraphs is that the effect of abolition of Privity of Contract varies depending upon the state of the property market. When optimistic sentiments prevail, security of income becomes a low priority and, conversely, when a recession occurs, investors look towards the contractual obligations contained in the lease to ensure that, at least, their income is unaffected.
Currently, there is a degree of mixed sentiment. Investors are looking forward to a period of rising rental values, but they also recognise that the risks of not achieving such growth are exceptionally high. Nevertheless, it is likely that we are entering a period when the market increasingly focuses on growth and the gradual erosion of the security of income occasioned by the transition of leases under the Act is not explicitly acknowledged in market pricing. In effect, other factors of performance and risk will tend to dominate until, of course, the next down-phase occurs and the market, once again, focuses its attention on the income characteristics of property.
Effect on the market as a whole
Whilst investors were concerned about the impact on individual properties, many institutions (insurance companies and pension funds) were also very concerned about the effect of legislation on perceptions of overall values in the property market. Like all investments, the value of property reflects both the expectation of returns and the risks that such returns may not be achieved. Thus, the abolition of Privity of Contract can alter this relationship increasing the financial loss associated with tenant default and, consequently, the value of property should fall to reflect this. As, however, the legislation only affects new leases in this respect, the effect will be gradual and spread over a long period. It will probably take in the region of ten years before the majority of occupational leases are post-implementation of the Act and perhaps another ten years before the market consists overwhelmingly of such leases.
Institutional investors are not, of course, the only major players in the market. Property companies (quoted or private) and high net-worth individuals also play a part and sometimes, their role can be quite substantial. The big difference between the two groups is in the method of financing their investments. The institutions will almost exclusively use equity finance, whereas the property companies/individuals will use a greater or lesser proportion of debt finance. The debt is typically provided by domestic or foreign banks and their position is somewhat different. They are lending money at a margin to produce a profit; the margin may reflect the degree of risk involved in the transaction, but basically the cost of money is priced on the expectation that the principal will be returned in due course. They have little concern about growth in value - their interest is ensuring that adequate security for the debt is provided. For them, therefore, anything which erodes that security need to be taken seriously. Already, during the period when that abolition of Privity of Contract was under discussion, many banks showed themselves to be reluctant to advance monies where the covenant strength of an original tenant formed part of the security because of the risk of retrospective legislation.
Now that the position is clearer, they will need to consider what controls the landlord is able to exercise in the event of an application to assign to a weaker covenant (and even the affect of a further assignment) so as to protect the quality of the income flow. This might, ultimately, prove to be the most significant effect on property values.
Of course, the Act also provides for the landlord to have a greater degree of control over the assignee than previously. These controls can take the form of requirement for a guarantee by the assignor of the assignee (subject to conditions), and lease provisions pre-determining the acceptability of the assignees. Together, these provisions go some way towards mitigating the effects of the abolition of Privity of Contract. Indeed, it is not inconceivable that, should the bargaining strengths of the respective parties change, the Act may place the landlord in a stronger position than he might otherwise be.
Although it is suggested that the overall effect on the market will be muted because of the time scale involved there will, nevertheless, be some parts of the market more adversely affected than others.
For most of the past 30-odd years, investors have held property as, essentially, an equity-type investment. In other words, they are holding the assets not just for their current income but also because of their growth prospects. For such investments, the security of income comes secondary to the growth prospects. Indeed, if the investment is truly one which does grow in value, it is because there is increasing occupational demand for it and, in the event of tenant default, a re-letting should therefore be readily achievable.
Such an argument applies to a lesser extent to those properties which are producing higher income, (relative to their value) because their growth prospects are perceived to be limited. Typically, such properties are older obsolete industrial buildings, although retail and office properties can also fall into this category. It might be thought that such properties would be those most affected by the legislation but, of course, these properties will be let on leases which were granted prior to the implementation of Act and will therefore not be affected.
The above arguments do, however, point to the type of property investment which will be most adversely affected by the legislation. These are properties which are obsolescent - in other words, those which tend to become obsolete. Obsolescence can be physical in nature, where the building fabric and services are no longer able to fulfil their intended purpose, or economic where the location, size, layout, etc mean that the building can no longer be used for a purpose which is financially viable. Of all the commercial property sectors, offices have shown the highest level of historic obsolescence although industrial properties also exhibit this characteristic.
Retail properties, partly as a result of relatively tight planning policies, but also because a large part of their value is due to the location, have not been so prone, but the greater proliferation of alternative retailing types and locations is expected to mean that obsolescence will become a more important factor for this group in the future. Although it is difficult to generalise in respect of the life of a building, locations which are marginally-located to central areas and building types which tend to be specialised in their design would normally be expected to be most at risk.
Lease Provisions and Rental Values
Although the Act is not expected to come into effect until 1st January 1996, it has already started to become a factor in negotiations for new leases. In open market lettings, prospective tenants (who are currently in a strong negotiating position) are, in some instances, requiring the lease to contain provisions which are designed to provide the benefits to the tenants as the Act provides. Most tenants, however, believe that, as they are currently able to negotiate either short leases or leases with break clauses, they are provided with sufficient ability to avoid future problems with Privity of Contract. Of course, over time, the balance of power will swing back toward landlords but then the new leases will fall within the Act's provisions.
Although, in future, landlords will have the ability to require a guarantee of the immediate assignee and/or predetermine the acceptability of the assignee, no "Institutional Standard Clauses" are available and we will undoubtedly see a period when various versions vie for universal acceptance. Perhaps the greatest difficulty in this respect will be the form that the test for assignees' acceptability will take. A rule of thumb that some landlords have applied in the past is that a prospective tenant's or assignee's net profit should be equal to at least three times the rent on the building to be occupied. The flaws are in such a measure are, unfortunately, all too obvious. Nevertheless, it is likely that an acceptable explicit test will tend to focus on the financial position of the assignee and will need to be quite precise in its application. Measures, such as those used in assessing credit ratings and corporate bond qualities would seem to have much application in this area.
Arguably, there could be a difference between the rent which a tenant is willing to pay under a lease of which Privity of Contract has been excluded, and an old lease where Privity of Contract still continues.
In practice, the situation is more likely to be akin to the arguments sometimes put forward that tenants would be willing to pay higher rents for a shorter lease on the basis that these limited their Privity liabilities. Unfortunately, the evidence for supporting such a case has always been very scant and it is only in particular situations that a landlord has been able to succeed before an arbitrator at a rent review. In general, market inefficiencies and different tenant perceptions make it difficult to differentiate the "premium" that a tenant might be willing to pay for the exclusion of Privity of Contract.
This is not to say, however, that it may not occur in future. With a growing number of leases from which Privity of Contract has been excluded, sufficient evidence may develop to differentiate a Privity Effect.
There is, nevertheless, one further complication. Although, traditionally, "institutional-type" leases have been of twenty-five years length, this practice has substantially changed for leases granted since of the beginning of the 1990s. More typically now, lease lengths are between five and fifteen years, with most of these longer terms also incorporating tenant's or mutual break clauses (sometimes, admittedly, with penalties) and, for such leases, the tenant's liabilities for Privity of Contract are obviously very much lower.
Indeed, it could be argued that, from the tenant's perspective, the abolition of Privity of Contract currently will have little effect because their negotiating strength in the market place ensures that they can secure most of the benefits anyway.
Landlords need to be conscious that if they are able to impose conditions on assignment which are unusually onerous, these are likely to be picked up by the tenant or his surveyor on during the rent review process and used in negotiations. The tenant will typically argue a case that, compared to the comparable evidence of market rents, the subject property is less attractive to a tenant because of the difficulties which will be experienced in finding a suitable assignee, and, therefore, the reviewed rent should reflect this.
This might become a particular issue over the next few years, as existing leases would normally contain no provisions limiting assignments (other than requiring the landlord's consent, which is not to be unreasonably withheld), and as these normally form at least a part of comparable rental evidence, conceivably a case may be made in respect of any provision which is more restrictive than the previous norm.
Although solicitors will only occasionally become involved in issues of day-to-day estate management, it is worth considering how the Act may affect working practices.
Perhaps the most important aspect in this area relates to the ability of the landlord to recover arrears of rent and service charges from the assignor/tenant. The Act, in requiring a notice to be served within six months of the date when the amount was due, places an onus on the landlord to take action at a relatively early stage. Because there may be difficulties in tracing the whereabouts of the assignor and ensuring that the notice is correctly served, this might suggest that action needs to be taken when, say, the rent is only three months in arrears. At this point, the landlord might normally still be pursuing the existing tenant and only when all normal action has been exhausted would he then look toward a previous tenant. This requirement also suggests an obligation on the landlord/agent to maintain adequate records and systems to prompt for this action.
Even serving such a notice is not, however, without its downside. The ability of the assignor to respond with the right to call for an "over-riding lease" means that the landlord should reflect on the effect of such outcome if the assignor so decides to serve such a notice. Although the assignor will be taking on the obligations of a lease (and the will need to consider on whether this is appropriate) the landlord also need to judge whether this represents an attractive outcome.
Finally, the landlord's ability to secure a release from its own covenants on disposal on a property is a new concept. In the frenzy of a sale, this issue is something which can be very easily overlooked.
For further information please call Alan Patterson on 0171 629 7666, extension 2376 or write to him at Hillier Parker, 77 Grosvenor Street, London, W1A 2BT.
For additional expert analysis provided by Hillier Parker enter text search "Hillier Parker" and "Business Monitor".
For information on the services Hillier Parker provide enter text search "Hillier Parker Corporate Profile".