Having developed out a block of flats and sold them on individual long leases, many savvy developers look to maximise their capital return before moving on to the next project.
An ideal, and, on the face of it, easy way to do this is to sell the freehold reversion, i.e. effectively the right to collect the ground rent and service charge, and manage the block. With many investors in the market and some being prepared to pay up to 40 times the annual rental income, the incentive to cash-in can be great.
Unfortunately, what may appear at first to be a fairly simple transaction can become a lengthy and complex process which requires specialist advice from a solicitor with expertise in the area.
The first difficulty to face is the protection offered to tenants by the Landlord and Tenant Act 1987 (“1987 Act”). The 1987 Act gives residential tenants a right of first refusal to buy their landlord’s reversion to the building and effectively become their own landlord. The legislation requires that, when a sale of the reversion is contemplated, a notice of the intended sale must be served on at least 90% of the tenants.
The tenants are then given a two month period in which to decide whether or not to exercise the right to buy the freehold. Unless at least 50% of the tenants respond positively to the notice, the landlord is free to proceed with a sale to a third party. The landlord can only proceed on terms “no less advantageous” (e.g. not at a lower price) than those offered to the tenants.
This statutory protection for tenants creates a number of problems for developer landlords in that, quite apart from the administrative headache of serving the large number of notices which will be required on a large block, it will cause a delay in the progress of any third party sale whilst the two month acceptance period elapses.
The landlord is not permitted to exchange contracts to sell the reversion to a third party during this period and thus the transaction is effectively put on hold pending a response from the tenants. Furthermore, having served the requisite notices detailing a sale price, the landlord’s hands are then tied as it cannot sell to a third party at a lower price without first serving fresh notices offering the reversion to the tenants at that lower price and waiting a further two months.
Common sense dictates that the price stated in the notices should, therefore, be pitched at a level to take account of possible price chips by the third party buyer, but the landlord should be aware that it will have to sell to the tenants at that price should they wish to buy.
The price of failing to comply with the law in this area is high: the sanction is criminal with an unlimited fine. In any event, sellers are unlikely to get away with non-compliance since aggrieved tenants can use their statutory rights to force a buyer of the reversion (if the selling landlord failed to comply with the law) to sell to them, so any well-advised buyer will refuse to proceed without evidence of compliance.
Another issue facing developers seeking to sell their freehold reversion is the content of the flat leases themselves. Any buyer’s solicitor is likely to be instructed to check the terms of every lease in the block and leases which are inconsistent, particularly as to rent payment dates and term expiry dates, are likely to make the reversion less marketable.
When granting the leases the developer should therefore ensure consistency between them so far as possible. This makes the block much easier to manage from a buyer’s perspective and may make the reversion more attractive. Developers should particularly be aware of discrepancies between service charge provisions in leases, as these can lead to areas of expenditure which cannot be fully recovered. They can end up constituting an on-going liability for any buyer which will impact upon the price it is prepared to pay.
If there are any commercial units within the block which the developer wishes to retain (perhaps because these are let on shorter-term occupational leases rather than long leases and are therefore a source of significant regular income) particular thought needs to be given to these. The law will not permit the developer to sell the freehold reversion of the flats whilst retaining the freehold title to the commercial units.
Instead the landlord will have to grant overriding leases of those units to itself, prior to selling the freehold and, in fact, prior to serving any notices on the residential tenants. Expert accountancy and tax advice will need to be taken by a developer in determining the premium and/or rent to be reserved by those leases.
Another point for developers and their solicitors to bear in mind is the fact that the developer is not automatically divested of responsibility for complying with the landlord’s covenants in the leases on the sale of its interest. Statute provides that a landlord may remain liable for breaches occurring after the landlord sells its interest unless the landlord makes a formal application to the tenants to be released.
Obviously, such an application is well-worth making to ensure that the developer is free of the risk of tenants bringing claims against it in the future in the event that the purchaser of the reversion fails, for example, to provide any of the services stipulated in the lease or to adequately insure the block.
In addition to the above, further issues and complications can arise as a result of the specific details of the transaction.
Myerson have considerable expertise and experience in this area and would be happy to assist in negotiating this complex area of law to enable you to maximise the return on your residential development.