Developers beware! The pitfalls of tenants’ rights of first refusal and collective enfranchisement
By Anthony Radevsky, Peta Dollar and Sarah Thompson-Copsey
Residential developers are fired with enthusiasm by the Government’s current policy of encouraging the building of more and more homes and mixed use developments in town centres; but it is all too easy for a developer to fall foul of legislation benefiting residential tenants unless he structures his development carefully from the outset. This article offers some practical guidance.
The 1987 Act
Part 1 of the Landlord and Tenant Act 1987 (which grants rights of first refusal to qualifying tenants on a proposed disposal by their landlord) applies to premises if they consist of the whole or part of a building, they contain two or more flats held by qualifying tenants and the number of such flats exceeds 50% of the total number of flats contained in the premises.
Assume that a developer is building a new residential or mixed-use development from scratch. Unless and until there is a building containing flats on the site, it appears that the 1987 Act does not apply at all. Consequently, there is nothing to prevent the developer from putting into place, at this stage, arrangements such as the grant of a long lease to an associated company or management company (1). ‘Flat’ is defined as a separate set of premises constructed or adapted for use for the purposes of a dwelling (s60(1)). ‘Dwelling’ is defined as a building or part of a building occupied or intended to be occupied as a separate dwelling (s60(1)). Consequently, the developer needs to be fairly far along the road towards practical completion before what is being constructed could be described as ‘flats’, or indeed a ‘building’.
It is customary for house-builders to sell dwellings ‘off plan’ to intending purchasers long before the dwellings are fit for occupation; indeed in some cases dwellings are contracted to be sold or leased before development has even started on site. Where all or most of the flats that are to be developed are the subject of agreements for lease, the contracting lessees will be ‘tenants’ by virtue of s.59 of the 1987 Act (2). If, therefore, construction on site has reached a stage where the half-built block of flats could reasonably be described as a building, those contracting lessees may have rights under the 1987 Act and so, to be on the safe side, the developer should grant his overriding lease to a management company or associated company before that stage.
The 1987 Act is concerned with a building or part of a building. Unhelpfully, ‘building’ is not defined in the 1987 Act (3). The natural meaning of ‘building’, as a matter of ordinary language, may be a structure of four walls with a roof on top, but in many cases the position is far from clear. Take, for example, a development of what looks like four separate tower blocks of flats. If in fact, below ground level, there is a continuous underground car park, common foundations and common services, the four tower blocks may constitute one building for the purposes of the 1987 Act. The importance of determining whether there is one building or several is that, if the 1987 Act applies, the landlord must sever the transaction so as to deal with each building separately (s5(3)). Indeed in some cases it is impossible to tell whether or not the premises fall within the 1987 Act without knowing the number of buildings involved.
This point was considered by Deputy High Judge Vos QC in the important High Court decision of Long Acre Securites Ltd v Karet ( EWHC 442 (Ch),  Ch. 61). The case concerned four blocks of flats on a predominantly residential estate. The landlord wanted to dispose of his leasehold interest in the whole estate, and served s. 5 offer notices on the residential tenants, treating all the blocks as though they were a single building. The tenants objected to the notice saying that the transaction should have been severed and that four forms of notice should have been served, one form for each block. The Deputy Judge held that, because the tenants of each flat were entitled to use the communal roadways and grounds, the same ‘appurtenant premises’, all four blocks should be regarded as a single ‘building’ for the purposes of the Act.
The decision has no doubt been welcomed by many landlords since it makes matters much easier from a conveyancing point of view. It is particularly helpful for a developer landlord seeking to sell the ground rents in a development scheme where that scheme comprises several blocks of flats dotted around within a landscape with shared garages, bin stores and other amenities. Severing the transaction so that each block is the subject of a separate disposal is in practical terms virtually impossible, and exposes the landlord to the risk of disposing of some blocks but not others, and hence retaining part of (for example) a bin store or garage block. Additionally, severing the transaction would make the sale of the ground rents far less attractive.
However, it is not clear that the judgment is correct. It is difficult as a matter of ordinary language to see how four completely detached buildings could be said to be a single ‘building’(4). Having said that, the judgment is thorough, and the previous cases are fully discussed. One of the consequences of the decision is that some tenants’ rights under the 1987 Act could be nullified. Consider an estate comprising two blocks of flats set in communal grounds. In one block there are 40 flats, where all of the tenants wish to acquire the freeholder’s interest if it is sold. The other block contains 80 flats, and only 20 of the tenants wish to acquire the freeholder’s interest. If the blocks are treated separately, the tenants in the first block can acquire the freeholder’s interest; if the blocks are treated together, there is only a bare 50% (60 out of 120 tenants), rather than a percentage of more than 50% which is needed for there to be a ‘requisite majority’ (s18A).
On the other hand, some tenants may find themselves being able to acquire the freehold interest as a result of the decision. In the above example, let us suppose that the block of 40 flats contains only 10 tenants who wish to acquire their landlord’s interest, whereas all 80 tenants in the larger block wish to acquire the reversion. If the blocks are treated independently, only the tenants of the larger block will be able to acquire their landlord’s interest, but if the blocks are treated together the tenants of both blocks will be able to acquire the reversion.
There is an exception to the basic definition of premises to which the 1987 Act applies. Premises fall outside the 1987 Act if the internal floor areas of parts occupied or intended to be occupied otherwise than for residential purposes exceeds 50% of the internal floor area taken as a whole (s1(3)). The area of any common parts is disregarded in this calculation. In many mixed-use buildings, careful measurements may need to be taken. If one assumes a 3-storey building plus basement, with a retail shop on the ground floor, basement storage for the shop, and two residential flats above let on long leases, one may get very close to the 50% limit. Some guidance in calculating the internal floor area of the various parts may be provided by the RICS Code of Measuring Practice, though it must be borne in mind that this is not incorporated into the 1987 Act (5). There is no further statutory guidance as to what is meant by internal floor area, unlike in the case of the 1993 Act.
Consider, then, a new development which will result in a building or buildings to which the 1987 Act will apply, and where the developer wishes to dispose of the freehold, once he has granted all the leases, without suffering the delays and uncertainties arising from being forced to offer it first to the occupying tenants. What can he do?
As previously stated, at the outset of the development the 1987 Act will not apply to the building as it will not contain flats. At that stage, the developer, if he has identified the eventual purchaser, could enter into a contract, or grant an option, to sell the freehold once the building has been completed and the flats are let. Under the 1987 Act it is the entry into a contract or the grant of an option that amounts to a relevant disposal (ss4A and 4(3)). The corollary of this is that a disposal in pursuance of a contract or option is not a relevant disposal (s4(2)(i)). Accordingly, if the premises are not within the 1987 Act when the contract is entered into, or the option granted, no relevant disposal takes place when the freehold is transferred, even though, by then, the premises fall within the 1987 Act.
Another way of proceeding by looking to the future relies on a different exemption from the definition of ‘relevant disposal’. Under s. 4(2)(l) of the 1987 Act, a disposal by a body corporate to a company which has been an associated company of that body for at least two years is not a relevant disposal. To be an associated company, one company must be the other company’s holding company, a subsidiary of that company, or another subsidiary of the same holding company (6). A developer embarking on a new development would be well advised to create a subsidiary at the earliest possible time so that it can be utilised when needed. Even more simply, the developer can acquire the site for the new building in the name of a single purchase company and then sell the shares in that company when the development has been completed and all the flats let. Note that, as well as avoiding the 1987 Act, there will also be a Stamp Duty Land Tax saving; the stamp duty on the transfer of shares is only 0.5% rather than the 4% Stamp Duty Land Tax on the transfer of property for a consideration in excess of £500,000.
The 1993 Act
So, having avoided the need to comply with the 1987 Act requirements, is that the end of the story for the developer and his purchaser? Well, no – the tenants also have rights under the The Leasehold Reform, Housing & Urban Development Act 1993, which enables tenants of flats to protect what would otherwise be considered a depreciating asset by providing for the enforced sale of the freehold of a building to the tenants acting together (known as “collective enfranchisement”) (7). The 1993 Act gives tenants rights which they may exercise regardless of the landlord/developer’s intentions or actions ie he does not have to propose to dispose of his interest, as under the 1987 Act, for the tenants’ rights to arise and be exercisable. There are, accordingly, fewer opportunities for the landlord/developer to avoid the tenants’ 1993 Act rights impacting upon his development.
Granting an intermediate lease to an associated or management company at an early stage is of no help here. Unlike in the case of the 1987 Act, the existence of any intermediate lease is irrelevant; if a tenant has rights under the 1993 Act he may exercise those against the freeholder regardless of the existence of (or indeed number of) intermediate landlords. The only real way to avoid the 1993 Act is to take the building, or the tenants (or at least a sufficient proportion of the tenants), outside the Act.
In order to fall within the 1993 Act, the building must be a self-contained building or part of a building (ie a part capable of separate redevelopment) containing a minimum of two flats (s3(1) and 3(2)). No more than 25% of the internal floor area, excluding common parts, must be for non-residential purposes (s4(1)) (8). Accordingly, a developer landlord may wish to ensure that the non-residential proportion of the building is more than 25% of the total internal floor area. The alternative option of ensuring that there are fewer than two flats is unlikely to prove economically attractive to a developer, except in very particular circumstances.
To qualify under the 1993 Act a tenant must have a long lease (9) of his flat, ie generally an original term of more than 21 years; break-clauses and forfeiture provisions being disregarded for these purposes. Additionally owners of two or more flats in the building are completely excluded from the count (s5(5)) of eligible tenants under the 1993 Act (s3(2)). So, alternative methods of avoiding the Act would be, for example, to grant only assured tenancies (or at least sufficient to ensure that fewer than 2/3 of the total number of tenants have long leases (s3(1)(c)) or to ensure that every tenant has a lease of at least two flats in the building (10).
None of these methods of circumventing the 1993 Act is particularly practical, but all is not completely lost for the developer landlord. In developing and then selling flats on long leases that may form the subject of a claim for collective enfranchisement, the developer not only receives the premium on the grant of the long lease, but also effectively has a ‘second bite of the cherry’ when he comes to deal with the enfranchisement claim, and receives compensation from the tenants for his ‘lost’ interest. In other words, the tenants must pay first for their respective leasehold interests, and then again for the collective freehold interest. Indeed, it has been suggested that this may be one reason why commonhold has not taken off to any significant extent; the price of the commonhold unit needs to be higher than that of a long leasehold flat because the developer/landlord will never receive a second payment on enfranchisement, but currently prospective purchasers are unwilling to pay extra for a commonhold unit.
(1) Note that the existence of an intermediate lease for a term of at least 7 years and without the right for the landlord to determine that lease during the first seven years of the term will mean (S.2(2) of the 1987 Act) that the head landlord can dispose of his interest in the property without the need to serve offer notices on the occupying tenants under the 1987 Act, hence the importance of putting an intermediate lease in place before the premises fall within the provisions of the 1987 Act.
(2) The 1987 Act simply states that ‘lease’ includes an agreement for lease, but does not deal with the situation of a conditional agreement for lease. It may be that a contracting tenant under an agreement for lease, where the preconditions for completion of the lease remain unsatisfied is not a tenant within the meaning of the 1987 Act.
(3) Unlike in the case of the Leasehold Reform, Housing & Urban Development Act 1993
(4) The only opposition to the landlord’s application for a declaration as to the validity of the single form of notice, was from one of the tenants who was represented only as to costs.
(5) But note that the assessment of specific areas using the Code of Measuring Practice cannot be an exact science - see ilmartin SCI (Hulton House) Ltd v Safeway Stores  EWHC 60 (Ch);  05 EG 273 (CS).
(6) The Companies Act 1985 definitions are incorporated: s. 20(1) of the 1987 Act
(7) The 1993 Act also entitles the tenant to call for the grant of a new lease of his own individual flat.
(8) S. 4(1) of the 1993 Act; Indiana Investments Ltd v. Taylor  3 EGLR 63 gives guidance on how to measure the building under S.4, and includes a reference, at para , to the RICS Code of Measuring Practice
(9) S.7 of the 1993 Act defines ‘long lease’ in full
(10) This could technically be achieved by demising two flats in each lease, and then prohibiting any assignment or subletting of part – but this is unlikely in reality to encourage tenants to take up leases!
© Radevsky, Dollar and Thompson-Copsey
(This article was first published in the Landlord and Tenant Review)
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