Property Industry Update August 2010
BANK CONSENTS – RISKS AND REASONS
The good old days (and the less good new days)
Banks have always imposed controls on borrower activities, including letting or taking property on let, through facility and security covenants.
But it’s perhaps fair to say that in the past there was little investigation by those banks of the precise lease terms, provided they were satisfied with tenant covenant and proposed rental. There were exceptions in the case of key or high value purchases or lettings – but generally there wasn’t a great deal of oversight.
It’s now easy to see that perhaps that wasn’t a sustainable position from a risk management perspective.
Today the property industry operates in a different environment – one which is much more risk-averse. That means lenders are taking a far greater interest in the detail of existing occupational leases when funding a purchase and any dealing in secured property.
The bank’s concerns
Most commonly we’re talking about an existing property which is let to one or more tenants, providing a revenue stream to the landlord and contributing to an enhancement of value of the asset as compared to its unoccupied state.
The income which is generated through payment of rent under the occupational leases will comprise a substantial part of the value of the investment – so, in providing funding, the bank is clearly interested in ensuring that sufficient value is retained in the property in order to meet the borrowing in the event of default.
That means it’s in the interests of the bank to look carefully at the terms of the occupational leases to ascertain their quality – and that’s a view which is taken from the landlord’s point of view against the possible calling-up by the bank of the security and the sale of the security subjects, either immediately or perhaps after some time, with the bank running the investment property in the interim.
So what is the bank really interested in?
1. The bank’s main concerns surrounding any occupational lease will obviously centre on the basic commercial terms and how those relate to asset value and interest service – but the bank are also looking at the more intangible aspects of marketability and the extent of tenant covenants and landlord liabilities.
The continuation of revenue stream and determination of the value of the property will depend largely upon the duration of the lease, the amount of rent and the frequency and provisions for rent review.
Clearly the state of the economy has had an adverse effect on the cash flows of all kinds of businesses and for those operating from leased premises, quarterly rental payments are likely to be one of the biggest outgoings.
The longer the rental payment remains in the tenant's bank account, the more interest they will accrue and the more likely that cashflow issues will be eased. Of course late payment isn’t ideal from the landlord’s point of view and could prove to be an early warning sign of real financial difficulty and that the tenant is unable to pay its debts as they fall due.
That’s another reminder that in the investment context, evaluation of tenant covenant is a vital part of the process for both borrower and bank – there’s little point in bringing a tenant on board if there’s every likelihood of default in the foreseeable future.
2. However, the detailed terms of the lease beyond tenant covenant and headline provisions also potentially impact on both cash flow and business value, as well as more broadly on the landlord’s ability to service its loan commitments.
Other issues the bank will likely want to consider will include service charge recoverability, the existence of turnover rents, and deviation from full repairing and insuring terms.
Each of those will have an effect on value – and, in extreme cases, could impact on marketability of the asset.
So, ideally, an occupational lease should maximise the return to the landlord while minimising risk – and this holds true from the perspective of either landlord or its funder.
For example, in the case of a single occupancy, there would ideally be a substantial tenant covenant, an FRI format with no residual liability attaching to the landlord, a market value rent, no tenant breaks and regular upwards-only rent reviews.
There’s nothing surprising in this, and it’s simply the case that the bank is looking for what the landlord itself should expect – the only difference being that the bank is less likely to accept concessions or deficiencies.
Help the bank help you
Douglas Gourlay, a Director in Semple Fraser’s Banking & Finance Group and editor of our Finance Industry Updates, agrees that although borrowers can sometimes feel pain when trying to obtain bank consent to an investment purchase or a new letting, the key issues for a bank shouldn’t usually be unexpected
He states that:
“The key for borrowers is to ensure that those issues are adequately addressed so far as possible by a proper understanding of the bank’s position, and being ready to provide detailed information to support any investment property purchase or lease proposal – including tenant covenant information, financial projections, and sufficiently detailed information on the key terms of the letting documentation.”
TENANTS’ TOP TIPS FOR LEASING
If your business is expanding, you may well need additional space.
Leasing can be more attractive than buying. You need less capital outlay up-front, and terms can be flexible.
The main points to consider are:
-
Which entity should take the lease? – the lease will become a liability for that entity. Be aware the landlord may request a rent deposit or guarantee if it has doubts on covenant.
-
How much space do you need? How long for? Do you need the ability to end the lease early, e.g. halfway through? – if not, then a longer rent free or lower rent may be on offer.
-
The premises may become surplus to your requirements unexpectedly – so try to ensure your ability to assign (sell) the lease or sub-let isn’t too restricted.
-
Traditional “open market” rent reviews can produce shock increases in boom times – so consider asking for any rent increases to be linked to e.g. RPI (or the lower of “open market” and index-linked).
-
If the premises are part of a multi-occupancy building or industrial estate, Service Charges (a share of the cost of common services) may be payable. Request previous Service Charge accounts, and consider asking for a cap (either just for the first year or two, or only increasing in line with e.g. RPI) – so your outlays are more fixed. Check the level of rates too (the tenant usually has to pay these).
-
Have a lawyer check the title deeds for any important title conditions – e.g. use restrictions.
-
A lease usually makes a tenant responsible for repairs – so consider a Schedule of Condition recording the state of repair at lease start, plus an obligation only to hand the premises back in that state when the lease ends.
-
If your needs are short-term, consider flexible-leasing options, e.g. serviced office accommodation – often more expensive, but better if you only need space for a few weeks.
RIGHTS OVER A PUBLIC ROAD – SOME WELCOME CLARIFICATION FOR DEVELOPERS
The recent decision in the case of Hamilton v Nairn has clarified what constitutes a public road in Scotland, and may provide valuable support for developers in Scotland facing opposition to their development by third parties using “ransom strips” on the verges of public roads to prevent access to the developer’s land.
The Hamiltons of the case had concluded a contract for the purchase of property adjacent to the Cutler House Road in Peterculter, Aberdeen. They had also obtained planning permission to redevelop the property as a cattery and livery stables (a business which the Hamiltons were relocating from their existing premises).
Access to the Cutler House Road property is taken by means of a track which opens into a bellmouth over the verge of the Culter House Road – a road which is adopted for maintenance by Aberdeen City Council as the local roads authority. Consent was also obtained from the Council to carry out road improvement works to the junction at this bellmouth.
However a neighbour, Mr Nairn, was opposed to the development. He owned the title to the verge at the junction and took steps to prevent the Hamiltons taking access over it. Mr Nairn claimed that as he owned the verge, he was entitled to use it as he desired, including refusing access over it and preventing the proposed works from being carried out.
The Hamiltons sought confirmation from the court that they were entitled to carry out the improvement works to the junction and, crucially, take access over it.
The Hamiltons were successful; the court gave that confirmation, and also granted an interdict against Mr Nairn, preventing him from thwarting access being taken over the verge.
In reaching its decision, the court considered the definition of a “road” in terms of the relevant legislation, the Roads (Scotland) Act 1984, which specifically includes the “road’s verge” but, crucially, does not define “verge”. The Court took the view that, as the road is included in the local list of public roads, it is a public road and, furthermore, that the land in question is all part of the verge of the road as listed (which was conceded by Mr Nairn during the court hearing), and therefore part of the public road. The listing of the road (for so long as it remains listed) gives rise to an inference that there is a public right of passage over the whole of the verge, thereby removing the rights of the owner of the verge to control or object to its use.
So the court found that, because the verge in this case was part of the public road, the roads authority was entitled to grant consent to the improvement works and allow access over the junction.
June Gilles, Head of Semple Fraser’s Planning Team, says that:
“Although the decision is essentially a reiteration of the existing law, it may nevertheless assist developers confronted with the challenges that apparent ’ransom strips‘ pose. If the land in question is part of the verge forming part of the public road, adopted for maintenance by the local authority, the owners can’t prevent access being taken over the verge or road improvement works authorised by the roads authority simply by dint of the fact they own it.“
We understand the decision has been appealed, so it’s a case of “watch this space”…
Empty Rates update
In 2008, landowners in England and Wales lost relief from business rates for empty property. In those countries, there is now only a 3 month exemption period for non-industrial properties and a 6 month exemption period for industrial properties – and full business rates are payable following the exemption periods.
Despite the controversy surrounding the changes, it seems that empty rates liability is here to stay in England and Wales.
Mitigation schemes
A number of potential schemes to mitigate liability for empty rates have been debated by the industry.
Since 2008, many of these schemes have been tried and tested. This is a summary of some of the more common schemes in England and Wales and their potential problems.
1. Short intermittent reoccupation
Method: Reoccupy your property for at least 6 weeks. You will be liable for full rates for that period however upon vacating, a new exemption period (3 or 6 months) applies. It seems the process can be repeated as often as required.
Problems: You must derive some actual benefit from your occupation. So it’s possible that your actual use of property may be queried.
2. Short intermittent letting
Method: Grant a short lease for at least 6 weeks. Your tenant must occupy the property and will be liable for full business rates. Following the expiry of the lease and the tenant vacating the premises, a new exemption period (3 or 6 months) applies. It seems the process can be repeated as often as required – grant another short lease and gain a further exemption period each time.
Problems: Finding a tenant. “Guaranteed Tenant” schemes are currently being marketed where a tenant is found for a 6 week period, with a new exemption period arising upon the “tenant” vacating. These schemes involve paying a fee and the landlord usually has to indemnify the tenant for its 6 week rates liability.
The tenant must derive some benefit from its occupation. Accordingly it is possible that such schemes might be challenged on the basis either (a) that the tenant/landowner derives no genuine benefit from its short term occupation, or alternatively (b) that a genuine tenancy has not been created.
If you are offered a “Guaranteed Tenant” scheme, check who would bear the risk and costs of a successful challenge – and ensure that you respect the tenant’s right to exclusive possession of the property while the 6 week tenancy is in place.
3. Charities
Method: Letting a property to a charity or a community amateur sports club allows the landowner to avoid liability for empty rates. Charities have a full exemption, provided it appears that when the property is next in use it will be used wholly or mainly for charitable or community amateur sports club purposes.
Problems:
It must appear that the expected future use will be of the whole or the main part of the building. The Courts have ruled that occupation of one small part of a larger building will only mitigate rates liability for the part that is occupied – meaning that full rates are still payable for the rest of the building.
4. Insolvent tenants
Method: Let the property to a company that then enters insolvency, e.g. an SPV that is put in to administration or liquidation. Companies in liquidation or administration are exempt from liability for empty rates.
Problems: If the transaction is set up with the sole aim of avoiding a liability for empty rates and the SPV was never genuinely solvent then it is possible that the directors of the company might face sanction under insolvency legislation. It is arguable that such conduct could amount to fraudulent trading. As the local authority could be the largest unsecured creditor, they may appoint their own liquidator to investigate the background to the transaction in which case the landowner would lose control over the liquidation.
Any liquidator may disclaim a lease of premises located in England and Wales – and is likely to do so at the earliest opportunity – at which point the owner becomes liable for rates again.
5. Property unoccupiable
Method: If a property is in such poor repair that it cannot be occupied and cannot be economically repaired, or if occupation is prohibited by law (for example due to non compliance with fire regulations), no business rates are payable.
Problems: Anti-avoidance legislation may be brought in soon, so that changes in the state of a property after it becomes vacant are disregarded.
In the meantime, the Valuation Office (which deals with business rates in England and Wales) has stated that it may take a view that any damage, however caused, is economically repairable. Deliberate vandalism may therefore often be ignored, and the property deemed to be in repair for rating purposes.
6. Unfinished Developments
Method: Leave your development unfinished, as no rates are payable whilst the property is being constructed.
Problems: The local authority may serve a completion notice, if it considers that the development could reasonably be completed within 3 months. The notice will specify a completion date (in 3 months time) from which the development will be deemed complete and the exemption period will start to run. The landowner will then become liable for empty rates in the usual way.
Comment
Empty rates can be a significant liability which landowners will obviously want to avoid wherever possible.
Some property owners have been approached with schemes that promise to avoid empty rates liability. However, these schemes may not always necessarily work. In some cases they may even carry significant risk. If you wish to investigate whether a mitigation scheme would work for you, make sure you obtain legal advice on your options, strategy and any risks.
And the position in Scotland?
The Scottish position on empty property rates wasn’t subject to a change such as that in England in 2008. Empty office and retail properties in Scotland are eligible for a 3 month exemption, with a 50% discount after that, while there are no rates to pay on empty industrial properties even after the first 3 months.
RACE TO REGISTER FOR CRC ENERGY EFFICIENCY SCHEME
The CRC Energy Efficiency Scheme is a UK-wide environmental initiative. The idea is to drive energy efficiency by forcing certain organisations to:
-
count and report on their greenhouse gas emissions; and
-
purchase, and later surrender, enough "emissions allowances" to cover their annual CO2 emissions.
The Scheme will impact on commercial leases and sale and purchase contracts, as well as the administration and operation of multi-let buildings. The major issue faced by the property industry, and landlords in particular, relates to who is responsible for energy use in a large multi-let building with common parts – the CRC currently makes the counterparty to the electricity supply contract responsible for the energy used under it.
Although the Scheme is regulated in Scotland by the Scottish Environment Protection Agency, by the Northern Ireland Environment Agency in NI and the Environment Agency in England and Wales, it is administered across the UK by the Environment Agency.
Figures published on 11 August 2010 by the Environment Agency show that just over 1,200 organisations have already registered for the Scheme. Organisations which qualify only have until 30 September 2010 to register for this mandatory scheme – and the Environment Agency is expecting an increase in registrations as remaining organisations rush to sign up before that deadline.
Do you need to register?
If your organisation was a party to electricity supply contracts under which it consumed more than 6,000 MWh electricity through half-hourly meters during 2008, it has to take part in the Scheme.
Organisations which are part of a group must participate as a group, with the highest UK parent company responsible for compliance – though subsidiaries which qualify for participation in their own right can choose to take part on their own.
The CRC is largely revenue-neutral, because money you spend on "emissions allowances" is "recycled" back to you six months later – however, a penalty is deducted or a bonus added based on your performance in an annual "league table". The league table ranks participants based on emissions reductions – and a poor ranking could affect your corporate image.
There are also cashflow issues – because of the 6 month gap between buying your allowances and your payments being "recycled" back to you.
Vincent Brown, Head of Semple Fraser’s Environment & Pollution Team, has compiled a list of top five tips on dealing with the CRC:
-
Check whether your organisation has to comply.
-
If it does, calculate how much you need to spend on “emissions allowances” – and whether there’s scope to reduce that.
-
Assess your contractual and corporate arrangements to ascertain whether or not there’s scope to reduce your future exposure under the Scheme.
-
Don’t leave registration until the last minute – organisations which register late face significant penalties.
-
Note that even organisations who don’t meet the 6,000 MWh threshold have to provide the Environment Agency/SEPA/NIEA with a list of all of their half-hourly meters settled on the half-hourly market, as well as details of their total consumption of HHM electricity during the calendar year 2008, by end September 2010.
For our detailed briefing on the impact of the CRC on the Property Industry, click here.
RECOVERING POSSESSION FOR REDEVELOPMENT
Security of tenure for business tenants in England and Wales can make it costly and time consuming for landlords to recover possession for redevelopment.
Is it possible for a tenant to defeat the landlord’s right to possession by making a summary application to Court before the landlord is ready to redevelop?
A recent English case – Somerfield v Spring – covered this point.
The background facts are that a lease held by Somerfield has expired. They are holding over and seeking a new lease.
However the landlord opposes the grant of a new lease, claiming that it intends to redevelop.
This case has already been before the Courts once before, in June 2009. The landlord had entered administration and – hoping to buy time to work up a redevelopment scheme – the landlord’s administrators refused to allow the tenant’s lease renewal claim to continue in the normal way. Somerfield felt this would prejudice their claim for a new lease and successfully applied to Court for permission to continue their claim.
Somerfield’s next move was to apply for summary judgment. In order to succeed, Somerfield had to prove that the administrators had no realistic possibility of being able to prove their intention to redevelop the premises.
Summary judgment applications are liable to fail wherever there is a genuine dispute of fact, which the Court can decide only by hearing evidence from witnesses at a full trial. This will usually be the case where a landlord claims an intention to redevelop, which is disputed by the tenant. Therefore, successful summary judgment applications in contested lease renewals are not common. If summary judgment is refused, the case will proceed to a full trial in the usual way.
Somerfield’s application in this case raised an important point of law.
It is well established that a landlord who opposes lease renewal on redevelopment grounds only has to prove his intentions by evidence at the trial itself and not at any earlier stage.
So the landlord can use the period leading up to the trial to gather evidence on issues such as the likelihood of obtaining planning permission, finance and any pre-lets, if these have not already been obtained and would be critical to the viability of the redevelopment.
However, Somerfield argued that if the landlord could not prove its intention to redevelop at the date of the summary judgment hearing, then summary judgment ought to be granted – which would result in Somerfield being granted a new lease.
The Court rejected this argument.
The Court held that the relevant date when the landlord had to prove its intention was not the date of the summary judgment hearing, but the anticipated trial date. Accordingly, Somerfield’s application was refused.
It is not inconceivable that any tenant might apply for summary judgment application for purely tactical reasons, in order to delay the proceedings and put off the date when the premises must be handed back to the landlord.
However now that the timing issue has been determined by the High Court, it will be much more difficult in future for a tenant to apply for summary judgment purely for tactical purposes.
That said, a tenant could still get summary judgment in certain circumstances, for instance if the landlord’s plans required planning permission or some other consent which, indisputably, would not be granted.
Equally, a landlord could still get summary judgment application where, for example:
-
the landlord simply intended to demolish the premises regardless of any subsequent redevelopment scheme, or
-
the landlord intended to reoccupy the premises for its own business, and there were no factors that would affect the viability of its plans, such as a need for planning permission.
Except in these relatively unusual circumstances, both landlords and tenants should generally avoid making applications for summary judgment in contested lease renewal claims, unless they can genuinely be justified and are of tactical value.
If you are reasonably sure that you will ultimately be successful at Court in a contested lease renewal claim, then the quickest route to a successful judgment will normally be to comply with the Court directions and keep to the original trial date – rather than trying to short-circuit the proceedings by applying for summary judgment.
The matters covered in this ebulletin are intended as a general overview and discussion of the subjects dealt with. They are not intended, and should not be used, as a substitute for taking legal advice in any specific situation. Semple Fraser LLP will accept no responsibility for any actions taken or not taken on the basis of this publication.
FOR FURTHER INFORMATION PLEASE CONTACT: ROLAND SMYTH