Capital Commercial Leases of Part

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1 Page 1 Capital Commercial Leases of Part Charles Anderson, Partner, Farrer & Co LLP Over several decades, long-term leases of commercial properties have been a common feature of the investment market particularly for prime real estate in the City and the West End. Estate and institutional freeholders seeking capital have often transacted with developers and investors by granting 125- or 250-year leases. The 1980s saw the evolution of sophisticated side by side/equity share leases with property companies and their funders prepared to take a long leasehold investment from a historic or institutional freeholder whose concern was to conserve its freehold "estate". Additionally, the freeholder's retained income slice did not prove to be a particular deterrent with rising rental yields and potential for gearing levels to be brought down to single figures. This market sector principally concerned leases of whole sites or buildings but this article is to cover long-term commercial leases of part. Traditionally, the market had not seen many commercial buildings or sites transacted by grants of long leases of part the principal exceptions would be investment / development leases of city shopping centres and premises over rail/tube stations. However, the current market has seen City and West End buildings/sites being transacted so as to create separate long-term interests for development, investment or owner-occupation particularly with commercial use at ground, basement and possibly first floor and with residential refurbishment at upper floors; most recently, comment has been in relation to development of parts of buildings for educational use. Such transactions bring together separate commercial and residential developers/investors/occupiers, in effect "sharing" an acquisition cost for the property and each acquiring a major interest. One party may acquire the principal freehold interest with the other being granted a long-term lease of its part; commercial considerations largely based on the respective extents or values of the commercial and residential premises determine which party takes the freehold. Specific examples of which we are aware are: (a) international investor acquiring West End basement/ground floor casino/restaurant by way of long-term lease with residential developer acquiring the freehold to develop the upper floors for residential use; (b) national institution acquiring ground floor/basement office accommodation adjacent to its "heritage" headquarters by long lease with a developer acquiring the freehold of the building for residential conversion of upper floors. Additionally, the market is seeing renewed investor interest in premises at transport hubs, often structured through a long lease of part. Although there are many sophisticated forms of long-term commercial leases of whole buildings/sites and, indeed, there are well-established forms of long-term individual apartment leases, there is little by way of an institutional form of a long-term commercial lease of part. There is possibly less general appreciation of the significant provisions required for such long leases, particularly to cover development, investment, funding and occupational issues. A look at the Council of Mortgage Lenders' requirements gives an indication of the provisions and underlying reasoning as applicable to apartment leases but there is little in the commercial sector; for example, the City of London Law Society Certificate of Title, a key element of many funding transactions, has no bespoke provisions relating to a long commercial lease of part; indeed, initial drafts of leases of part are sometimes derived more from a form of short-term rack rented commercial lease rather than, for example, the more appropriate starting point of a long lease of a valuable apartment. The particular points to be covered by the form of lease are: 1. The Premises and Related Rights Generally the premises as demised by the lease will be the internal non-structural parts of the building. It is important to have a satisfactory definition of the structure of the building so as to ensure adequate rights for: (a) support from the structure;

2 Page 2 (b) entry to undertake repair works to the structure in the event of default by the landlord; and (c) entry to undertake redevelopment works which impact upon the structure. It is good practice for the lease to have a "fast track" third party determination procedure under a suitably qualified surveyor/engineer to resolve any disputes. Similar provisions as apply to the structure apply to communal facilities and services. 2. Use permitted by the Lease The use clause should be as wide as possible though it is not unreasonable for the freeholder to expect to have a tenant obligation not to cause any nuisance to other occupiers of the building. There still needs to be careful consideration of use restrictions particularly where commercial uses may be most active outside normal business hours. 3. Dealings with the Premises The tenant's rights to transfer and underlet the premises should be as wide as possible if freeholder consent does have to be obtained, it should be subject to the provision that it will not be unreasonably withheld. Generally an institutional lease will prohibit a transfer of part of the premises but this should not be accepted necessarily as standard in a long commercial lease. It may be that there are parts of the commercial premises that may be capable of future separate development or refurbishment and so most appropriately sold as a part of the premises; indeed, it might be preferable to sell by way of a transfer of part than creating an inferior underlease. It is possible to draft satisfactorily to provide for the lease to be "split" by a transfer of part and in a way that makes each resulting lease of part acceptable to a funder. 4. Insurance Insurance is a particularly important area for a long lease of part of a building. It is not unreasonable for the freeholder to wish and, indeed, to insist that it insures the building. The critical issue for the tenant is to ensure that there are effective insuring, reinstatement and frustration provisions, particularly in a form acceptable to a funder. It is here that the advanced state of residential leases of part and the provisions of the Council of Mortgage Lenders' Report offer guidance. Principal points are: (a) the freeholder should be under an obligation to insure; ideally a commercial tenant should seek to be joint insured under the policy rather than merely a party with its interest noted; (b) the freeholder should be under an obligation to claim under the policy, to apply proceeds in reinstatement and to make up any deficiency out of its own monies; alternatively, there should be a freeholder obligation to claim against other tenants whose default has led to part of the insurance monies being irrecoverable; (c) there should be provisions to cover frustration, namely the situation in which reinstatement is not possible the insurance monies and any "top-up monies" from the landlord or any other tenant should be apportioned according to the respective interests of the freeholder and tenants of the building including the commercial tenant. The lease might go on to provide that if the building/site is sold the sale proceeds will be apportioned on the same basis;

3 Page 3 (d) the tenant may want the right to specify and/or approve the insured risks and the amount of cover; (e) the tenant may want provisions for the insurers to waive rights of subrogation against the tenant and for the policy to contain a satisfactory non-invalidation clause; (f) a landlord's obligations to comply with insurance requirements to accord with any tenant's contractor's insurance cover relating to any tenant's works. The tenant may wish to explore with insurers the possibility of insuring against loss in value in the event of reinstatement of the building being frustrated. Particular care should be taken to ensure that the form of lease does not include insurance provisions more appropriate to a short-term lease; particularly, there should not be: (a) any form of insurance break clause exercisable by the landlord there should just be the frustration provisions as indicated above, none of which amount to a right to terminate the lease; and (b) provisions imposing liability on the tenant in the event of default by third parties outside the tenant's control. 5. Management Structure for the Building In relation to the repair of the structure of the building and provision of communal services/works the commercial tenant, as is the case for the residential tenants, needs to ensure that there is a satisfactory structure in place for the building with: (a) effective freeholder/management company obligations to provide services/works; (b) effective obligations on the commercial tenant and the other tenants to contribute towards costs; (c) effective obligations on the commercial tenant and the other tenants to contribute towards costs; and (d) an entitlement for the tenant to a shareholding and directorship in the management company. In essence, the provisions for the benefit of the commercial tenant should reflect the matters required by the Council of Mortgage Lenders for apartment tenants. 6. Redevelopment, Refurbishment and Alterations The lease should contain provisions as wide as possible for the tenant to redevelop, refurbish and alter its premises. As indicated above, these will be linked with the rights to enter upon the relevant parts of the building/site. Tenants should bear in mind the provisions of the Landlord and Tenant Act 1927 which allow a tenant to carry out improvements to its premises notwithstanding any provision in the lease this is a helpful often-overlooked fallback though it does nevertheless involve an application to the court for a declaration that the tenant is entitled to carry out the relevant improvement, the landlord having the right to elect to do the works itself and to charge rent accordingly. 7. Forfeiture provisions The forfeiture clause should contain the modern mortgagee protection clauses covering the following:

4 Page 4 (a) (b) (c) a freeholder obligation to notify a disclosed funder of any intention to take action to forfeit the lease; a right for any notified funder to remedy the relevant breach within a reasonable period; an obligation on the freeholder to enter into any tripartite "direct agreement" between the landlord the tenant and its funder as the tenant or its funder may require direct agreements are intended to create a direct contractual relationship between the freeholder and the funder primarily to enable the funder to prevent forfeiture by stepping in and either remedying a breach or procuring a transfer to a satisfactory tenant to remedy the breach. By way of reminder the forfeiture clause should never be expressed to be exercisable in the event of any tenant insolvency; this would make the lease unsaleable and unmortgageable. 8. Freeholder obligations in respect of statutory agreements It is prudent nowadays for tenants to seek a freeholder obligation to enter into any planning, highways or utilities agreement as may be required by the tenant in the event of the tenant proposing major works. This is likely to be subject to the tenant indemnifying the landlord and procuring that the relevant agreement contains the release of liability for the landlord on disposal of its interest in the building/site. Often, it will be the tenant that is to undertake major works which require such an agreement and the relevant authorities generally insist that the freeholder is a party to the agreement (even though it may hold only a nominal reversion of limited value). An express obligation on the freeholder in the lease ensures no delay or other issues in this respect. 9. Pre-emption Right to acquire the Freehold The investor tenant should consider seeking a right of pre-emption in the event of the freeholder seeking to dispose of its interest. This would need to be created in advance of the grant of long-term residential leases as otherwise it will be subject to the residential tenants' prior statutory rights of pre-emption. 10. Underleases of Part Where the relevant lease is held out of a head lease of the whole building a tenant should remember to examine the terms of the head lease in detail particularly as: (a) any right for either the freeholder or the head tenant to terminate the head lease will automatically terminate the tenant's lease; particular care is needed to check there are no insurance termination rights in the event of reinstatement frustration. (b) use restrictions in the head lease will apply to the underlease. 11. Mixed Commercial and Residential Buildings The points above relate to the content of a long commercial lease of part so as to make the product institutional and acceptable in terms of the tenant's acquisition, occupation, redevelopment and funding. Where the relevant building is mixed commercial and residential use the tenant will also need to be advised as to the key legislation benefiting the residential tenants to the extent it may impact upon the commercial tenants. In particular: (a) the tenants' right to manage the building; this applies to buildings where the total internal floor area of the residential premises represents 75% or more of the total internal floor area. The end result is that the residential tenants may achieve the appointment of their own right to manage company to take over management of the building (b) the tenants' rights to acquire the freehold of the building: this applies to buildings where the total internal floor area of the residential premises represents 75% or more of the total internal floor area; the end result is that the commercial tenant may have the residential tenant's management company as its landlord (enfranchisement)

5 Page 5 (c) tenants' rights of pre-emption on the transfer of the freehold: this applies to buildings where the total internal floor area of the residential premises represents 50% or more of the total internal floor area; the end result is that if the landlord seeks to dispose of its reversionary interest the tenants may acquire that interest and accordingly become the direct landlord of the commercial tenant If you require further information on anything covered in this briefing please contact Charles Anderson (charles.anderson@farrer.co.uk; ), or your usual contact at the firm on Further information can also be found on the Property page on our website. This publication is a general summary of the law. circumstances. It should not replace legal advice tailored to your specific Farrer & Co LLP, January 2015