United Kingdom

Author: | Published: 3 Apr 2003
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Commercial leasing

In England and Wales the law of landlord and tenant is founded on principles of common law modified by statute. The landlord and tenant relationship is historically governed by the notion of freedom of contract. In the commercial property sector statutory intervention has been kept to a minimum, limited primarily to the tenant's rights to renew the lease and compensation payable to it at the end of the lease.

When a commercial lease is at market rent, tenant insolvency will usually give the landlord the right (but not the obligation) to forfeit, meaning to end the lease. The tenant's trustee in bankruptcy may also be able to end the relationship, by disclaiming the lease as onerous property. In cases of corporate insolvency the lease does not automatically vest in the liquidator. Where the insolvent tenant is the original tenant and the lease has not been assigned, the lease comes to the end on disclaimer. If the insolvent tenant is an assignee the lease continues to exist following disclaimer; all the disclaimer does is extinguish the liability of the bankrupt assignee to pay the rent.

The Statement of Standard Accounting Practice (SSAP) 21 distinguishes finance leases, which are capitalized in the tenant's balance sheet (as being equivalent to borrowing to acquire the asset), from operating leases where the tenant company charges the amount of rent paid each year as an expense in the profit and loss account for that year. The Accounting Standards Board considers the distinction too arbitrary. In a 1999 paper, the Board raised the possibility of new accounting standards requiring tenants to show leases as an asset and corresponding liability on their balance sheet. This may lead to lease terms becoming shorter in the UK, where historically terms have been for 20 or 25 years.

In July 2002, the government proposed amendments to the Landlord and Tenant Act 1954, which regulates business tenancies in England and Wales and gives tenants statutory rights to review their leases. These amendments will become effective six months after The Regulatory Reform (Business Tenancies) (England and Wales) Order 2003 comes into force. The proposals involved streamlining lease renewal procedures, replacing the need to obtain a Court Order to exclude the security of tenure provisions of the 1954 Act with a health warning notice to be given by the landlord to the tenant before signing a lease, explaining the rights that the tenant would be giving up. It is further proposed that if a tenant vacates on or before expiry of a fixed term, notice need not be given to the landlord and the lease simply ends on the expiry day.

Article 1, Protocol 1 of the European Convention on Human Rights, incorporated into domestic law by the Human Rights Act 1998, guarantees the right to keep one's property. As with most other substantive rights guaranteed by the Convention, the state may, if it is in the public interest and in certain circumstances, deprive one of one's possessions or control the use of property. The ancient, and perhaps anachronistic, self-help remedy of distress (seizing and selling a tenant's goods to cover rent arrears under the lease) is now susceptible to challenge as it involves serious interference with tenant's privacy and property rights.

Commercial leases normally provide that tenants may only divest themselves of surplus property by transferring their tenancy to another party. There is no automatic right to surrender the lease if the tenant no longer wants the property. Further such transfer is usually to a party approved by the landlord, who is normally under an obligation to act reasonably. Statute requires the landlord to act without unreasonable delay when its consent is sought and the tenant has the right to apply to Court for a declaration that the landlord is unreasonably withholding consent if he or she does not respond promptly.

Securitization of real estate

Securitization can provide an effective method of raising funds using the cash flows generated by real estate assets. As a method of raising finance it has becoming increasingly popular over the last 10 years in the UK and throughout Europe. A record total of €29.1 billion ($31.7 billion) of commercial property-backed bonds were issued in 2002, an increase of 40% from 2001, according to Moody's.

The UK accounted for around 36% of last year's issuance by volume, though in 2001 UK deals made up two-thirds of the European volume. However, this still pales into insignificance compared with the $97 billion in commercial mortgage-backed securities issued in 2001 in the US, according to Commercial Mortgage Alert and Lendlease Real Estate Investments.

Recent transactions completed in the UK include the £331 million ($531 million) securitization by Marks & Spencer of 45 of its prime retail properties in December 2001 and the British Land securitization of the rental income from 35 Sainsbury's stores to generate a £575 million bonds issue. The Marks & Spencer deal also demonstrated that high loan-to-value ratios (94.4%) could be obtained on securitization.

Declining confidence in the real estate market will inevitably impact on growth, with predictions that the average deal size in 2003 will be lower. Occupancy levels are likely to fall and there will be fewer banks willing to hold or capable of holding the relevant high value assets before securitization.

The success of a real estate securitization depends largely on the rating process. The rating agencies will assess the underlying business and financial risks and perform an analysis of the key ratios, usually based on the income generating leases being the only liabilities of a bankruptcy remote vehicle. The analysis aims at deriving an expected loss on the rated bonds that will then be mapped to a rating. There are two key ratios that a ratings agency will focus on: a fixed charge coverage ratio and adjusted debt to Ebitdar.

The principal area of focus is on net cash flow to obtain precise details of actual funds available to service the debt on a long-term basis. In particular, the debt service coverage ratio is a critical factor in an assessment by the credit agencies of the frequency of default of a particular loan. The net cash flow will also be used to calculate the loan-to-value ratio. The quality and type of property and tenants are also assessed and graded together with a valuation of the financial structure, participating parties, legal and tax issues.

The structure of the transaction must clearly minimize the risk of the level of the income stream being reduced, and provide effective remedies if any credit risk materializes. New regimes are to be implemented in England and Wales that may affect the documentation of these structures.

In the UK, those leases that generate the required level of rental income tend to be longer than those elsewhere in Europe and in the US. In addition, they are triple net in that the landlord bears no, or minimal, costs associated with operating and maintaining the relevant property. These leases can also impose on the tenant requirements to implement capex programmes. The traditional bondable lease of UK properties has upwards-only reviews. This is a particular feature distinguishing the UK property market from that elsewhere in Europe where, in some jurisdictions, reviews are regulated by legislation. However, this freedom to contract in the UK property market is under threat from the UK government, which may legislate on commercial leases and possibly even introduce a form of restriction on upwards-only reviews.

The terms of leases of high value properties are often commercially sensitive, in particular the levels of rent, method of review and the details of any fixed uplifts. The parties can keep this information confidential, because in England and Wales only leases for a term of more than 21 years have to be registered at HM Land Registry, and then the terms of these leases are not open to public inspection.

However, there are proposed new Land Registry rules that will require leases for a term of seven years or more to be registered and that will open up leases and also charge documents to public inspection for the first time. Though there will be scope for commercially sensitive documents to be exempted from public view, the procedure is likely to be cumbersome.

An applicant applying for exemption for public disclosure of any such document must demonstrate that the disclosure would be likely to prejudice an entity's commercial interests. Though that entity will usually be a party to the document it may not necessarily have to be.

The new open register rules will apply from October 13 2004 to all existing registered leases and charges registered before October 13 2003. There will therefore be a transitional period of one year during which applications to the Land Registry can be made for a document to be given an exemption status. From October 13 2004 all existing leases and charges will go public unless given a designation by that date.

In addition, the Enterprise Act 2002 will introduce a significant change to insolvency law. This will entail the abolition of administrative receivership for floating charge-holders where the charge in question was created after the new law comes in force (probably later in 2003). Under this Act, the floating charge-holder will no longer be able to appoint an administrative receiver. The Act encourages the appointment of an administrator instead. However, the securitization market appears to be exempted from these provisions as the appointment of an administrative receiver will still be possible in a number of cases, including certain capital markets transactions, subject to certain criteria being met.

Property outsourcing

The past five years have seen the beginnings of a revolution in the way UK corporates have approached the procurement of their property needs. Previously, property was held either through inflexible, landlord-friendly 25-year leases or in capital-intensive freeholds. Where the corporates chose to realize the capital locked up in the freeholds, they usually took back a right to occupy under a 25 year lease without any rights to flexibility. This revolution has been led by innovative thinking in the public sector rather than the private sector.

It began with a transaction known as Project PRIME carried out by the UK Department of Social Security (DSS). The DSS owned about 300 freeholds and leased a further 700 buildings, many of them in a poor state of repair and in poor locations. Managing this property was a distraction from the core business of providing benefits. The innovative transaction was to dispose of all of their property in return for fully serviced accommodation on a flexible basis, allowing the DSS to vacate property without penalty over the 20-year life of the contract. What the DSS pays for its occupation is directly linked to the quality of service it receives.

Since then, there has been a steady flow of private sector transactions building on this model, but following a number of distinct themes based upon the business driver that was most important to the corporate. These drivers are certainty of cost - meaning no unpredictable rent reviews - capital raised; flexibility; and risk transfer. The structure of the project varies based on the most important drivers for that particular business. Thus, for Abbey National, whose structured sale and leaseback was the first private sector transaction of this type, the most important thing was to achieve flexibility in its business occupation to allow it to reshape its estate to match its expected future business need at a time of great change for the retail financial sector. On the other hand, the most recent of these transactions, involving Bradford & Bingley, was focused upon risk and the desire to find a solution to its large surplus estate. There have also been a number of transactions that have limited the other benefits obtained to realize as much cash as possible for the business.

Not all private sector transactions have included services. Many commercial organizations feel that they have adequately dealt with FM services through separate outsourcing transactions. Some of the property transactions have included management of the existing outsourced contracts with a right to subsume those services into the property contract in due course. The services are usually hard services such as building maintenance and security and have not moved into areas such as general IT and human resources. This is not because the transactions are impossible, rather because transactions are typically led by the property department and tend to be for about 20 years to give the purchaser time to recoup the large investment made in purchasing the properties. HR and IT outsourcing tends to be for a much shorter timescale.

Post Enron, one of the main issues will be the imposition of long heralded changes to accountancy rules to require that all the leases held by a company go on to its balance sheet. However, this should lead to a more transparent review of a company's performance and benefit those companies that have been astute in managing their corporate real estate by ensuring they are not carrying large numbers of surplus properties or freeholds as a drag on the balance sheet. So rather than new problems, it may create new opportunities.

Financing of real estate transactions

The method by which purchasers finance high value real estate transactions in the UK depends on a number of factors, in particular whether the acquisition is for development or investment purposes.

The structure of any acquisition, whether of development or investment property, and the financing of the acquisition will take into account the impact on the level of stamp duty liability. Indeed, the structure will often be dominated by the need to minimize such liability and usually the cost savings, and consequently the higher price that can be achieved for the property makes such structures commercially attractive. In relation to stamp duty, UK rates are, in the main, lower than those elsewhere in Europe, with the current rate of stamp duty for real estate transactions with a value of over £500,000 at 4% of that consideration, as at March 11 2003. There are a number of stamp duty schemes in operation in the UK that mitigate or, in some cases, eradicate, the cost of stamp duty with a consequent sharing of risk and benefit between the vendor and the purchaser.

However, the UK government is committed to closing down the opportunities for these schemes. Proposals for the future include a new tax on transactions (not documents as at present) and the disposal of property-rich companies attracting stamp duty at the rate of 4% instead of the current 0.5%. The proposals will have an adverse effect on the commercial viability of such stamp duty savings structures.

There are a number of structures for financing acquisitions for development purposes, reflecting the competing interests of the parties, particularly the financing bank. The usual method by which a developer obtains the required finance is to enter into an arrangement with a funding institution (for instance a pension fund or insurance fund) whereby this institution provides the finance at the start of the proposed development. The relevant institution acquires the property and the developer takes on the risk of any shortfall between the maximum commitment of the fund in financing the development and the actual cost of the development. Known as forward funding, the relevant finance is advanced to the developer during the project. Or, if the financial institution does not want to take any development risk, it may agree to commit to purchasing a completed and fully let development. This is known as a forward purchase. In these circumstances, when the development has been completed the financial institution will acquire the property at a pre-determined value. Any profit generated by the completion and letting of the development is usually apportioned between the parties by reference to a pre-agreed formula.

Joint venture structures are also commonly used for the acquisition of and investment in commercial property. These structures enable parties with conflicting commercial objectives to participate in an investment, limiting exposure by the sharing of risk while increasing profitability with a view to ultimately realize their interests in the open market. A participating party's contribution may not be cash. For example, a property owner may contribute its land but no cash whereas another party may finance the proposed scheme. The use of a limited partnership structure, in particular, is increasingly popular for joint ventures because it is both flexible in the context of profits and capital distributions and has the advantage of tax transparency for its participants. A limited partnership is made up of one or more general partners that have unlimited liability, and other partners, each of whose liability is limited to the level of its capital contribution.

Investment acquisitions are, however, usually financed by a blend of equity, senior debt and mezzanine debt structures with inter-creditor arrangements regulating the priorities between the parties. The rental income from the property must be sufficient to pay interest and amortize the senior and mezzanine facilities and the loan-to-value ratios are generally at around 75%, often with a balloon at the end of the facility. These facilities are usually limited or non-recourse under which the recourse of the lender is limited to the land and property-related assets.

In relation to debt financing, the type of security available to a lender will depend on the type of borrower, but in relation to property finance transactions, where the land is the key asset, the lender will take a first legal charge over the property, which is registered at HM Land Registry supported by the deposit of the title deeds as further protection. The legal charge will include all fixed buildings on the land and usually all fixed plant and machinery. With any enforcement action, a lender under a fixed charge also has the right to receive the rents and profits of the property either by taking possession itself or appointing a receiver.

A legal charge has to be created by deed and affords to the lender full rights over the borrower's title to the property, subject always to the borrower's ability to undo the arrangement if it wishes to redeem the mortgage (equity of redemption). Notwithstanding these rights the borrower retains its legal title to the property and, subject to the terms of the mortgage, may continue to deal with and manage the property unless and until it defaults on any loan covenants or payments and the lender takes enforcement action.

The terms of a registered charge, notwithstanding its registration at the Land Registry, remain confidential and are not open to public inspection. New proposed Land Registry rules will open up charge documents, though as mentioned previously, there will be a procedure for exempting certain commercially sensitive documents. Lenders and borrowers are likely to try to obtain exemption for charging documents because a mortgage deed generally incorporates the terms of a loan agreement and the parties will be reluctant to want the amount of the facility or the interest margin becoming public knowledge.

Conveyancing issues

Modern conveyancing in England and Wales is based upon 1925 property legislation. Since then only two legal estates in land can exist - freehold and leasehold. Title to these may either be registered at the Land Registry or unregistered. Registration of a person as registered proprietor of land is conclusive proof of ownership, with provisions for compensation out of public funds if a register subsequently requires rectification or loss is suffered by reason of an error or omission in the register.

The practice of vendors taking advantage of development uplift is prevalent. This is usually achieved by the buyer promising to make a further future payment usually in a deed. Under English law, the burden of such positive covenants cannot be assigned so that the vendor cannot sue a successor to the original buyer, with limited exceptions. Because it may be a subsequent owner of the land who achieves the development uplift, the obligation to pay needs to be supported by some other legal device to ensure that that the vendor will be able to enforce the original promise to pay. One of the typical devices used is a restriction on the registered title to the land, preventing the original buyer selling the land without its purchaser entering into a similar obligation to pay the original vendor. Otherwise, the payment can be protected by a charge over the sold land, the retention of a ransom strip, a lease or an option. If the public sector is involved the vendor may have the benefit of further legislative protection.

The government intends that all conveyancing in England and Wales will eventually be carried out electronically, thus abolishing the legal requirement that land transfer documents must be written and signed. It is intended that the e Conveyancing System be operated through a secure electronic communications network controlled by the Land Registry that will be used to conduct all stages of the transaction in electronic form. Designated persons, probably solicitors, will be authorized to use the secure network and sign electronic documents on their clients' behalf. When the transaction is completed the register will immediately show the name of the new owner in place of the old. It is intended that it will ultimately be compulsory, though the timing of the proposed switch is still uncertain.

The Land Registration Act 2002 paves the way for its introduction within the next three to five years, authorizing the Lord Chancellor to regulate by rules that transactions can be effected electronically. The first transactions to be effected electronically are e-Lodgements. Since 2002, solicitors using Land Registry Direct have been able to lodge certain applications to change the title registers electronically. The next proposed changes are the electronic creation and release of mortgages possibly by summer 2003.

Historically, anyone occupying someone else's land with the intention of excluding the owner and without the owner's consent for 12 years could claim it. The claim could be made where the occupation had been by not one, but a succession of occupiers. Under the Land Registration Act 2002, such adverse possession, for however long, will not extinguish the owner's title to registered land. A squatter can apply to be registered as proprietor after 10 years adverse possession when the registered proprietor, any registered chargee and certain other persons will be notified of the application. Successive occupations will not count. The squatter will be registered as proprietor of the land if the application is not opposed. If anyone notified does oppose the application it will be refused (with limited exceptions). If the application is refused but the squatter remains in adverse possession for a further two years he will be entitled to apply once again to be registered. Then he will be registered whether or not the registered proprietor objects. Where the registered proprietor brings proceedings to recover possession from a squatter before he is registered as proprietor the action will succeed unless the squatter can establish certain limited exceptions. The intention is that the new scheme produces a decisive outcome. Either the squatter is evicted, or is registered as proprietor of the land.

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