We can work it out
22 November 2004
The benefits of residential commonhold schemes are clear. But is commonhold a viable option for commercial investors? By Christopher Harrison
So we know about commonhold now. We know it is an alternative way of owning freehold-registered land within a community of freeholders whose commonhold association company, of which each unit-holder is a member, owns the common parts. We know the great majority of rules and regulations are statutorily prescribed, with some but not a great deal, of scope for flexibility.
But where will commonhold bite in the market, apart from new residential developments, at which it is primarily aimed?
A commonhold scheme, as a whole, holds no scope for the investor because there is no rental income from the commonhold units. But it is possible to imagine large developments comprising separate buildings, each possibly having a different use and each benefiting from common facilities. The scheme as a whole could be structured as a commonhold. An investor might consider taking the freehold in a non-residential building which is treated as a separate unit. Such an investor would be free to let on rack rent terms. But the investor landlord is not in sole control. The community statement rules will be binding on the tenants and can be enforced against them by other unit freeholders and their tenants and by the commonhold association itself. Nor would such an investor have a one-to-one voice in the quality of services provided to the overall common facilities. That is the preserve of the commonhold association, of which the investor would be one of several members.
Take the commercial property developer who builds to sell. That is a different matter. How many schemes have you come across where the developer constructs buildings, usually industrial units, and sells them on long leases with a relatively small service charge levied for the upkeep of the estate roadway and not much else? The purchasers would like the freehold, but the developer is advised to grant leases because that is the only efficient way of making positive covenants run. Well, not really. The developer, or whoever owns the estate roadway, could reserve an estate rent charge out of the freeholds. The developer could impose a regime of Land Registry restrictions on disposals coupled with new direct positive covenants by freehold purchasers. That can be made to work.
But who owns the roadway? The developer wants to bank the money and leave the roadway behind for others to manage in the future. So the developer creates a company to which each building purchaser is required to subscribe for shares. When you get down to it, what is the material difference between that and a commonhold? There may be some devil in the detail of the developer’s retained and temporary rights to develop the commonhold land (see Regulation 14(8) of the Commonhold Regulations and the prescribed Articles of the Commonhold Association). That, though, is also the type of detail the developer needs to implement if it forms its own estate company. It is perhaps understandable that, after only a few weeks into its life, commonhold is not looked on with great favour for such schemes. Lack of flexibility is the frequent cry. Well, study the regulations and understand the scope for adding local rules to the community statement before deciding against a commonhold structure for straightforward build to sell schemes.
And what of the mixed-use scheme involving residential flats above commercial space? Is there scope for commonhold there, bearing in mind that there are no restrictions on letting the commercial space but accepting that a residential unit freeholder could not let for more than seven years? The short answer is yes, if the developer is content to realise the residential value by capital disposals.
The problems associated with residential tenants having pre-emption rights on a disposal of the reversion under the Landlord and Tenant Act 1987 would go by the board because there would be no qualifying residential tenants. The building owner’s headache about service charge regulation would be cured and the reasonableness test on provision of services would not bite because the Landlord and Tenant Act 1985 would not apply either. The developer or its funder might have concerns about the possibility of collective freehold enfranchisement or the collective right to manage, removing altogether the investment in the commercial space and all management control. Commonhold could provide an answer to the concern, because there would be no scope for enfranchisement or for divesting management control from the association.
Of course, there is no point in structuring a commonhold unless it is bankable by the unit purchasers. It appears that lenders will have to get used to the idea of lending on commonhold residential schemes. Having regard to the relatively tightly controlled documentation, lenders will at least be able to measure the risks. There will be no risk of the security being forfeited. There is, though, at least a theoretical risk of a lender who takes possession stepping into service charge assessment arrears, because there is a clean break on debt following a change of unit ownership. The outgoing freeholder walks away from the debt and the incoming freeholder walks into it. (See paragraph 4.7 of the prescribed community statement about information certificates which the commonhold association must supply on notice from a unit-holder).
Lenders may also be anxious to have some notice, and perhaps a measure of control, over the exercise of the borrower’s voting rights, which if treated too lightly could cause a reduction in value brought about by lax management. The Articles of Association give receivers, administrators, trustees in bankruptcy and mortgagees in possession voting rights in place of the member borrower. For all potential lenders, look out for the commonhold revisions to the Council of Mortgage Lenders’ Handbook. That is likely to give a good steer on required controls across the spectrum of lenders.
And for lawyers acting on corporate acquisitions, look to your warranties. A representation that the target company’s properties are freehold begs the question of whether they are freehold units in commonhold land. If they are, the company does not have the degree of control over the property that is normally associated with freehold ownership. In these early days, you may say that is a long shot. Fair enough, but the time may come.
Government sponsorship of commonhold heralds it mainly for residential schemes, but with good possibilities for commercial and mixed use schemes. A panacea for freehold ownership where there is no landlord looking over your shoulder. True, there is no landlord. Instead, there is a community of unit-holders and their commonhold association’s directors all looking at each other. Let us hope they all get on. Don’t rule it out.
Christopher Harrison is a partner in the real estate department at Herbert Smith