Most property professionals will be aware that the Landlord and Tenant Act 1987 creates a right of first refusal in favour of residential tenants. Jane Janvier and Bill Chandler consider some of the problems this right causes in practice for landlords and developers.
Put simply, the right of pre-emption requires a landlord who wishes to make a relevant disposal affecting qualifying premises to offer the same deal to the qualifying tenants before proceeding with the disposal. It sounds so simple, but there is a lot of detail to wade through.
Premises qualify if they contain at least two flats held by qualifying tenants and the number of flats held by qualifying tenants exceeds 50 per cent of the total number of flats contained in the premises. The definition of qualifying tenants will generally include residential tenants on long leases but not, for example, tenants on assured shorthold tenancies. Tenants who own three or more flats are excluded. Mixed-use premises qualify if the commercial areas do not exceed 50% of the overall internal floor area (ignoring common parts).
A relevant disposal does not just include the outright disposal of the landlord's reversionary interest, but also includes disposals of part and the grant of leases. It is not necessary for the disposal to include any of the flats themselves, and a disposal of appurtenant premises or the airspace above a building can also be caught.
There is a whole raft of excluded disposals that aren't caught, including disposals to associated companies (provided they have been associated for at least two years) and the grant of a lease of a single flat.
If a proposed disposal is caught, the landlord must serve a 'section 5 notice' on the qualifying tenants, giving them at least two months to accept the deal. This creates delay and uncertainty for a landlord, especially since exchanging contracts is a disposal and so the landlord cannot even enter into a conditional contract for the disposal during the offer period.
If the tenants accept the offer, the Act provides the machinery to conclude the disposal to the nominee of the qualifying tenants. This article is however concerned with transactions where the tenants are unlikely to exercise the right and the primary concern is to ensure that the procedural requirements of the Act are complied with, or avoided where possible.
Many of the problems created by the Act can be avoided if ownership is structured sensibly at the outset.
Only disposals by the immediate landlord of the qualifying tenants are included, although superior landlords are also caught where the intervening lease is for less than seven years or can be determined within the first seven years. Fragmenting ownership of the site among connected companies, or creating intermediate leases of the residential and/or commercial areas, therefore gives greater flexibility at a later date.
Timing is crucial if those arrangements are not themselves going to comprise relevant disposals. The Act treats an agreement for lease as a lease, so the Act can apply to disposals made before the leases are granted, maybe even before the building has been completed. Any reorganisation should therefore be implemented before contracts have been exchanged on half of the flats.
After that date, it may still be possible to argue that the Act does not apply if the flats do not physically exist yet. In the recent case of Aldford House Freehold Ltd -v- Grosvenor (Mayfair) Estate  EWCA Civ 1848, the Court of Appeal held that a flat cannot be said to exist until it is suitable for use as a dwelling. That case concerned collective enfranchisement under the Leasehold Reform, Housing and Urban Development Act 1993 rather than the right of pre-emption in the 1987 Act, but with similar statutory definitions you would expect the same result.
If section 5 notices do need to be served, it is not always as simple as offering the qualifying tenants the same deal that the landlord has agreed with the third party. If the transaction involves multiple buildings, the qualifying tenants in each individual building must be given the chance to buy just their building for an apportioned price. Whilst this might make the offer more attractive - and achievable - to the tenants, it creates problems for landlords.
Landlords run the risk that tenants in one block but not another might accept, fragmenting the site and leaving the landlord with a commercially-unattractive residue. It is even possible that section 5 notices may be required for some parts of the site but not for others, depending on the number and proportion of qualifying tenants in each block.
Notwithstanding a bank of useful caselaw considering specific factual scenarios, it can frequently be difficult in practice to confidently assess whether and how a complicated site should be subdivided for these purposes, especially where blocks share essential services or where one block uses common parts (perhaps parking) at the other end of the site.
If you are fortunate enough to be dealing with a handful of qualifying tenants, who all live in the building, service of section 5 notices may be relatively easy.
Complications arise where the leases prohibit service on the property, or where agreements for lease are involved. Those circumstances create particular difficulties if the tenants are overseas-based investors.
The Act provides some assistance by only requiring 90% of the qualifying tenants to be served, but even that can be challenging to achieve with any certainty.
Deal or no deal?
What if the deal changes after the section 5 notices have been served?
It is not necessary for the ultimate deal to be identical to the deal offered to the tenants, although obviously you can't sell the property for less than you offered it to the tenants for! The Act simply requires that the price and deposit of the actual disposal must be 'not less than' those stated in the offer notice, while the other terms must correspond to those specified in the notice.
There is a slight trap in respect of deposits. If you offer the tenants the opportunity to buy for £1 million with a 10% deposit, you would need to offer it back to the tenants if you subsequently agree a deal at the higher price of £1.2m but with only a 5% deposit. In those circumstances, you would expect most buyers to agree the higher deposit rather than require new section 5 notices to be served.
This is the quintessential 1987 Act question. In a typical mixed-use building comprising ground floor retail unit with residential floors above, is the grant of a rack rent lease of the shop a relevant disposal that must be offered to the residential tenants first?
It is now widely accepted that the Act requires the landlord to serve section 5 notices in this situation. While there is no direct judicial authority on this important point, Warren J's judgment in the case of Dartmouth Court Blackheath Ltd-v-Berisworth Ltd  EWHC 350 (Ch) implies that the Act does indeed apply to the grant of a lease of commercial premises within the building.
That judgment was followed more recently in York House (Chelsea) Ltd-v-Thompson and another  EWHC 2203(Ch), where it was held that the 1987 Act applies to a disposal of any part of the building unless excluded by an express provision in the Act. Whilst the Act excepts a lease of a single flat, there is no corresponding exception for a lease of a single commercial unit. However, the judge expressly refused to opine on commercial lettings, since that was not relevant to the case in hand.
In practice the issue is best avoided, usually by creating a 'buffer' lease of the commercial parts of the building.
Proceed with caution
The challenges presented by the 1987 Act should not be underestimated. Its application can be uncertain in all but the most straightforward cases, and questions regularly arise as to how to apply the Act to more complicated premises and transactions. Unusually for landlord and tenant legislation, failure to comply is a criminal offence.
Developers should take early advice on creating an ownership structure that affords maximum flexibility in the future, particularly when it comes to things like commercial units and airspace. And landlords need to consider the detail of the Act to ensure that disposals affecting existing buildings are conducted in compliance with the Act.
An earlier version of this article appeared in Estates Gazette
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.