Imparting the mixed-use message

In the second of their three-part mini-series, the team at Dentons looks at the importance of setting up a management structure in respect of a mixed-use scheme. When putting together service charge provisions for a mixed-use scheme, the landlord’s ultimate aim is full recovery of its costs from the tenants (both commercial and residential). This task is complicated by the need to be fair to each tenant and to be compliant with applicable laws and industry-set requirements. For example, most long residential leases need to comply with the Landlord and Tenant Act 1985 (1985 Act) and also take into account the UK Finance Mortgage Lenders’ Handbook requirements (formerly the CML). Commercial leases (long or short), although not subject to the 1985 Act or the Mortgage Lenders’ Handbook, will need to take account of the RICS Service Charge Code (soon to be updated by the RICS professional statement – Service Charges in Commercial Property (1st edition) – which takes effect from 1 April 2019). Getting the service charge regime right is important both in the short and long term. In the short term, badly drafted provisions will be unattractive to investors, buyers and lenders, and could increase the time it takes to negotiate deals. In the longer term, a poor service charge regime that results in shortfalls could affect the management and maintenance of the scheme and potentially have a material adverse effect on the value of the reversion and/or individual units. As such, it is important to adopt the right approach from the start. On a practical level, there are various issues to be considered by the landlord at the outset, to include but not limited to: which services are to be provided to the development as a whole and which are limited to part who is going to provide the services and will they be under an absolute obligation or a “reasonable endeavours” obligation to do so whether there should be separate categories of mandatory and discretionary services whether any of the services are specific to any particular class of tenant (for example, lift maintenance where the lift services only the residential elements) what is the fairest method of apportioning the cost of the services between the tenants and whether a distinction should be made between residential services and commercial services. Once the practical points have been considered, a landlord’s legal adviser should then factor in the various legal considerations when drafting the service charge provisions. For example: while it may be difficult to list every single service that may be provided from time to time, reliance on a “sweeper” clause should be avoided as, historically, the courts have tended to construe these restrictively against landlords if there are tiered leasehold interests in the scheme (whether created for tax or as part of mixed-use planning), how the service charge will work across those different tiers where a service is to be provided to both residential and commercial tenants, thought should be given as to how to reconcile the differing legal regimes that apply to each for the commercial elements, landlords will need to take account of the new RICS professional statement on service charges which brings in “mandatory requirements to ensure service charges to commercial tenants are transparent, upfront and fair” for the residential elements, landlords need to take account of the statutory protection under the 1985 Act. This includes section 19, which provides that a landlord can recover costs only “to the extent that they are reasonably incurred, and where they are incurred on the provision of services or the carrying out of works, only if the services or works are of a reasonable standard”. Another key protection afforded to residential tenants by the 1985 Act are the consultation requirements. Section 20 consultations A common trap for those new to the mixed-use market is the 1985 Act consultation obligations owed to residential tenants; something that would not apply to a distinct commercial/industrial development. Under section 20 of the 1985 Act, landlords have a duty to consult with residential tenants when certain works or services are being considered, provided the cost of such works or services is to fall into their service charge expenditure. It is therefore imperative that service charge liabilities for commercial and residential tenants are clearly defined in a mixed-use scheme. If not, it can be difficult to ascertain whether section 20 is caught. There are two circumstances where landlords must consult with the residential tenants (and any intermediary landlord): 1. Before carrying out works of a certain value – triggered if the tenant’s relevant contribution as a result would be more than £250; and/or 2. Entering into qualifying long-term agreements (QLTAs) relating to services, which means a tenant’s relevant contribution would be more than £100 in any 12-month accounting period. The penalties for not consulting are severe. A landlord who does not consult (or fails to consult properly) can pass on only limited costs to the tenant. The maximum sum recoverable from each tenant per year will be £250 for qualifying works and £100 per tenant for QLTAs. It should be noted that developers can avoid the obligation to consult in respect of a QLTA provided the QLTA is entered into before the building is constructed or the residential flats are let, as confirmed in BDW Trading Ltd & Comet Square Phase 2 Block Management Co Ltd v South Anglia Housing Ltd [2013] EWHC 2169 (Ch). In such circumstances, the tenants are still afforded the protection of section 19 of the 1985 Act – any charge back to the tenant must be reasonable. Right to manage As well as being afforded protection by the 1985 Act, residential tenants acquire specific rights under the Commonhold and Leasehold Reform Act 2002 (the 2002 Act). This gives qualifying tenants (ie a tenant of a flat held on a lease granted for a term in excess of 21 years) the right to take over the management of their block of flats through a tenant-controlled management company (known as the right to manage or RTM). This is a non-fault right, exercisable by the tenants without the need to demonstrate any mismanagement of the building. The RTM applies only to premises that are (i) a self-contained building or part of a building, with or without appurtenant property; (ii) contain two or more flats held by qualifying tenants; and (iii) where the total number of flats held by such tenants is not less than two-thirds of the total number of flats contained in the premises. The right extends only to the management of those parts enjoyed by the qualifying tenants, with the management of any non-residential parts or non-qualifying residential tenants not transferring to the RTM company. This can cause severe complications in a mixed-use context. For example, where common parts are shared by both the residential and commercial tenants, it can be difficult to ascertain who has the responsibility for these common parts if the management of the commercial and residential element of the building is severed. Similarly, where plant or equipment services both the commercial and residential parts, who retains the responsibility for that plant? The prospect of an RTM company being responsible for plant that partly services the commercial units will have an impact on the marketability of these units. Of course, a development with a well-defined legal and service charge structure can circumvent these issues. Importantly, the RTM does not apply to a building where 25% of the internal floor area is used for non-residential parts (ie parts neither occupied, nor intended to be occupied, for residential purposes, nor comprised in any common part of the premises). A prudent developer can therefore look to avoid the rights conferred by the 2002 Act by constructing the development in such a way so that it does not qualify for the RTM. Careful consideration does, however, need to be given to the fact that the RTM applies to a “self-contained” building (ie one that is “structurally detached”) – so, depending on the size of the development, it may apply only to certain buildings within it. To be excepted from the 2002 Act, 25% of the internal floor area of this self-contained building will need to be used for non-residential parts. The Upper Tribunal found that to establish “structural detachment” (which, in turn, establishes whether the building is a self-contained building for the purpose of the 2002 Act), any attachment between the building and another building or structure must not be structural in nature (No 1 Deansgate (Residential) Ltd v No 1 Deansgate RTM Co Ltd [2013] UKUT 580 (LC); [2013] PLSCS 5 and ratified in CQN RTM Co Ltd v Broad Quay North Block Freehold Ltd [2018] UKUT 183 (LC); [2018] PLSCS 142). Finally, while it is a non-fault right, a well-managed property goes a long way to deter qualifying tenants from making an RTM claim. Instructing a management company at the outset (as outlined above, it is advisable to do this before there is an obligation to consult pursuant to section 20 of the 1985 Act) can help ensure a harmonious existence between competing commercial and residential interests. This will, in turn, retain value in the asset by making it a desirable investment for the end user. In our final instalment next week, we will look at the market as a whole, with particular consideration as to what the current uncertain economic and political climate means for mixed-use. Main image © Gill Allen/Rex/Shutterstock See also: Mixed-use mindfulness: a guide to de-stressing Thomas Nolan, Andrew McGrath and Charlotte Phippen are associates and Bryan Johnston is a partner at Dentons