Common structures
for leasehold mixed
use developments
Common structures for leasehold mixed
use developments
This practice note sets out the potential pitfalls in mixed use developments which may arise from residential leaseholders’ rights - to buy, to manage, to
enfranchise and to require an extended lease - and examines the common structures used to mitigate the effects of such rights.
Residential floor space less than
50% of the total floor area in the
scheme (excluding common parts)
Residential floor space more
than 50% but less than 75%
(excluding common parts)
Residential floor space
more than 75%
(excluding common parts)
yes
yes
yes
No: right to manage, right to buy,
right to enfranchise
Right to extended lease applies
No structure
mechanism required
No: right to manage or right to
enfranchise
Right to extend lease and
right to buy apply
Structure: buffer lease required
of residential element
Right to manage, enfranchise,
buy and extend apply
Structure: buffer lease required
of residential element and /or
commercial element
Why is structuring a mixed use scheme important?
Mixed use developments are schemes which comprise one or more buildings used for commercial, retail and/or industrial use where there is also an element
of residential accommodation. Even where the residential element is ancillary to the main commercial use, these schemes need to be treated with a certain
degree of caution. Common pitfalls and challenges include:
Right to buy
Rights of pre-emption pursuant to the Landlord and Tenant Act 1987 (1987 Act) give qualifying long lease residential tenants the right of first refusal to
purchase the immediate reversion to their leases. A landlord wishing to dispose of the reversion must first offer it to such tenants, who then have two months
to exercise their rights. Failing to comply with the requirements of the 1987 Act is a criminal offence. See further practice note: Landlord and Tenant Act 1987 –
tenants’ right of first refusal
Right to enfranchise
The Leasehold Reform, Housing and Urban Development Act 1993 (LRHUDA 1993) gives occupiers of long residential leases (more than 21 years) the collective
right to buy the freehold and any intermediate leasehold interest where the residential floor areas account for over 75 percent of the whole development (not
including common parts). In a mixed use development where there are service charge contributions or commercial rental income streams, the collapsing of
superior leasehold interests could result in the obligation to contribute to service charge falling away or the potential loss of the commercial rental income by
the leasehold reversioner. See further practice note: The collective right to enfranchise
Lease extension
Rather than act collectively, individual tenants in a leasehold building may exercise the right under LRHUDA 1993 to be granted a further 90 year lease- whilst
the immediate landlord is paid a commuted sum in respect of lost ground rent. If there are a significant number of leasehold extensions this may seriously
erode the value of a ground rent portfolio. See further practice note: The right to an extended lease – flats
Right to manage
In circumstances where residential units form more than 75 percent of the overall floor area (and on certain other conditions being fulfilled) residential tenants
may collectively exercise rights under LRHUDA 1993 to take over the management of the scheme, by forming a Right to Manage (RTM) company. Where there
are commercial elements in the building, the RTM company can require the landlord to contribute to the service charge it levies for the building. This will be bad
news for landlords who agreed to cap commercial service charges on the basis that they controlled the services. The landlord may also lose control over the
building insurance since RTMs are also required to insure. The landlord’s ability to recover insurance rent from commercial tenants may also be impaired. See
further practice note: The right to manage
Service charge issues
Different regulatory and common law principles apply to the recovery of service charges in commercial and residential developments. Residential service and
administrative charges are heavily regulated and impose additional preconditions to and limitations on their recovery. By contrast, commercial service charges
are relatively free from direct statutory constraint. In a mixed use development it is often difficult to separate and avoid any overlap of the commercial and
residential service charge regimes. In such cases, the landlord may have difficulty recovering service charge expenditure in full. See further practice notes:
Commercial service charges – what expenses can the landlord recover?
Commercial service charges – the importance of following procedures
Residential – code for residential service charges
Residential – statutory consultation procedure for service charges
Residential – statutory limitations on recovery of service charges and
administration charges
3
Common structures
Careful forward planning and structuring of mixed use developments can mitigate the effect of the above rights. Three common structures are used for buildings
mixing long residential leases and shorter rack rent commercial leases. The choice of structure will largely depend on the freeholder/developer’s primary objectives
i.e. whether it wants to receive capital or income; and when (or if) it wants to exit the scheme at the end of the development.
A common tool in leasehold structures is to interpose “buffer” or “blocking” leases between the residential leases and the freehold enabling the freehold to be sold
without triggering the right to buy under the 1987 Act.
Model A- simple developer capital receipt model
Figure 1
Freeholder
Rent/service charge/
insurance
Rent/service charge/
insurance
Commercial
Tenant
Residential
Tenant
4
Model A- simple developer capital receipt model
Figure 1
This model does not make use of any buffer leases between the freeholder/developer and the residential and commercial long leaseholders. A classic example
would be the development of a single mixed use block with commercial space on the ground floor and flats above. Prior to entering any sale agreement for
residential units, the developer enters into an agreement for lease or long lease of the commercial space. As a result the completion of the commercial leases
will not trigger the right to buy under the 1987 Act. The developer then provides the commercial and residential services and insures the building and in return
receives the service charge; ground rent; and insurance rent.
This model is best suited to simpler, smaller developments, where: i) the developer’s main objective is to extract capital profit on the sale of individual
residential and commercial units on long leases; and ii) the developer has no intention of selling the reversion and is not concerned about remaining
responsible for the management of the scheme. The freeholder/developer is left with a nominal ground rental income and the reversion will have minimal
value.
Potential drawbacks of this model are:
• If the residential element of the scheme is more than 75 percent, residential leaseholders may exercise the right to manage or the right to collectively
enfranchise. This may not be that great a concern to a freeholder/developer who has already extracted its profit. In this case the cost of implementing and
maintaining any buffer structure outweighs the potential benefit of protecting a freehold with minimal residual value.
• 1987 Act, s5 If the freeholder/developer decides to sell the freehold reversion this will trigger the residential leaseholders’ right to buy under the 1987 Act
and the developer will need to serve notice under 1987 Act, s5 before selling. Again, as the residential leaseholders would have to match the offer price for
the freehold, the freeholder/developer may stand to lose very little other than the time and cost of serving the section 5 notices. As an alternative, if the
freeholder/developer is a corporate entity it may circumvent the 1987 Act by selling its shares as a corporate transaction.
Model A- simple developer
capital receipt model
“This model is best suited to
smaller simple developments
where the developer’s main
objective is to extract its
capital profit on the sale of
the individual residential and
commercialunits on long
leases and has no intentionof
selling the reversion and no
concern about remaining
responsible for the
management of the scheme.”
• the freeholder/developer will remain responsible for managing the scheme, providing the services and collecting ground and insurance rent. Often in this
sort of scheme, the freeholder/developer will contract with a specialist management company to provide the services and manage the buildings on its
behalf. In this case, it is important to ensure that the leases allow the freeholder/developer either to provide or to procure the services; and to charge or
pay a management fee as part of the service charge.
• if the freeholder/developer decides to retain the rack rental income stream from the commercial units then, as the usual term for secured commercial
lettings range between 15 and 25 years, when the commercial lease expires the developer will need to consider whether the grant of an extended or new
commercial rack rent lease will trigger the 1987 Act right to buy if the commercial floor area is less than 50 percent of the total floor area in the scheme.
5
Variation to Model A - using a management company
Figure 2
Ground rent
and insurance
Freeholder
Service charge contribution
Service charge and
insurance
Rack rent
Commercial
Tenant
Service charge
and insurance
Residential
Tenant
Residential
Management Co
Ground rent
Services
As a variation to Model A, the freeholder/developer may contract with a specialist management company to provide the residential services. In this case the
developer will want to join the management company in to the residential long leases to covenant to provide the residential services. The freeholder/developer
can either provide the commercial services itself or require the management company to provide those services too. The freeholder/developer will collect the
commercial service charge; rack rent; and insurance rent. The management company will collect the residential service charge; insurance rent; and ground
rent, passing the ground rent and insurance rent to the freeholder/developer. The freeholder/developer will pass on the commercial service charge to the
management company.
6
Model B clean freehold investment
Figure 3
Model B - clean freehold
investment
Freeholder
Rent
Rent
Management Co/Group Lease
Rent
Services
Commercial
Tenant
Service
charge
Services
Rent
Residential
Tenant
This model aims to create a buffer lease between the freehold reversion and the long residential leases in order to achieve a clean investment freehold with
minimal responsibilities for management of the scheme. This model is often used in larger developments where the freehold developer wants to receive both
capital and income. The essentials of this structure are:
“This model aims to create
a buffer lease between the
freehold reversion and the
long residential leases in
order to achieve a clean
investment freehold with
minimal responsibilities for
management of the scheme.
This model is often used in
larger developments where
the freehold developer wants
to receive both capital and
income.”
freehold developer and management / group company
• An agrement for lease of the whole of the scheme including the commercial element is granted to a management or group company before two or more
residential units come into existence or (if already in existence), before any sale agreements have been entered into for two or more residential units
• the lease to the management company is completed upon the later of: i) the transfer of the last residential unit in the scheme; and ii) completion of the
last commercial lease. The freeholder/developer may retain a golden share in the management company until completion of the lease to the management
company enabling it to direct and control management of the scheme notwithstanding its diminishing interest in it.
• the lease to the management company obliges it to provide the services, collect insurance rent, ground rent, rack rent and service charge and to pass
the ground rent, rack rent and insurance rent up to the freeholder/developer . Both the freeholder/developer and the management company will have an
insurable interest and either may assume responsiblitity for reinstatement. However, the freeholder/developer will typically want to control reinstatement
and would therefore elect to insure, with insurance rent being passed up to it by the management company.
• the benefit of this structure is that it creates a clean freehold investment with a buffer lease between the freehold and the residential units enabling the
freeholder to hold or sell the freehold with the ground rent and rack rent income as an investment. The freeholder/developer is not responsible for the
management of the scheme. On subsequent sales of the freehold investment, there is no need to serve notices offering the freehold to the residential
leaseholders. A potential disadvantage is that the freeholder/developer loses direct control over the commercial unit(s) and related income. The lease to the
management company may however include consultation and consent provisions in relation to certain issues e.g. rent reviews, re-lettings and the approval
of commercial tenants.
7
Variation to Model B - Freehold developer with management / group company and
separate commercial element
Figure 4
Freeholder/Developer/
Investor
Rent
Service
Charge
Commercial
Tenant
Services
Rent
Service Charge Contribution
Management Co./
Group Company Lease
Services
Rent
Residential
Tenant
A variation to model B is for the freeholder/developer to carve out the internal demise of the commercial units from the management lease and to retain
direct control of the commercial premises. Depending on the layout of the scheme, the management lease could either require the management company to
provide the services to the whole of the scheme or keep the provision of the commercial services separate to be administered by the freeholder/developer. In
the first case, the management company is likely to require the freeholder to contribute to the service charge for the commercial premises and the freeholder
would recharge this to the commercial tenants. Depending on the scale of the commercial development, non-recovery of service charge from commercial
tenants may pose a risk to the freeholder/developer . In the second case, the freeholder/developer would remain responsible for the provision of services to
the commercial units which might detract from it being a pure investment model. There may also be a residual service charge payment to the management
company as a contribution to the maintenance of common structures and facilities.
The disadvantages of both of these structures is that where the residential element is 75 percent or more of the scheme, residential tenants could exercise
the right to manage or the right enfranchise which could result in the freeholder/developer losing the income from the rack rent commercial lease unless it
counters the claim for enfanchisement by serving a counter-notice requesting a leaseback of the commercial space or setting up the scheme initially with
a separate commercial buffer lease in place from the outset. See further practice note: Collective enfranchisement—the counter notice and precedent
Reversioner’s counter-notice
8
Model C - SPV
Management Company
(no buffer lease)
Model C- SPV management company - no buffer lease
Figure 5
Freeholder
(SPV)
Shares
Shares
Services
Service Charge
Commercial
Tenant
Services
Residential
Tenant
This model makes no use
of any buffer leases. It may
be used for more complex
developments but is not
always popular with residential
tenants as it involves the
requirement for them to hold
shares in the management
company and be involved in
its management. It is favoured
by developers who want the
capital receipts from the sale
of units but no income.
This model makes no use of buffer leases. It may be used for more complex developments but is not always popular with residential tenants as it requires
them to hold shares in the management company and be involved in its management. It is favoured by developers who want the capital receipts from the
sale of units but no income. In its basic form, the developer will transfer the freehold into a special purpose vehicle (SPV) which will either be limited by shares
but more commonly, limited by guarantee (which has fewer corporate governance requirements) with the appropriate articles and memorandum from the
start. The SPV will grant the leases of the units and each leasehold owner will be required to take a share in the SPV along with its long leasehold interest. The
developer will hold a golden share in the SPV until the sale of the last unit in the scheme, thereby retaining control over its management until such time as the
developer has sold all of the units. The owners of the leasehold units will be responsible for the management of the scheme by way of the SPV which will also
own the freehold. The developer will exit the scheme once it has sold all the units and have no further interest in it nor will it receive any ground rent.
See precedents:
Memorandum of association--tenants’ management company limited by shares
Articles of association--tenant’s management company limited by shares
Memorandum of association--tenants’ management company limited by guarantee
Articles of association--tenant’s management company limited by guarantee
9
Variation to Model C - SPV management company- ground rent model
Figure 6
Freeholder
Rent
Rent
Management Co/
Group Lease
Rent
Services
Commercial
Tenant
Service
charge
Services
Rent
Residential
Tenant
A variation on Model C may be used where the freeholder/developer wants to receive ground rent. The freeholder/developer acquires the freehold and
immediately puts in place an agreement for lease with the management SPV which is controlled by the freeholder/developer . The agreement for lease or lease
of the commercial element needs to be put in place before any residential units are sold, or a separate commercial buffer lease (or agreement) put in place
similar to the variation to Model B. The freehold developer will require the management SPV (or SPVs) to pass up ground rent to it. To mitigate against the right
to extend leases, the management SPV lease(s) could be granted for 999 years or if granted for a lesser term, include the right to renew.
For a Precedent concurrent lease to a tenants’ management company see: Concurrent lease to Management Company.
10
Further reading/information
We hope you’ve enjoyed this Guide to Common Structures for Leasehold Mixed Use Developments.
This Guide mentioned a number of relevant Practice Notes and Precedents and these are listed again below,
together with information on other products and sources of information you might find useful.
Practice Notes referred to in this Guide (Subscribers Only)
LexisPSL Property – why not try it out?
Landlord and Tenant Act 1987 – tenants’ right of first refusal
LexisPSL Property brings all of the different sources you need together so you can find the answers
you need, fast. Our succinct practice notes are designed to be read in six minutes or less. They’re full
of practical hints and tips from practising property lawyers (who understand what you need to know
and do, because they’ve been in your position before). With direct links for deeper research, you can
dive straight in to the relevant cases and consolidated legislation (including Butterworths Property
Law Handbook, Ross Commercial Leases, Hillman and Redman’s Law of Landlord and Tenant and
everything in Lexis®Library). Regular news reports let you stay on top of what’s happening in the law
and the industry.
The collective right to enfranchise
The right to an extended lease – flats
Exercising the collective right to enfranchise - leasebacks
Collective enfranchisement – the counter notice
The Right to Manage
Commercial service charges – what expenses can the landlord recover?
Commercial service charges – the importance of following procedures
Take a FREE TRIAL: lexisnexis.co.uk/mixeduse/freetrial
Residential – code for residential service charges
Residential – statutory consultation procedure for service charges
Free Content
Residential – statutory limitations on recovery of service charges and administration charges
For regular FREE content from the LexisPSL Property team and guest contributors visit “Purpose
Built”, the LexisNexis blog about the Built Environment.
Precedents referred to in this Guide (Subscribers Only)
Visit the blog: lexisnexis.co.uk/mixeduse/purposebuilt
Memorandum of association--tenants’ management company limited by shares
Articles of association--tenant’s management company limited by shares
Memorandum of association--tenants’ management company limited by guarantee
Articles of association--tenant’s management company limited by guarantee
Agreement for sale or lease to a Management Company.
Concurrent lease to Management Company.
Reversioner’s Counter Notice (to claim for enfranchisement)
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