Commonhold An opportunity for developers

Commonhold An opportunity for developers Contents Commonhold a starter for ten 2 The Commonhold law 2 The nuts and bolts of a Commonhold scheme 2 The pros and cons of Commonhold 3 Developer s control 3 The transitional period 3 Development rights 4 Developer s exit from the scheme 4 Restrictions on leasing 4 Commonhold finances 4 Enforcement 4 Voting and minority unitholder s rights 5 The impact of Commonhold on the development market 5 Opportunities 5 How popular is Commonhold likely to be? 6 Valuation issues 6 Potential benefits of Commonhold 7 Benefits for developers and occupiers 7 Benefits for investors and business owner-occupiers 7 What is Commonhold? The concept of Commonhold Commonhold is a new standard legal structure for property developments, comprising individual plots or units with shared facilities. A Commonhold scheme will look no different on the ground compared to a leasehold development. Commonhold provides developers with a simpler procedure behind the scenes. The most important benefit is that each unit in the scheme gains an individual freehold title. So in vertical developments, such as office buildings or mixed-use schemes, developers can sell off each floor with freehold title no more long leases! www.pinsentmasons.com www.knightfrank.com

2 Commonhold: an opportunity for developers Pinsent Masons What is Commonhold (cont d) Traditionally, developments such as industrial or retail parks, or mixed-use and residential schemes have been structured using long leases to sell off each of the units or flats. In these traditional leasehold structures:- the value of leases reduces as their term runs down the landlord manages the scheme the lease is usually negotiated by the buyer (leading to nonuniformity of terms amongst the leases in the building) Commonhold enables developers to set up schemes with minimal documentation. This is because one document the Commonhold Community Statement ( CCS ) governs the whole of the Commonhold scheme. In addition, because the title to each unit in a Commonhold scheme is freehold, the process of selling off each of the units in the development is more straightforward. Whether developers choose to use Commonhold or go with traditional structures for their schemes will depend on how confident they are with the new structure, including how much they can sell Commonhold units for, and whether buyers and investors will go for Commonhold. Here, we will look at these issues from the developer s perspective, looking at new build schemes. Pinsent Masons look at what Commonhold is and what the pros and cons are for developers who choose to use it. Knight Frank looks at the valuation issues, and considers the take-up of Commonhold by both developers and buyers of Commonhold units. Commonhold a starter for ten Susan Samuel, Associate in the Property Group, Pinsent Masons The Commonhold law The new law of Commonhold was introduced by the Commonhold and Leasehold Reform Act 2002 ( the Act ). Commonhold commenced on Monday, 27 September 2004. Developers are now able to create Commonhold schemes. The nuts and bolts of a Commonhold scheme There are four main components of a Commonhold scheme: The units At least 2 units must be specified as Commonhold units when the scheme is being created. Each unit can include a car space or storage area. A plan must accompany the application for registration and this must show the extent of each of the Commonhold units and the scheme generally. Commonhold units may be horizontally or vertically divided, or may be freestanding so Commonhold can apply to not only flats and houses but also industrial or retail units or office suites. Each unit will be allocated:- a percentage contribution to the finances of the scheme (i.e. the service charge for Commonhold); and a number of votes in meetings of the Commonhold Association. Developers will be able to use these allocations to customise their schemes. The Common Parts The Common Parts of a Commonhold scheme include every part of the Commonhold that is not a Commonhold unit. On registration of the scheme, Land Registry will issue separate freehold titles for:- each of the units in the scheme (initially in the name of the Developer, to then be transferred to the individual purchasers of each unit); and the Common Parts (to be registered in the name of the Commonhold Association after the transitional period see below). The Commonhold Association The Commonhold Association will own the freehold title to the Common Parts and will be responsible for its ongoing maintenance. The Commonhold Association will also be responsible for collecting and managing the Commonhold finances. The Commonhold Association is a company limited by guarantee, and must be registered at Companies House before the Commonhold scheme can be registered. Its members are the unit-holders of the Commonhold scheme. The prescribed form of the memorandum and articles of association are mandatory (although additional provisions may be included). There must be at least 2 directors appointed to the Commonhold Association. The directors do not have to be unit-holders themselves, although non-member directors are not entitled to vote upon any resolution of the Commonhold Association. A developer setting up a Commonhold Association may appoint its own directors upon setting up the company. www.pinsentmasons.com

Knight Frank Commonhold: an opportunity for developers 3 It is very important that developers are able to retain full control of the scheme until construction is completed and the last unit is sold. Directors may delegate their powers to a managing agent. The Commonhold Association may find this useful to deal with its numerous administrative functions, such as keeping the register of members, managing the scheme finances (discussed below), insurance and dealing with the day-to-day management of the Commonhold scheme (including disputes with and between unit-holders). The Commonhold Community Statement The CCS is the key document in a Commonhold scheme. The CCS will have the basic details and plans showing the extent of the scheme, and will define the location and extent of each of the units and the common parts. It will include details of the permitted use of each unit and the common parts and define any limited or exclusive use areas (i.e. areas of the Commonhold that may only be used by specified users). The CCS contains the rights and duties of the unit-holders and the Commonhold Association in relation to the scheme. Generally speaking, it contains the kinds of provisions that you would usually find in a lease, such as service charge, use restrictions, insurance and repair and maintenance. The form of the CCS is mandatory, although additional provisions can be included to enable developers to tailor the CCS to each individual scheme. The pros and cons of Commonhold Developer s control It is very important that developers are able to retain full control of the scheme until construction is completed and the last unit is sold. There are a number of ways of putting these protections in place in Commonhold schemes. Developers will be aware of the method used to protect the developer s interest in completing and selling the rest of the development in traditional schemes, known as the Developer s Golden Share. In these arrangements, the voting rights attached to new owner's shares in a management company are suspended until after the sale of the last unit. The CCS can be drafted so that the member s voting rights are weighted in this way. However, whether buyers will accept this is a separate question! A balance will need to be struck between developer s control and protection of purchasers during the development period. In any case, the Act deals with the issue of control of the scheme by the developer in two ways, by providing for a transitional period, and ability for a developer to reserve to itself development rights. A balance will need to be struck between developer s control and protection of purchasers during the development period. The transitional period Where a developer constructs a new Commonhold scheme, a transitional period will apply from the date the scheme is registered until the first unit is sold (and the sale is completed). During the transitional period, the developer will have total control of the scheme. The developer will be registered as the proprietor of each of the units and the common parts, and the provisions of the CCS will not be effective. Importantly, if the developer finds that it cannot sell the scheme, it can de-register the scheme. The transitional period ends when one of the units is sold. The Commonhold Association will then be registered as the owner of the freehold title to the common parts, and the rights and duties conferred and imposed by the CCS shall come into force.

4 Commonhold: an opportunity for developers Pinsent Masons Development rights The Act allows developers to reserve to themselves the right to complete the development works and market the development until all of the units are sold. The developer must include specific provisions dealing with this in the CCS. The regulations restrict the developer s rights here, so that a developer cannot, in exercising these rights, interfere unreasonably with the enjoyment by a unit-holder of his or her unit in the scheme. Commonhold is structured so that when the developer has completed construction and sold the units in the scheme, that the scheme will then be run by the new owners of the units. Developer s exit from the scheme Commonhold is structured so that when the developer has completed construction and sold the units in the scheme, that the scheme will then be run by the new owners of the units. In traditional leasehold schemes, a developer can only exit after selling the freehold reversion (for example, to a management company). Being able to exit the scheme in this way will be a benefit to many developers. Restrictions on leasing The Commonhold regulations prohibit certain types of residential leases. The general rule is that it will not be possible to grant a lease over a residential Commonhold unit if it has a term exceeding 7 years or if the lease has been granted in consideration of a premium. It will also not be possible to grant a lease for less than 7 years and grant an option or enter into an agreement that extends the term beyond 7 years. Although there is no prohibition on the grant of leases of commercial Commonhold units, the Act allows the CCS to include provisions which restrict leasing of these. Commonhold finances Commonhold Assessment and Reserve Fund The Act gives the Commonhold Association the right to require unit-holders to contribute to the expenses of the Commonhold Association. The Commonhold Association s finances are covered under the following two main headings: Commonhold Assessment (which includes Association's general expenses, including administration costs); and Reserve Fund (to meet the costs of repairing and maintaining the common parts of the Commonhold Scheme) The Commonhold Association may also make provision for emergency funds to be payable by unit-holders (i.e. to cover any unexpected expenses). The directors of the Commonhold Association are required to estimate these amounts on an annual basis and notify unit-holders of the amount payable by them and when those payments are to be made. The unit-holders have one month to make written representations to the directors regarding these estimates and the directors must take due consideration of these representations. However, the directors will have the final decision on what amount is actually demanded from each unit-holder. Enforcement There has been a lot of press in relation to the enforcement powers of the Commonhold Association (or lack thereof). This is because in a traditional leasehold development, a landlord has the ultimate enforcement power of forfeiting the lease for non-payment of rent. As the underlying estate in Commonhold is freehold, owners will not be at risk of forfeiture of their interest in their Commonhold unit. www.pinsentmasons.com

Knight Frank Commonhold: an opportunity for developers 5 The position remains, however, that if the defaulting unit has not been let or is not being sold then the Commonhold Association s only power is to sue the relevant unit-holder. Non-payment of Commonhold finances will result in the Commonhold Association not being able to collect enough money to operate the scheme. If the Commonhold Association cannot recover these payments at all, the arrears will need to be made up by the owners of other units in the scheme. The Commonhold Association can sue the defaulting unit-holder (and could obtain and register a charging order over the defaulting Commonhold unit). The Act and underlying regulations include the following provisions which improve further the position of the Commonhold Association:- in the CCS, the Commonhold Association has a right to require that any rent payable in respect of a Commonhold unit in which there are arrears be diverted to the Commonhold Association to cover those payments; on transfer of a Commonhold unit, the buyer of the unit also acquires debts owed by the former unit-holder in respect of the Commonhold unit acquired. The position remains, however, that if the defaulting unit has not been let or is not being sold then the Commonhold Association s only power is to sue the relevant unit-holder. Voting and minority unit-holder s rights The standard articles for the Commonhold Association provide that each unit will have one vote on a resolution put to the members of the Commonhold Association (although as discussed above, this can be changed). Most resolutions of the Commonhold Association must be passed by 75% of those who vote. As the Commonhold Association is a company limited by guarantee, company law will apply to it and so too will the position at law regarding the rights of minority shareholders. This means that if there are a number of units held by a single owner, or where a new development has yet to be fully sold by a developer (and the developer still holds a number of units) there are potentially problems for the minority of unit-holders, because they may be outvoted by the majority unit-holder. Developers will, therefore, need to give careful consideration to the voting rights to be allocated in respect of each unit in a Commonhold scheme. However, to protect individual unit-holders, the standard form CCS provides, for example, that unit-holders will not be able to change the permitted use or extent of a Commonhold unit without the consent in writing of the affected unit-holder (and the registered proprietor of any charge over that Commonhold unit). Developers will need to give careful consideration to the voting rights to be allocated in respect of each unit in a Commonhold scheme. The impact of Commonhold on the development market Liam Bailey, Head of Knight Frank Residential Research Opportunities The Government s objective in establishing Commonhold, was that it should create a popular and workable alternative to the existing leasehold system. To this end Commonhold has been designed to overcome several basic problems with the current leasehold framework. Commonhold allows developers to set up a scheme with freehold title of units, a new concept in the property industry, especially for vertical developments such as mixed-use schemes. Also, Commonhold has been designed to be as simple to set up as possible; if it was too complicated the take-up would be limited because people would be keen to retain the familiar leasehold structure.

6 Commonhold: an opportunity for developers Pinsent Masons How popular is Commonhold likely to be? Is your company considering building a Commonhold development when the new act comes into force? % of respondents % of the survey Yes No Yes No Not Returned 44 56 4.6 5.8 89.6 Source: Department of Constitutional Affairs Nature of development for those developers who would use Commonhold Pure Residential 45.5% Residential led mixed-use 36.4% Commercial led mixed-use 9.1% Pure Commercial 9.1% Source: Department of Constitutional Affairs Figure 1 Relationship between lease length and value, expressed as a % of freehold value Percentage of Freehold value 100 80 60 40 20 0 Source: Knight Frank 20 40 60 80 100 120 Lease Years Remaining At the current time it is very hard to quantify the likely take-up of Commonhold. The adoption of the system is voluntary and will depend upon the acceptability of Commonhold to developers and purchasers. A Department of Constitutional Affairs (DCA) survey designed to understand the potential scale of Commonhold take-up*, comprised an approach to 240 developers. These developers collectively represented approximately 28% of the new build house and flat market. Perhaps indicative of the interest in Commonhold at the time of the survey, only a small proportion of replies were received. The limited response rate is perhaps indicative of the property industry s lack of interest in relation to Commonhold. In addition there was a long time lag between the initial government proposal to create Commonhold and the introduction of the law, which not surprisingly has led to some degree of fatigue in relation to this initiative. We can expect that the proportion of developers who will take an interest in Commonhold will grow after this option has become established. Whilst the sample in the DCA survey was small, it did give some indication that it is in mixed-use schemes rather than in pure residential schemes that Commonhold is likely to be more successful. The following chart illustrates the nature of the development product completed by developers who expressed an interest in using Commonhold in future developments. The DCA survey estimated that following the introduction of the new rules that it was likely that somewhere between 2,600 and 4,400 Commonhold residential units could be completed and released into the market per annum. Valuation issues We need to differentiate between advantages accruing to occupiers and those accruing to developers. If developers do not see an obvious upside from adopting Commonhold then fewer Commonhold units will be released into the market. As far as prospective purchasers are concerned, there are well-documented problems with the leasehold system. Leases are a wasting asset, usually subject to a right of forfeiture in favour of the landlord. As the remaining term of a lease diminishes its acceptability as mortgage security declines. Notwithstanding the statutory right to extend or enfranchise a lease, the concern expressed by lenders regarding mortgagability remains. Figure 1 illustrates the relationship between lease length and lease value, expressed as a percentage of freehold value. We can see that with a 99 year lease, or longer, the lease s value is effectively equivalent to that of a freehold. The decline in value is slow until approximately 60 years. From this point forward the rate of decline increases rapidly. Difficulties with mortgagability set in at about the 60 year lease length remaining. As Commonhold units will be freehold, and would therefore not be subject to forfeiture, this decline in value is no longer relevant. This is good news for purchasers. For developers, Commonhold units will be freehold and should equate in value terms to a leasehold unit with 99 years to remain. However, there is an issue for developers who routinely set up their schemes with an entitlement to ground rent. Because the underlying title to Commonhold is freehold, the developer no longer retains the freehold reversion and therefore has no entitlement to the recovery of ground rent. The developer effectively loses the capitalised value of ground rents. The obvious answer to this would be to include the ground rent component in the sale price for Commonhold units (i.e. so that the purchaser effectively pays the ground rent up front). It is not clear whether the market will allow the developer to be compensated for his loss of ground rent value in this way. For purchasers, a saving of 200-400 in ground rent per annum may be a small factor in their assessment of unit value at the outset; it would seem unlikely that the capitalised value of the ground rent would simply be added to a Commonhold unit s price. A more plausible alternative for developers is for them to push the fact that the purchaser is taking a property which is not a wasting asset in their marketing. www.knightfrank.com

Knight Frank Commonhold: an opportunity for developers 7 This is of particular significance when we consider investment purchases where occupiers are looking to hold units for the long-term and perhaps even to contribute to their pension funds in later years. A property bought with a 99 year lease by a 30 year old investor will only have 64 years left to run if the investor were to retire at 65 and look to draw on the enhanced capital value. At this point the leasehold property would have lost a not insignificant part of its value, compared to an identical Commonhold unit which will not have lost any value resulting from lease erosion. As Commonhold units will be freehold, and would therefore not be subject to forfeiture, this decline in value is no longer relevant. Potential benefits of Commonhold There are many benefits which it is hoped Commonhold will bring, these have been highlighted through the consultation process. The following section examines each of these benefits in turn. Under the current leasehold system leases are individually drafted. It is not known how many are drafted in a defective manner, but one consultee to the DCA suggested the proportion may be as high as 10%. Once a defect has been noted it must be remedied for a property to be saleable. One of the benefits of Commonhold is that documentation will be standardised under the regulations, avoiding this requirement to remedy defects. Sales documentation will be simpler for a developer under Commonhold rules. They will sell the units with reference to the Commonhold Community Statement. For the developer of a Commonhold block there should be a saving of selling by reference to one document and the task of the buyer s adviser is made much easier. This could lead to savings on transaction cost. A person familiar with Commonhold documentation will only have to examine the departures from the standard form. These will of course vary from Commonhold to Commonhold but regulations should ensure that these are easily identifiable. Benefits for developers and occupiers Developers can perhaps draw on the fact that the experience of living within a Commonhold scheme should at the least, be as good as the experience of living in a leasehold scheme. Particularly as there will be a dispute resolution procedure aimed at preserving the harmony of the Commonhold community. As the DCA commented, the removal of the landlord tenant distinction should make ownership of interdependent properties more attractive especially to those who want to play an active part in the shaping and running of their own community whether residential or commercial. There will, however, be purchasers who will not want to be actively involved in the Commonhold Association. It will be the degree to how well the Commonhold Association is managed which will influence the success of the Commonhold community. This is an area where property consultants and others within the property industry could look for business opportunities in the provision of good management and advice to Commonhold Associations. Benefits for investors and business owner-occupiers Investors will be attracted to Commonhold because the Commonhold law sets down standard protections for unit-holders. In addition, investors can acquire freehold title without the restrictions imposed by a landlord. Commonhold will create saleable freehold property in smaller lot sizes, which will attract small to medium investors in property. Business owner-occupiers can acquire the freehold title to their business premises and participate in how the scheme is managed and administered. *Department for Constitutional Affairs 2002 Final Regulatory Impact Assessment

Residential Research Biographies Susan Samuel, Associate in the Property Group, Pinsent Masons Susan is an Australian lawyer, now practising law in England. The Australian equivalent of Commonhold has been in use for over 30 years, and Susan has far-ranging experience of how Commonhold type schemes work in practice in her home jurisdiction of New South Wales. She has acted for property developers setting up these schemes, and buyers and sellers of Commonhold property and Susan specialises in Commonhold law and Property Development and Investment at Pinsent Masons. Liam Bailey, Head of Residential Research Knight Frank Liam Bailey heads Knight Frank s specialist Residential Research team. He has extensive experience across the residential development and investment sectors, and has close involvement with mixed-use development and regeneration issues. Knight Frank Residential Research provides strategic advice, consultancy services and forecasting to a wide range of clients worldwide including developers, investors, funding organisations, corporate institutions and the public sector. All our clients recognise the need for expert independent advice customised to their specific needs. General enquiries Knight Frank Liam Bailey Head of Residential Research 0113 297 1950 liam.bailey@knightfrank.com Pinsent Masons Susan Samuel Associate, Pinsent Masons 0113 244 5000 susan.samuel@pinsentmasons.com Knight Frank LLP and Pinsent Masons 2004 This report is published for general information only. Although high standards have been used in the preparation of the information, analysis, views and projections presented in this report, no legal responsibility can be accepted by Knight Frank LLP or Pinsent Masons for any loss or damage resultant from the contents of this document. As a general report, this material does not necessarily represent the view of Knight Frank LLP or Pinsent Masons in relation to particular properties or projects. Reproduction of this report in whole or in part is allowed with proper reference to Knight Frank LLP and Pinsent Masons. Knight Frank LLP is a limited liability partnership registered in England with registered number OC305934. Registered office: 20 Hanover Square, London W1S 1HZ