Hello, I’m David Slade, I’m a partner in the Commercial Real Estate team here at Wright Hassall. And I focus on development work and commercial investment work and leasehold management work, mainly for landlords. And as part of all that I’ve dealt with many commercial property investment sales and purchases over the years since I was involved in my first one as a fresh-faced newly qualified lawyer in the mid-1990s, which was the sale of Reindeer Court shopping centre in Worcester. So I’m going to talk about the main things we solicitors look out for on a property investment sale transaction.
So what do I mean by an investment sale? Well, by an investment property, I mean a tenanted property, one that is subject to one or more leases. It’s a property acquired by a landlord to make a return from the investment, by making money from collecting in the rent, and ultimately by selling the property at a profit.
So this podcast is all about acting for landlords on the sale or the purchase of the tenanted property.
The talk is split into two. * First of all the all-important bit: the * reporting – most importantly, reporting on the leases, which is at least half of the work, especially on a multi-let transaction, and then for the second part * I’ll look at the quirks and the nuances of a property investment sale contract. There are several facets to an investment sale contract which are different from a normal sale and purchase agreement for a commercial property with vacant possession, which I’ll come onto. And I’ll focus particularly on VAT – and the ability to avoid in on an investment sale
**So, if you’re acting for a purchaser, you will probably get heads of terms which say exchange within 15 working days of receipt of the papers, with completion two weeks after exchange. It’s a tight timescale to meet; sometimes it’s a strict timescale, sometimes it’s there above all to focus minds, but you need to try and work yourself into a position where you’ve achieved, or you’re as close as possible to achieving, that 15 working day date. As with many commercial property transactions, as buyer’s solicitor, I’m one of 6 parties – the clients on both sides, the solicitors on both sides and the surveyors on both sides, and it’s my philosophy that you need to work with, not against, the five other parties. We are not adversarial; we are not litigators!
Now, the one thing that won’t take up a lot of that time is negotiating the contract. Although I am going to go through the peculiarities of an investment contract in some detail shortly, there’s nothing unduly contentious about the contract. It’s very rare indeed that you’ll need an all parties meeting to negotiate the contract. If you genuinely thought of the transaction as being three weeks from receipt of papers to exchange of contracts, then I wouldn’t deal with the contract until the start of week three because there are things arising from the result of your due diligence against the title and above all against the leases which will feed into the contract. It’s in weeks 1 and 2 that the lawyer should be doing what I think is the most important bit, which is reading and reporting to the client on the leases.
And this will be a bigger job on a multi-let property than on a single let property such as a single retail unit.
What should you be focusing on when you prepare your lease reports? Well, yields make the world go round. If you look at yields – the return from the investment – as a fraction, then, once your client has bought the property, it is going to want that top half of the fraction, *the rent, to be as big as possible as against the bottom half of the fraction, the purchase price and the purchase costs. So what the client is going to be concerned about, from your report on the leases, is to ensure that there are as few outgoings on the property as possible that will eat into the income from the property, i.e. the rent. So, what the client is keen to know from you is as follows:
- What the rent is, and whether that reflects the client’s understanding from the negotiation leading up to the heads of terms.
- *Whether there are any on-going rent-free periods or whether, as is sometimes the case, there are future rent-free periods (such as a rent-free after a rent review date), that will mean your client is not getting, for a time, the rental income he is expecting.
- *Rent review. You need to report on the rent review provisions carefully. Are there any upwards or downwards rent reviews or oddities in the rent review provisions which would prejudice the client’s ability to get the best possible rent on review.
- *Service charge shortfalls. On a multi-let building or estate, the landlord will be spending costs on providing services to the estate and will be expecting full recovery of those costs by receiving a full-service charge from the tenant. So, does any tenant have a capped service charge, which would mean the landlord would have to meet the balance over the cap out of its own pocket? Are there any services which one tenant is obliged to pay for, but which another one is not, under its lease?
- *Repair is also very important. Your client will expect the leases to be FRI leases, fully repairing and insuring leases, which means that the landlord can get full recovery of its insurance premiums from the tenants, and also that all the tenants are fully responsible for repair. Anything less than that in relation to repair means that the landlord will have to fork out money from its own pocket to put the units back into a lettable state of repair when any lease has come to an end, and that will be an outgoing which will obviously eat into the landlord’s expected income stream, and affect its yield. So, when reading the leases, it’s vital to look out for things such as schedules of condition limiting the tenant’s repairing obligation, or parts of the premises which the tenant may not be responsible for the repair of.
- *Break clauses are also very important. Usually, the purchaser will have been told of these before you are instructed. It’s obviously critical that you highlight all break clauses in any event, as a landlord who is expecting a ten-year income stream from a property will want to know if that ten-year income stream is only one for five years if there is a break clause in favour of the tenant halfway through.
- Are there any residual development obligations in agreements for lease if the investment is a new build or a recent build? Hopefully not – as between the landlord and the tenant, they should have been made personal to the original developer/landlord because otherwise, they will pass automatically to the investment purchaser, the new landlord, creating unwanted financial liabilities for your purchaser client.
Onto the contract itself now.
Perhaps the most particular nuance about the investment sale contract is VAT.
VAT needs to be paid on the purchase price for the commercial property if either the transaction is the sale of a freehold of a new commercial building before completion of its construction, or within three years of practical completion; or the seller has opted to tax the property (elected to waive VAT exemption), as is common. If one of those scenarios applies, stamp duty land tax (SDLT) would need to be paid not only on the purchase price but also on the VAT that was charged on the purchase price – double taxation. That could significantly increase the SDLT liability.
On property investment sales, it is important to try and take away that additional SDLT liability, by taking away the VAT liability.
Transfers of businesses as going concerns (TOGC’s) are outside the scope of VAT if certain conditions are met, meaning that no VAT is payable. The sale of a commercial investment property is prime facie a TOGC because the Revenue sees the act of letting the property and generating income from the rents on the property as being a business being carried on from the property. If the buyer itself opts to tax the property and notifies the Revenue of that option before the VAT supply is made to the buyer, the transaction is a TOGC, outside the scope of VAT, no VAT is payable on the purchase price, and therefore the buyer does not take the additional SDLT hit on the VAT element. The fact that the buyer opts to tax the property before completion means that it will have to charge VAT on the rents, payable by the tenants after completion, but most tenants will expect that and should be able to reclaim the VAT from the Revenue when making their VAT returns.
When talking about property investment sales, what is and what is not a TOGC? Well, a freehold sale of an entirely let property is a TOGC. A freehold sale of a partially let property is highly likely to be a TOGC, in respect of the whole purchase price, even though part only of the property generates rental income. HMRC says – if have a partially-let building which is capable of being a property rental business, providing that the letting constitutes economic activity, that’s a TOGC, but such cases should be considered on their facts - HMRC would not see a TOGC if the letting element of the transaction was so small as to be negligible. I’ve sold a building as a TOGC where the only leases were of phone masts and advertising hoardings – as long as the rent s generated from them were not negligible, then that sale should be a TOGC.
Where there is a lease in place of part of the building but no rental income (such as where there is an on-going rent-free period), that’s a TOGC, no VAT payable; there is still a transfer of a letting business. Where you have merely a pre-let, an agreement for lease in place, HMRC regards this as being sufficient evidence of economic activity for there to be a property rental business being transferred – even if the agreement for lease is conditional on something. That’s a TOGC, in whole.
For many years, grants of long leases at premiums, subject to subsisting occupational leases, were not considered TOGC’s, because it was an essential requirement of the TOGC that the seller had to pass on the same interest, i.e. a freehold or an assignment (not grant) of the long lease for TOGC to apply.
However, following a 2012 case, the Revenue has revised its guidance and stated that – provided that the interest retained by the landlord granting the lease is small enough not to disturb the substance of the transaction – the transaction will be a TOGC if the other usual conditions are satisfied. By an interest being small enough, the Revenue guidance states that, if the value of the interest retained is no more than 1% of the value of the property immediately before the transfer, as will very often be the case in this scenario, then the grant of the long lease subject to the occupational lease or leases, will be a TOGC. Even more recent guidance now, a surrender of a long lease back to the freeholder, subject to subsisting occupational leases, to be treated as a transfer of a going concern.
What isn’t a TOGC? Well, if you have heads of terms agreed with a tenant but no agreement or lease in place at the time of sale, that isn’t a transfer of a letting business, not a TOGC; a sale to a sitting tenant is not a transfer of a going concern because, at the date of the transfer, the letting business falls away, and the new business being carried out is whatever business the tenant is carrying on.
Beware also of subsales from seller A to subseller B on to buyer C under England and Wales law (not necessarily Scots law) subseller B is not holding the letting business long enough for him to be a letting business purchaser; the chain is broken, and there is no TOGC on either sale. Subseller B may be able to avoid stamp duty land tax if the subsale structure is drafted correctly.
The investment sale and purchase contract is a rather particular animal. Specific things you have to look out for are making sure the rents are apportioned correctly between seller and buyer when you are completing in the middle of a rent period. Tenant arrears – as a buyer’s solicitor, I would always look to resist a request by a seller to pay off to the seller any tenant arrears which are due to the seller.
If there are on-going rent reviews when you complete, you will need to agree how they are conducted after completion so that the seller gets its due proportion of any uplift after the rent review is settled.
With a multi-let investment, you may well need to consider what happens to service contracts on completion – are they to be assigned or novated to the buyer, or terminated by the seller? And there may be employees assigned to the property, such as receptionists, caretakers and security guards who may well transfer to the buyer under TUPE, so my buyer/client needs to be fully aware of the terms of their employment contracts.
Treatment of service charge between seller and buyer always seems to be the most significant focus of negotiation in the investment sale contract.
What you need to envisage here is that there will be a pot of money which the seller should have to hand over to the buyer on completion. The seller will be collecting service charge from its tenants, advanced sums on account from the tenants which it will be placing into the pot, and from that pot the seller will be paying for services for the property, such as security, cleaning, landscaping etc. Whether there is a pot to pass to the buyer on completion is a balancing act between the income received by the seller - the service charge paid by the tenants - and the expenditure made by the seller, the payment made from that pot for the services. *If the service charge income exceeds the service charge expenditure, then it should be a simple question of the seller paying the excess, the unused money in the service charge pot, to the buyer on completion. *If the service charge expenditure exceeds the income, then there won’t be a pot to pass over. There should be provisions in the sale contract requiring the buyer to recover the deficit from the tenants after completion and to pay the seller that deficit when received. If all the tenants have been diligently paying their proper on account payments of service charge, the buyer may not be able to recover that deficit until, as a landlord, it carries out the final service charge reconciliation at the end of the service charge year. So it may be that the seller will have to wait until the end of the service charge year until it gets its proper proportion of that deficit back.
*The service charge account is an ever-changing animal, particularly with a complex multi-let estate, with income coming in from tenants and outgoings being paid out all the time. You often find that the investment sale contract may provide for only an estimate of what’s in the service charge pot to be paid over to the buyer on completion, or for nothing in relation to a service charge to be paid over to the buyer on completion at all, leaving the buyer an amount of time to prepare final service charge accounts, showing the final service charge income and expenditure incurred during its ownership, during a period of grace after completion.
If I was acting for the buyer, I would allow the seller no more than three months to do that. The contract would then provide that, at the end of those three months, what was in the service charge pot, if anything, should be handed over to the buyer.
**If there are void units within the investment, the landlord, effectively as quasi-tenant of those void units, should have been paying on account payments of service charge into the pot in respect of those vacant units. So those units should be treated no differently, for the purpose of the service charge reconciliation, than the occupied units. In essence, they are still part of the service charge income and expenditure balancing act on completion.
The only real difference is that the monies which the current landlord has been paying into the pot, as quasi-tenant, of the voids, should be apportioned as between the current landlord and the new landlord if completion occurs in the middle of a quarter.
*If there are service charge caps within any leases, then the parties need to decide how to treat the deficit if the actual service charge payable under the lease, disregarding the cap, exceeds the cap.
The obvious answer to that is that the deficit is apportioned; the seller makes it up for the period to completion (because the buyer will want the actual service charge for the capped unit paid into the pot by someone), and the buyer for the period after. But the obvious difficulty with that is that you will be completing in the middle of a service charge year and it will not be known until the service charge reconciliation, sometime after completion, whether the cap for that year is exceeded or not.
*Generally, it isn’t really practical to wait until the service charge accounts for the year in which completion occurs are finalised before making the final balancing payment as between seller and buyer. The parties just want a clean break, don’t they?
And if the seller was an SPV which is being wound down after the investment sale, then there might not be a company for the buyer to go against to collect any balancing payments.
So as a result, there’s usually an element of horse-trading before the parties settle on what they’re prepared to agree as regards the service charge reconciliation. And because of that, it’s the service charge clause, I find, which is the one clause which is heavily negotiated. I had one acquisition, for example, which could, and probably would have exchanged within four weeks if it had not been for the negotiation of the service charge clause. As it was, it exchanged in seven, with I would say 80% of the time in those extra three weeks spent negotiating the service charge clause alone.
With a multi-let investment, I would encourage a seller to have an open book policy with the buyer, and his accountant from the date terms are agreed; get the accountant in there from day one, not just from completion, looking at the service charge accounts, inspecting receipts, checking that voids are dealt with properly, assessing whether the parties can come to an arrangement at completion, or shortly after completion, whereby the seller can walk away from the service charge with a clean break. The buyer can start operating the service charge with a clean slate.
And that sort of preparedness within the transaction should also be happening before the transaction – by the seller, by the seller’s surveyors, and by us, the seller’s solicitors, when we are notified that an investment sale transaction is going to occur. A buyer with a good firm of surveyors and solicitors behind it it is going to do a fairly thorough, maybe forensically thorough, due diligence, for there are a lot of aspects to an investment purchase, some of which I’ve touched on. The better that the seller and its professionals ready themselves for sale beforehand, pre-empting the buyer’s thoroughness, the more likely that the investment sale transaction will exchange within that old good old three week period.
Bye for now, and thanks for listening.