Mixed use property investment
A mixed use property may well be a good investment for a landlord. There will be income streams from both residential and commercial tenants, potential opportunities for more active management and even development possibilities. However, landlord beware: with the up side, comes the down.
The interaction between the rights given to residential tenants and the rights given to commercial tenants in mixed use properties can create issues. In this paper, we take an in-depth look at some of the issues facing landlords of mixed use properties and recommend possible solutions.
Mixed use properties, where residential and commercial tenants are present in the same building, are now part of the modern townscape. At one end of the scale there is the very common scenario in most towns of a shop on the ground floor and one or two flats on the upper floors. At the other end of the scale there are large buildings with a number of commercial units on the ground floor and multiple residential flats on the upper floors.
Matters can become complicated in mixed use properties, namely with the type of lease and service charge levies. Some residential occupiers may be short term tenants under assured short term tenancies and other occupiers could be long leaseholders under leases of 125 years or more. In some cases, residential long leaseholders have rights under various statutes to either manage or purchase the freehold of their building, thereby potentially leaving the landlord with the prospect of losing either full or part control of his investment.
The law, in general, gives more protection to residential occupiers (both short term and long term) than commercial occupiers. The law also controls what can be demanded and recovered by way of a service charge from residential long leaseholders.
The interaction between the rights given to residential tenants and the rights given to commercial tenants in mixed use properties can create issues. Outlined on the following pages are some of the issues that landlords of mixed use properties can face and our recommended solutions.
 Smaller mixed use properties
Residential occupiers in smaller mixed use properties tend to be assured short hold tenants. The advantages of these tenancies are that the terms are frequently for six or twelve months, but the landlord can charge a market rent, and most importantly he can obtain possession at the end of the term without giving any reason and regardless of the tenants’ wishes.
The disadvantage is that the landlord has implied obligations to keep the main services (i.e. heating, water and light) in good repair and any deposit provided by the tenant must be kept in an authorised tenancy deposit scheme. Failure to protect the deposit in this way will effectively prevent the landlord from starting any possession proceedings to evict the tenant at the end of the term. Furthermore the law provides that no residential occupier can be evicted from their property without a court order. This eviction process is relatively straightforward, but there is a time and cost involved with all court actions.
The protection afforded to commercial tenants is much less. There are no implied rights to keep the main services in repair, there is no authorised tenancy deposit scheme and generally there is no requirement to obtain a court order to evict the tenant at the end of the term (with the exception of leases protected by The Landlord and Tenant Act 1954 where particular provisions apply on renewal).
There was also a very effective remedy for collecting arrears of rent from commercial tenants. The process was called distress and it involved a bailiff seizing the tenant’s goods if the tenant did not immediately pay the arrears of rent. The rules and the name have recently changed. Commercial Rent Arrears Recovery, or CRAR as it is now called, still allows a bailiff to seize the tenant’s goods at the demised premises, but a seven day notice must be given beforehand.
 Combined residential and commercial tenancies
The above sets out the general rules on residential short term tenancies and commercial tenancies, but what happens where the property is let as one unit and there are both residential and commercial occupiers?
If the tenant allows arrears to accrue during a term, then CRAR cannot be used to recover them. The landlord is forced to use the court or insolvency procedures to recover the rent. Such procedures involve more cost but providing the lease has a comprehensive cost recovery clause then the landlord will be able to recover its legal costs regardless of the outcome and costs awarded in any court action.
At the end of the term, in a mixed use property let as one unit, peaceful re-entry will not suffice. The landlord will require an order from the court to regain possession. Again, providing there is a comprehensive cost recovery clause in the lease, the legal costs of any possession action can also be recovered from the outgoing tenant, perhaps in conjunction with any claim for dilapidations.
 Larger mixed use properties
The issues with larger mixed use properties can be very different.
 Service charge levy
There is a statutory regime for residential service charges but there is none for commercial service charges. Therefore in a mixed use property, the landlord must ensure that the service charges are demanded and collected in accordance with the statutory regime for residential leaseholders.
In broad terms these require that a leaseholder need only pay for service charges which are reasonably incurred and are of a reasonable standard. If a leaseholder disagrees he has the right to apply to the First Tier Tribunal. In addition, where there are major one-off works of repair, there are detailed consultation requirements which the landlord must follow. If he fails to do so, then the leaseholder’s contribution is reduced to a maximum of £250, although recent case law has somewhat limited the effect of this draconian provision on landlords.
Finally landlords cannot delay in dealing with service charges. If a particular service charge cost was incurred 18 months before a demand for payment was made then that cost cannot be recovered from the leaseholder.
The law gives residential leaseholders the ability to obtain a ‘right to manage’ of the building. This procedure leaves the freehold with the landlord but the residential leaseholders take over the landlord’s management of the building. There are a number of procedural requirements which the leaseholders, in the form of a right to manage ('RTM') company, must meet before they can exercise the right to manage – and it is on these procedural requirements that the landlord stands the best chance of defeating a RTM application.
For the application to succeed, the internal floor area of the building (after excluding the common parts) occupied by commercial tenants must not exceed 25% of the total floor area, two thirds of the flats must be let to long leaseholders and at least 50% of the flats in the building must support the RTM application.
If the RTM company can meet the procedural requirements, then there are no further grounds under which the landlord can oppose the application. Thereafter it is in the actual management of the building where the problems arise for landlords. We outline three potential issues:
- Whilst the RTM company collects the maintenance contributions from the leaseholders, the right to forfeit the leases remains with the landlord and so the RTM lacks “teeth” to recover arrears from defaulting leaseholders.
- The freeholder retains the right to deal with non-management covenants but it is up to the RTM company to ensure that their leaseholders comply with their covenants and notify the landlord of any default.
- Relating to mixed use properties, the commercial and other non-residential parts of the building remain the landlord’s responsibility. However there are no provisions in the legislation for resolving disputes relating to issues such as the external appearance of the whole building and the maintenance of the common parts used by both residential and commercial leaseholders. The result is an uneasy relationship between the landlord and the RTM company where both control certain aspects of the building.
 Collective enfranchisement
Whilst the RTM procedure may partly remove the landlord’s control of a building, collective enfranchisement can remove the landlord from the building completely. This is a procedure whereby a group of leaseholders can come together and buy the landlord’s freehold interest in the building. Again there are a number of procedural requirements which the leaseholders must meet. The hurdles are very similar to the ‘right to manage’ application – ie no more than 25% of the internal floor area (after excluding common parts) must be for non–residential use, at least two thirds of the flats must be let to qualifying leaseholders and the enfranchisement cannot go ahead unless at least half of the flats in the building wish to proceed.
In mixed use premises, units let on commercial tenancies are invariably the subject of leasebacks from the leaseholders’ nominee purchaser to the landlord unless, on construction, the developer created two head leases – one for the residential part of the building and one for the commercial part. In this scenario, the lease of the residential part will get gathered up in the enfranchisement application while the lease of the commercial part will continue in force following enfranchisement.
If the landlord seeks to dispose of their interest in a mixed use building to a third party, then the residential leaseholders have the right to purchase that interest first. Under this particular statute, the qualifying tenants (essentially long leaseholders) must make up more than 50% of the flats in the building and commercial occupiers must not make up more than 50% of the floor space of the building (excluding the common parts). The legislation requires that the leaseholders are given the right of first refusal on the disposal of the landlord’s interest. If the leaseholders accept, then the statute provides a mechanism to complete the sale. If they refuse, then the landlord is free to complete the sale to the third party.
It can be difficult for landlords to avoid a RTM or collective enfranchisement application. On the procedural front, ensuring that the commercial areas exceed more than 25% of the internal floor areas or that more than one third of the flats that are let on assured short hold tenancies will certainly prevent any such applications but, if this is not possible, then landlords need to consider the tactical option.
Leaseholders are a disparate group with varying interests and this is clearly shown in the attitudes adopted by the two main types of leaseholders – owner occupiers and buy to let investors. Unless there is an overwhelming majority of leaseholders in favour of pursuing a RTM or collective enfranchisement application, then the landlord may be tempted to delay matters or “divide and rule” as much as he can in the hope that the leaseholders (or sufficient numbers of them) will give up their application causing it to fail.
In contrast to the ‘right to manage’ and collective enfranchisement applications there are a number of ways in which a landlord can avoid having to comply with the ‘right to buy’ legislation. Consideration of all of them is outside the scope of this article but it is, for example, perfectly possible for a landlord to transfer the building to an associated company (with which he has been associated for at least 2 years) and the disposal will not be caught by this legislation.
This article was written by Rex Cowell. It was originally published as 'The ups and downs of investing in mixed use property'.
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