Westfield and Stratford - JVs - the new form of financing?

Peter Bill, in his latest blog entry in the Estate Gazette (Westfield sells half of Stratford - more sales to come?) picks up on the announcement to the Sydney stock exchange that Westfield has agreed to sell a 50% interest in Stratford City, the part of the Olympic site which it is developing as its latest retail attraction in the UK.  The buyers are a Dutch fund and a Canadian pension fund.

This is yet another example of how developers have been turning to alternative sources of finance since the development finance market effectively dried up as a result of the credit crisis.  The truth is that joint ventures are not particularly new but they had gone out of fashion whilst developers were able to take out cheap development finance allowing them to keep significant profits to themselves rather than having to share them with partners.

What is clear now is that joint ventures are back with a vengeance and if you want to get in on the action you need to make sure you have a decent understanding of what you are getting into, what pitfalls to avoid and how to generally ensure that if the wheels come off you do not go over the edge of the cliff with your partners but can jump ship in an appropriate manner.

Some fundamental questions you need to consider when looking at entering into a joint venture include:

• how do I want to exercise control and be involved in the decision-making of the vehicle?  Depending on the type of vehicle decisions may be made at different levels and without the right controls in place you can lose control over important decisions; set the level of control too high and you risk paralysing the vehicle
• where should the vehicle be located? - there are likely to be significant tax implications depending on where a vehicle is located but beware of the effect decision-making can have on jurisdiction for tax purposes
• what are your long term intentions? - is it intended to hold the asset for a long time (i.e. as an investor) or is the intention to improve it and then dispose (i.e. as a trader)?  this can affect both the type of vehicle chosen and the jurisdiction
• Are there any deal specific issues? - some potential JV parties will have restrictions and/or preferences regarding the sorts of arrangement they can enter into.  REITs are a good example.
• Are there specific regulatory issues that make one type of vehicle more attractive? - bearing in mind the new Alternative Investment Fund Managers Directive this area needs special consideration and it will impact potentially on jurisdiction as well
• How will the vehicle be taxed and does this fit with your/partners' taxation? - some vehicles (e.g. partnerships) are generally tax transparent but this may not work for all investors

It is very difficult to change structure part way through agreeing a deal and so it is vital that you do your homework before jumping into bed.

Contracting with a UK REIT - does it make a difference?

REITs hit the UK landscape in January 2007 and now many of the best known names in the UK property world are REITs - Land Securities, Hammerson, Great Portland Estates, British Land to name a few.  As a matter of course there are certain questions one always considers in terms of the party with whom you are contracting.  It is important to consider whether they are executing the documentation correctly and, indeed, their power to enter into the transaction.  If it is a foreign entity the obtaining of a legal opinion is advisable.

REITs add something different to the mix and the risk to a party contracting with a REIT is that without knowledgeable legal advice one can be exposed to unnecessary risks or, indeed, lose out on potential advantages.

The rules governing REITs are complex and affect not only the REIT itself but also those with whom it contracts.  A REIT's business is split into a Property Rental Business (PRB) (which must be at least 75% of its total income) and the remainder being its Residual Business.  PRB income is effectively tax exempt (there is 20% withholding tax which exempt investors can reclaim) whereas the income from the Residual Business is taxable at 28%.

It is beyond the scope of this blog to go into detail (nor would I wish to give away trade secrets quite so easily) on the potential issues and pitfalls that can arise when dealing with a REIT but some highlights include:

• the sale of shares in an SPV property company by a REIT will be a Residual Business which may have negative tax consequences
• the base cost of a property in an SPV once owned by a REIT may be higher or lower than the SPV paid for it
• the sale by a REIT of a development within 3 years of practical completion is likely to be a Residual Business which again has negative tax consequences
• whilst the PRB part of the REIT does not pay tax it still benefits from capital allowances to reduce the dividend payments it needs to make so REITs will not simply give these up
• Joint Ventures with REITs raise all sorts of governance and tax issues and potential advantages

As mentioned the REIT legislation also provides potential opportunities as well.  Therefore it is key that when you are getting into bed with a REIT you know what those opportunities are and how to exploit them for both parties' benefit.

Is the FRI lease manifestly unfair?

I sat in a very interesting meeting the other day which was a general discussion on various points in negotiating an agreement for lease and lease when acting for landlords and tenants. Much of the discussion focused on the inter-relationship between warranties, repairing obligations and service charges and then moved on to insurance and uninsured risks. However, what was most interesting was that the discussion touched on a more general issue about the English institutional fully repairing and insuring (FRI) lease - is the whole proposition of an FRI lease not manifestly unfair and unbalanced.

For the uninitiated, in England and Wales the starting point with a lease which will be acceptable to institutional investors is one in which the investor receives all the rent and the tenant is financially liable for every cost associated with the property (apart from "income" tax on the rent). This works by imposing full repairing obligations on the tenant, requiring the tenant to fully re-imburse the landlord for the cost of insuring the building and requiring the tenant to pay, through the service charge, for the cost of repairing parts of the building outside the tenant's demise.

Now let us examine the relative positions and aims of the parties.

The landlord owns the property for the purposes of investment. It receives income in the form of rent and the potential for capital increases resulting from rent increases and/or yield compression. It is very much interested in the long term existence of the property.

The tenant is renting the property as a place from which to conduct its business. It does not care about the building per se. Its income is generated out of the property but not from the property and it does not, in general terms, specifically have to be located within a specific property. It does not benefit from changes in yields and only sufferes from rent increases.

Now let us consider where the risk in relation to the property should lie. The tenant requires occupation to run his business but has no interest in the long term existence of the property and sees no benefit from any increase in value. The Landlord benefits not only from the existence of the property but also from the continuing ability of the property to meet the tenant's needs. As the tenant's business flourishes so does the value of the property as it is likely to be let to a tenant with greater covenant strength. Therefore you would expect that the landlord would bear the risk of need to repair the property or it being destroyed; he is the owner afterall.

However, the FRI lease is such that the only risk the landlord is taking is that the tenant goes bust. All other risks are placed firmly at the tenant's door. Repairs within the demise the tenant will be required to carry out itself. Repairs outside the demise the landlord will carry out but recover the cost from the tenant. If the building is destroyed by an insured risk there is likely to be a rent cesser but this will only be for the period for which the loss of rent insurance is available and after that the rent restarts even if the building is still unbuilt. Uninsured risks, all things being equal, can fall completely on the tenant with the landlord being able to recover the cost of rebuilding through the service charge. So a tenant who decided against being an owner/occupier could actually find itself in a worse position as a result with higher annual costs and the potential for huge liability when something goes wrong.

Of course, the above is a worst case scenario but it is one which is likely to represent the legal position on a significant number of leases in the market today. The UK is unusual in its total lack of legislation in seeking to prevent landlords from placing the full burden and risk on the tenant. In Germany, for example, it is against the law for landlords to seek to recover the cost of structural repairs through the service charge; this is a risk the landlord took when he bought/developed the building.

Matters have in the last 20 years moved somewhat from the position highlighted above. Tenants have seen much success in toning down liability for things such as uninsured risks and liability to repair latent defects but the the risk is still most firmly with the tenant. So all you tenants out there, a little less criticism of the tenant lawyer who seeks to negotiate a lease and is reprimanded by his client for delaying the deal; the detail could very well matter.

Is this fair? As always it depends on who you ask. In reality it is market forces and perhaps as a result of the current downturn tenants and their lawyers will use the opportunity to further push the pendulum back towards the landlord in terms of carrying the risk. However, I doubt very much that it will swing too far. The fact is that tenants don't appear to care that much - maybe that is because occupiers are businesses who are used to taking larger risks than the institutional property owner funds who tend to be risk averse. Fair it might not be but so what.

Planning for flexibility

It appears that the Government wants to listen to the British Chambers of Commerce's wish to improve the planning system (see my blog of 19 June 2009) but it would appear that they are not quite on the same page when it comes to what is required.
On 18 June 2009 the Department for Communities and Local Government issued a consultation paper called:

Greater flexibility for planning permissions - consultation

The consultation considers two issues:

1. Extension of time limits for existing planning permissions; and
2. Minor material amendments to existing planning permissions.

Interestingly the issue regarding time limits has arisen because the recent legislation cut the time limit for implementation from 5 to 3 years. Now faced with an uncertain economic climate developers are not rushing to implement permissions and the 3 year limit means that applying for permission without any certainty that a development could be let/sold in the short term is unappealing. This means that planning authorities are likely to be deluged with planning applications.

Bearing in mind Gordon Brown's favourite phrase during his tenure as Chancellor: "Goodbye to Boom and Bust", it is not surprising that the implementation was lowered. Why allow five years for implementation time as surely once permission is given a developer will jump at the chance to develop.

So, yet another climb-down for the Labour Government from its previous policies is proposed. Although it does not propose a complete climbdown (or really a climbdown at all). The measure proposed would be temporary and only apply to major developments. Further an extension application would be considered a new application in terms of the need to obtain an Environmental Impact Assessment and result in supplemental planning agreements (at least in the form of a confirmatory deed). Whether or not the local planning authority decides to consult on the application is intended to be discretionary.

I can't see these proposals being greeted that warmly by the developer community.

As for the proposal for minor material amendments, well, the legal community are likely to be rubbing their hands together with glee - I can feel the warmth generated by BLP's planning department already. The interim proposals are that LPAs could approve a minor material amendment "if its scale and nature results in a development which is not substantially different from the one that has been approved". If that is not a proposal for dispute and litigation then I do not know what is.

One question I have is once you have made a minor material amendment can you then make another one? If so, is the reference point the unamended permission or the amended permission? If the amended permission then it is possible to envisage a situation whereby a permission, through minor material amendments, results in a development which is substantally different from the one that has been approved - I am assuming the legislation would not be that carelessly drafted!

Reform the planning system . . . again!

Those of you who follow me on Twitter will already know that The British Chambers of Commerce have just released "Planning for Recovery" which is their views on the problems with and solutions for the planning system in the UK if we are to get out of the current doldrums.
The report is very well set out highlighting in separate chapters:

1. The relationship between the planning system and its effect on businesses
2. The current planning system and its shortcomings
3. Reforms to the planning system already on track
4. Recommendations for further reforms to help speed recovery

There is little doubt that the need for planning regulation will automatically result in delays and frustration. The report highlights a number of cases where the delays have been hideous, for example, Heathrow Terminal 5 where a formal planning application was lodged in 1993 but consent was only finally given in 2001.

Broadly the idea of reforming the planning system to enable applications to progress more quickly especially on large infrastructure projects where the needs of the many can often outweigh the needs of the few is one with which I agree. Further, on a street level removing the obstacles to sensible extensions and loft conversions to enable families to grow within houses rather than having to move would hopefully help keep house prices better regulated. However, I do wonder the deliverability of any such reform. It seems to me that loosening the reins in order to speed things up will only lead to minority views being totally ignored. Also, contrast the current calls for greater regulation in the financial industry as a result of the credit crunch with the calls for the loosening of regulation (not necessarily in planning) in the construction industry to help it get back on its feet - is the construction industry not partially to blame for the current situation?

On a slightly separate point, I do not feel that the current predicament of much of the construction industry is, of itself, any justification for reforming the planning system to enable them to get back on their feet. Factors in developers getting into so much trouble were taking on too much debt, being overly optimistic in their predictions and forecasts, overvaluing their assets and generally not doing a good enough due diligence and financial plan job. Should we really reward such poor judgement?

So, whilst I support reform to reduce delays it should not be at the cost of the minority voice nor merely to save those who showed poor judgement but rather to benefit those who acted with due care and attention. Now if someone can come up with such reform I will be impressed. Any ideas let me know . . .