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Residential Tenant’s Right of First Refusal over Commercial Units

Wed 17 Sep 2014

The tenant’s right of first refusal was introduced to prevent landlords from selling the reversionary interest in a tenant’s flat without the tenant’s knowledge, and to give tenants a chance to become their own landlord. However, ambiguous drafting has caused some unintended issues for mixed-use developments.

The origins and development of the right of first refusal

The right is contained in section 5 of the Landlord and Tenant Act 1987 (LTA), a statute rushed through Parliament prior to the 1987 general election and which has since been criticised by the courts.

Section 5 of the LTA provides qualifying tenants with a right of first refusal on any sale or disposal which would affect their premises. The right only arises in respect of tenants of residential units, and it was initially believed that the right only extended to disposals of residential units. However, it has since been established that in certain situations, proposed leases of commercial units in mixed-use residential and non-residential blocks would be subject to the tenant’s right of first refusal.

What this means in practice is that, in some cases, landlords of a mixed-use building seeking to sell or lease non-residential units will have to offer those units to qualifying residential tenants first, reducing the freedom of the landlord to obtain a buyer or tenant of their choosing. Further, even in the event that the residential tenants do not take up their option to purchase the commercial units, the disposal process will be prolonged, and potentially additional expenses incurred, as a result of the statutory two month period which must be allowed to tenants to exercise their option.

When will the tenant’s right of first refusal arise?

There are four primary considerations to determine whether your mixed-use premises will be affected by the tenant’s right of first refusal.

1. Is the building a qualifying premises?

2. Is the proposed letting a relevant disposal?

3. Is the landlord a qualifying landlord?

4. Are there the relevant number of qualifying tenants?

The tenant’s right of first refusal will only arise if the answer to all four of these questions is yes.

Common situations in which the right will arise include when a single company owns a building containing primarily residential units but also contains one or more commercial / non-residential units such as a shop or a gym, and the landlord intends to grant a lease (even if only for a short term) of the non-residential unit.

Whether premises, disposals, landlords and tenants involved in a transaction will be considered relevant or qualifying for the purposes of the right of first refusal will depend upon a number of factors and each individual situation will be different. Below are some broad rules that may be applied in determining whether a particular transaction will be subject to the right of first refusal. It should be noted that this is not an exhaustive list of considerations and legal advice should always be sought in order to avoid any potential civil and criminal sanctions.

  • At least fifty per cent of the floor space of the building (excluding common parts) must be used or intended to be used for residential purposes, and there must be at least two flats. In this case, at least fifty per cent of the units within the building must be held by qualifying residential tenants for the disposal to trigger the right.
  • The landlord intending to let the non-residential units must not be a registered provider, a charitable housing trust, a local authority or a resident landlord. Additionally, the landlord must be the immediate landlord of both the non-residential unit subject to the disposal and sufficient residential units to qualify. This will usually apply when a single landlord owns the entirety of a building.
  • Assured shorthold tenancies, tenancies linked to employment positions, and a single person with tenancies of three or more of the properties within a building will not benefit from the right of first refusal.
  • Only the disposal of those non-residential units which relate to ‘the use and enjoyment’ of the residential premises will trigger the right of first refusal, and in previous cases electricity substations, maintenance offices and garages which are not linked to the residential tenancies have all legitimately avoided the s.5 process. However, each case will be considered individually, and it should not be assumed that disposal of units of this sort would always avoid the requirement for the s.5 process.

Penalties for failure to comply

Whilst the original draft of the LTA contained no criminal or civil sanctions for a defaulting landlord, the Housing Act 1996 introduced criminal sanctions for a failure to comply with the right of first refusal. Landlords may:

  • have the rights enforced; and / or
  • be subject to a criminal fine of up to £5,000

and the criminal sanctions can be applied to individuals within a company.

Structuring deals to avoid the right of first refusal

The landlord making the disposal of the non-residential unit must be the immediate landlord of the residential units for the right of first to refusal to arise. Accordingly, one method of avoiding the potential complications presented by the right to first refusal may be to ensure that group companies are used in setting up the ownership structure for the relevant property. For example, prepare a structure where Group Company A owns the residential units of a mixed-use building, and Group Company B owns the non-residential units.

Alternatively, if the commercial units are let first, before sufficient residential tenants exchange contracts, the transaction is unlikely to fulfil the necessary criteria to trigger the right.

These and other methods may be applied when structuring deals to eliminate the pitfalls of dealing with the right of first refusal.

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