Disruption in the Real Estate Industry - Don't leave the lawyers behind

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Lawyers have a tendency to be reactive-considering changes in statute and case law and applying that to the current transaction of a client. The much talked of disruption and change in the real estate industry necessitates a more forward thinking and innovative approach, predicated upon understanding the real estate sector, the drivers of change and how ways of acting and the application of technology are rapidly evolving.

All three main asset classes-retail, office and residential-are subject to the winds of change and in each there are areas where lawyers need to step away from precedent documents and consider new ways to protect clients and futureproof their investments or operation of their business from a premises.

An example of this change is seen in the Town and Country (Use Classes) Order of 1987. Perhaps coincidentally, aged 30, the Use Classes Order is slightly too old to be a millennial and perhaps that is why it looks ill at ease amongst the hipsters and other millennials driving the change in the use of property. The Use Classes Order which neatly delineates and zones how space is used looks antiquated and questionably not fit for purpose, given the way the use of space has evolved in the past decades. People now shop from home and the office, eat at the shopping mall and work everywhere and anywhere.

This is particularly seen in high streets and areas in the heart of cities, where multi-use spaces are becoming more common. There is a fusing of different-use classes, making the whole process of applying for and changing use more important and also more complex and nuanced.

Retail

It can no longer be assumed that retail stores are used solely for the sale of goods. “Click and collect” now accounts for a substantial proportion of sales and in some locations stores are used primarily as a local logistics warehouse, providing companies with an effective alternative to courier and home deliveries. An ex-board member of former US retailer Toys R Us recently explained to me how online sales reduced by 70% when free shipping was not offered, but that the cost of subsidising that shipping wiped out profitability. Realigning one’s retail footprint to act as “Click and Collect” hubs makes that “last mile” of the delivery chain. Similarly, “dark supermarkets” are being used to package and prepare orders for online deliveries. It can no longer be assumed that retail means A1 retail use. Lawyers need to ensure the use is specific to that which their client has in mind for the premises. The shorthand of Al retail or B1 offices may not be sufficient, albeit that this involves issues around planning permissions (see below).

Whilst there is nothing new in landlords of shopping malls using turnover rents, the trends mentioned above bring the precise wording of the turnover provisions of a lease to the fore. This is accentuated with the rise of online food delivery disrupters, such as Deliveroo, which act as a conduit between restaurants and customers. Each delivery service will have a different payment structure but-in the context of the turnover provisions of a lease-both landlords and tenants must pay particular attention to the extent of revenue derived from the premises as well as the deductibles which can be set off against such revenues so as to capture those matters (and only those matters) which were intended by the parties. The next innovation of delivery services may include local kitchen hubs whereby food is prepared off the “demised premises” and this is something which parties and their lawyers will need to consider very carefully. What revenue is generated, and where, is not as straightforward as verifying the EPOS system. Landlords and tenants need to consider the risks and rewards of turnover rents for the future as well as for current modes of customer delivery.

Finally, retailers and landlords of retail premises are continuing to experiment with food and beverage (F&B) offerings in an effort to increase footfall. Whilst such use is ancillary, no planning issues are likely to arise. However, leases will need to grant sufficient rights so as to allow flues and other service media to service a kitchen. Where premises end up being dominated by F&B over retail, parties will need to consider the most appropriate use class for the premises. Parties need to bear in mind that the rights granted and reserved need sufficient flexibility to futureproof the lease given the rapid changes taking place in retail.

It can no longer be assumed that retail means A1 retail use.

Office

Perhaps even more than the retail sector, offices and their use continue to develop and evolve. The breakdown of traditional familial and other groups and their structures, combined with increased mobility, has resulted in millennials searching for community. Co-working companies, led by visionaries such as Miguel McKelvey and Adam Neumann of WeWork, have created a community-combining an online platform and shared space. From a landlord and tenant perspective, this bundling of space and services has further blurred the lease versus permit divide, much more so than the first generation of serviced office provider.

From a legal perspective, this has put pressure on ensuring that security of tenure is not inadvertently granted to members. In addition to the inconvenience and costs involved in removing those claiming to have a tenancy, there is a risk in co-working companies of breaching the alienation provisions of their own lease, which may not have anticipated anything other than leases of whole or “permitted parts” of an entire floor. Agreements governing the rights of occupation must be drafted carefully, avoiding exclusive possession. Moreover, caution needs to be exercised in the operation of such co-working environments, given that a lease can be deemed to exist regardless of the content of the members’ agreement or permit. A lease can be created inadvertently and both landlords and operators need to ensure that security of tenure is only obtained where intended.

Some community-based operators, particularly one US brand yet to reach the UK, highlight offerings aside from office space including gallery space, restaurants and members’ events. This could be important in terms of planning use and also for the ratings treatment for the owner and the members. Every case is different, but parties entering into agreements must ensure they are aware of what is actually going on at the premises.

Residential

Margaret Thatcher, in her first speech as leader at the Conservative party conference in 1975, espoused the dream of a “property owning democracy”. Over 40 years after that speech, we are finally seeing the erosion of home ownership as a key aim of young people. The reasons are complex but two of the most significant reasons are undoubtedly the fact that housing is simply too expensive for most first-time buyers and that millennials are more interested in experiences than in objects. Perhaps of even greater importance is the impact of the trends mentioned above-increased mobility and a breakdown of traditional community.

Moreover, this generation has been the first to experience quality, branded student accommodation and expect the same convenience and service when entering the workforce. Private rental sector (PRS), co-living and micro-living have tapped into these trends, bringing a product to market which combines branded, quality accommodation, which may be smaller but which boasts shared spaces to encourage community.

Unlike office, retail and industrial investment opportunities, which are underpinned by long-term rental incomes, residential investment is viewed as a cash flow business. Normal rental cover tests do not apply in the same way. PRS and micro-living schemes usually involve an element of soft services (such as wifi, laundry or a concierge) which means a service provider will usually be involved. Duty of care agreements may be required by lenders where these services are being provided by third parties. Parties also need to consider their tax position relating to interest deductibility both of the funders’ financing as well as any inter-company loans.

As with any cash flow businesses, owner operators will need to be mindful of ongoing CapEx requirements, much like a hotel. The usual (and more comfortable) position of an FRI lease, which passes the liability onto a tenant, is not likely to apply where the owner keeps the risks and reward of PRS operation.

The government consultation into PRS (otherwise referred to as Buy-to-Rent) is now over and government intervention is likely, in order to promote the sector. A new use class for PRS is unlikely (and won’t work for lenders were they to seek to enforce and look to sell off units rather than keep these rented). Normal affordable housing provision does not work very well where a development scheme is intended to be retained by the owner/developer for rental and we are likely to see versions of the Mayor of London’s discounted rental requirements coming into play.

Conclusion

Disruption is different from other trends which affect the built environment. Very few of the above drivers are anchored in legislation. Instead, they highlight the need for lawyers to stay close to and understand their clients, the sectors within which they operate, and the way in which they are moving.

A lease can be created inadvertently and both landlords and operators need to ensure that security of tenure is only obtained where intended.

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