This article was originally published in the FTAdviser and can be accessed here.
The risks of commercial property investment
A combination of the growing appetite of private individual investors to seek higher returns on their investments and savings and the increased potential to offer property for sale in a global market, via the internet (and increasingly via social media) has created a new community of potential investors in property. Whereas, traditionally, private investors have confined their involvement in the property investment market to ‘buy to let’ property in the residential sector, higher returns from investing in commercial property are tempting private investors. However, investment in commercial property has a very different, and generally higher risk profile than investment in residential property.
The recent failure of a student housing investment scheme in a North Midlands university city illustrates the pitfalls which can be encountered in investing in commercial property development schemes, particularly those involving the purchase ‘off plan’ of leaseholds.
According to the Land Registry, 196 tenants now seem to hold leases in the Q Studios housing accommodation development in Stoke-on-Trent. This largely completed development now has an uncertain future following the management company, which had a pivotal role in the proposed management of the scheme, having been put into administration. A similar number of buyers also find themselves with uncompleted contracts to buy leases in the scheme.
The scheme seems to have involved the developer selling 250-year leases of individual rooms in blocks of student accommodation for relatively low capital sums (which seem to have been around £70,000) but with relatively high ground rents (£750 per room) subject to RPI indexation at five-yearly intervals throughout the term of the lease. On the grant of the room lease, the investor then granted a sub-lease of his or her room to the management company (which appears to have been connected to the developer). Under that sub-lease the management company agreed to pay the investor an “additional rent”, being a share of the rent received from letting the room to a student, which would achieve ”effortless” annual returns of between 8-12%. In addition, management company agreed to pay the ground rent and service charge payable under the investor’s head lease.
What the investors may not have realised was that in completing the grant of nearly 200 leases at individual ground rents of £750, the developer not only generated capital receipts of several millions of pounds for itself, but richly endowed its freehold reversion with an annual ground rent income stream of nearly £150,000 (which would have probably doubled on the completion of the grant of the uncompleted leases). According to the Land Registry, that allowed the developer to sell the freehold for over £2.8 million to a specialist ground rents owner.
To the investors who held completed leases with sub-leases in place with the sub-tenant company, all would have appeared well until 1st October 2018 when quarterly payment due from the sub-tenant company of the “additional rent”, were not paid. Following a further missed payment of that return in January 2019, the sub-tenant company was put into administration.
In addition to the failure of the management company, investors were made aware by the administrator of three further unpalatable facts concerning the scheme:
- That the management company had not generated enough income to pay all of the rent, service charge and additional rents under the sub-leases (although that may not have come as a surprise to investors given that two “additional rent” payments had been missed);
- That the investors would have to fund payment of the rent and service charge payable under their own leases (and then seek to recover those payments from the administrators) to prevent those leases from being determined by their landlord;
- That to enable the administrators to remain in office and continue the administration, the investors would have to waive their right to receive “additional rent” on a daily basis until all other necessary expenses of the administration had been paid. Therefore, even to the extent that rents were being generated by occupational lettings, those rents would first be used to pay rent, service charge and administration expenses.
At best, those tenants ‘lucky’ enough to have completed their leases have some form of asset. Given that the company responsible for generating the return in their investment is in administration, the value of that asset must be of dubious value as the success of the scheme relied on the completion and letting of all of the rooms in the project, not just the room an investor owns. Those buyers who have exchanged contracts but who have not completed face a more uncertain future, they may lose their deposits or, even worse, be forced by whoever has the benefit of the agreements to grant those leases to complete the grant of leases which have drastically decreased in value.
In principle, such a scheme is not an unattractive investment if, and whenever, the scheme becomes viable the returns on let rooms might be expected to be between 5-7%. However, it is essential that the investor (not unusually, in this case, a great number of the tenants were based overseas) understands the product, the process by which it would be realised and the risk associated with it. Some of that can be dealt with by in-depth research but a lot will fall to the investor’s lawyer to deal with.
Buying ‘off plan’ is highly speculative and, therefore, high risk. In particular:
- The ground rents (as a percentage of the purchase price being paid for each lease) were unusually high. Also, the five-yearly review by reference to retail or consumer price indexation will serve to increase the ground rent in each lease frequently and potentially exponentially. By way of example, a recent case in the Supreme Court concerned the interpretation of a similar ground rent review provision which seemed to have had the effect of increasing from £90 when the leases were granted in the 1970’s to £3 million towards the end of the terms of the leases.
- The greater the number of individual units that need to be constructed or refurbished to make the development viable, the greater the risk. Therefore, the investor must not look at his or her unit in isolation but what the economic prospects of completing and letting the scheme are. In this case, although the accommodation was close to two universities’ research into the local letting market and potential income from the scheme, even if fully let, might well have identified that there would not be enough income to pay the investors the predicted returns.
- Investors, particularly those not familiar with the quirks of owning leasehold property need to understand that a lease is both a wasting and, potentially because of the landlord’s right to forfeit, a vulnerable asset.
- Establishing the track record of the actual developer, particular in specialist sectors such as student accommodation, is vital – it is surprising how much information, for instance, can be gleaned from half an hour spent researching online at either Companies House or the Land Registry.
- Investors may have been under the misapprehension that the product being sold, and the seller were regulated in some way and that miss-selling would be penalized by some form of regulatory sanction or redress.
The package of legal documentation which would be needed to document the sale of one of the rooms in the Stoke development would be fairly extensive. Instructing a partner or a senior associate in a firm of solicitors with appropriate expertise in development conveyancing (especially involving leasehold structures) to advise on such a transaction might easily involve legal fees of £5,000 plus VAT and disbursements. Given the, relatively, low buy-in cost for the units being sold in the scheme (thought to be around £70,000) it is understandable the reluctance of would-be investors to take legal advice at that cost and to seek a lower quote or, possibly, not take legal advice at all. However, engagement of a lawyer, and the right lawyer, is a key part of a successful investment in a property scheme of this complexity.
There are a number of reasons why this is the case with instructing a solicitor:
- Perhaps a little cynically, all solicitors licensed to practice must have a minimum level of professional indemnity insurance. The current level of compulsory insurance cover would have been ample to cover claims by investors who instructed solicitors whose advice fell short of what would have been lawfully required;
- The standards which a solicitor must meet in a property transaction in order to have satisfied the duty of care owed to a client are high and, not meeting those standards would lead to the client having a good claim for negligence against his or her solicitor;
- Litigation funding and other fee payment arrangements (such as ‘no win no fee’) means that potential claimants will find it easier to bring a claim now than might have been the case in the past. That is particularly the case where there is a potential for group litigation by a number of claimants whose claims rest on broadly the same facts (as might indeed become the case with the Stoke development);
- More positively, a good and experienced solicitor should be capable of identifying and advising on the potential risks of the scheme and, most importantly, be capable of advising the client not to proceed with the investment or, at least, not on the terms offered;
- In plainer terms, in what other circumstances would a consumer consider spending a material amount of money on buying a product without seeking some appropriate advice or assistance?
Ultimately, however, the fate of the Stoke development seems to prove the old adage that “If it is too good to be true, it probably is”.