Leasehold pitfalls – termination risks of leasehold development site structures

Author: Simon Elliott, Senior Associate, Real Estate, London

A number of recent transactions where we have acted for banks and lenders have emphasised that care needs to be taken by developers at the outset of a project when buying into or putting in place a leasehold structure of the site. We have seen how important it is to be aware of the effect that the provisions of a headlease can have on the liquidity and bankability of underleases (for example, of sub-plots within the site). In particular, thought is needed around provisions that could bring any underlease to an end for reasons beyond the control or influence of the undertenant and thereby threaten the existence of a charge over the underlease interest. I explain below how forfeiture rights and contractual termination rights in favour of a head landlord in particular should be approached with caution, as both provisions can be of concern to a lender taking security over such an underlease.

Forfeiture

If the headlease is forfeited, all underleases beneath it also come to an end. In this situation, the undertenant's options are limited, and this may not be satisfactory to an undertenant (or its lender).

The problem is exacerbated where the headlease demise is more extensive than that of the underlease (ie the estate is bigger than the building), as the undertenant is not in control of all of the land and is less likely to be able to procure compliance with all of the headtenant's covenants relating to the headlease demise. Although the undertenant may apply to the court for relief from the forfeiture, the court has a wide discretion to refuse the application and may apply conditions to any such relief; for example where the headlease demise is more extensive than the underlease, the undertenant may be required to take on the wider obligations of the headlease in order to preserve its own interest.

There is also the problem of what happens to the undertenant's own tenants; in such a case all of the undertenant's subsidiary interests would come to an end, and whether or not relief is sought is a matter for the relevant sub-undertenant. This could result in an undertenant, relying on income from sub-undertenants, losing income from the property. An undertenant may insure against loss of its interest due to forfeiture of the headlease, but its interest in land (and the income flowing from it) may be lost nevertheless.

The preferable position for an undertenant (and its lender) is therefore the absence of forfeiture rights in the headlease where practicable.

Contractual termination

Equally of concern is a provision allowing a head landlord a contractual termination right in a headlease, whether a typical break right or a termination right following damage or destruction (for example where reinstatement is frustrated). Without appropriate controls (for example through a consent provision or right to an assignment of the headlease), an undertenant could find its interest determined without any power to prevent it.

Care therefore needs to be taken to balance the interests of all parties if the marketability of the development and the various levels of leasehold interest in it are to be preserved.

For further information please contact: