Re-structuring Headleases: Navigating a Path to Sustainable Offices
A sustainable workplace provides clear benefits for both occupiers and landlords. Occupiers know they are complying with essential ESG targets and enhancing their staff’s wellbeing while statistics show that green-rated buildings offer both a rental and sales uplift compared with non-rated buildings.
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Against this backdrop, and other advancements in the market, historic headleases can appear something of a straitjacket, impacting the goals of both parties. Without compromise on both sides, even common goals will be difficult to achieve, and assets may become ‘stranded’. Understanding how to navigate a solution is essential.
Andrew Tyler - Head of Central London Office Development
Outlining headleases
A headlease is typically the most superior lease between a freeholder and a long leaseholder. The headlease governs the relationship between the parties over the long term and importantly governs how building upgrades are implemented. Many headleases in London’s commercial buildings are historic agreements, of an age that means they do not adequately reflect the requirements of the modern office market.
Freehold of course remains the most superior form of property ownership. However, there are a number of landowners (predominantly Landed Estates and Local Authorities) that own the freehold of large swathes of London and grant investors long leasehold interests, transferring much of the value and control of an asset, but not surrendering the long-term ownership.
Once dominated by freehold transactions, London’s office market has evolved with significantly more long leasehold transactions taking place. In 2007, long leasehold transactions represented 34% of all activity compared to 43% in 2022. Moreover, the yield spread between freehold and long leasehold buildings has decreased as investors have necessarily become more accepting of well-drafted headleases. However, on these older leases as vacant possession looms, yields and values move out creating a short-term issue.
However, many older headleases are not structured to make changes to the building to meet the modern office market and need re-structuring to the benefit of both freeholder (landlord) and long leaseholder (tenant). At Knight Frank we specialise in the essential and complex work of re-structuring these headleases. By successfully renegotiating the terms in the headleases, we arrive at the right outcome for our clients, both landlords and tenants, and in the process, set out clear responsibility for ESG provision. Here we highlight three key areas to consider when restructuring headleases: the ability to upgrade the building, the sharing of the income and investment liquidity.
- Creating and maintaining a desirable building
The critical importance of ESG today means that it is vital that appropriate and necessary refurbishment can be carried out on buildings to bring them up to legal standards, whether that involves minor alterations or substantial redevelopment. The benefits of a sustainable office space to both freeholder and leaseholder are clear – increased revenue and a healthier and sustainable workplace - yet our grasp of the importance of ESG is a relatively recent advancement.
Many headleases long predate today’s focus on energy efficiency. They were created long before EPC ratings and the New London Plan came into existence and, as a result, may have no provision for upgrading and refitting in line with modern standards. The headlease will contain a general covenant to comply with legislation but this may cut across the alterations provisions leading to conflicting terms. So, while a large share of the London office stock requires redevelopment, many existing headleases prevent this taking place. The freeholder now faces a situation where rental income and value are eroded by the restrictions the headlease places on the long leaseholder.
So, a headlease should allow for future refurbishments and redevelopment over the course of the building’s life. With Local Planning Authorities’ sustainability-driven preference for refurbishment over redevelopment, modern headleases will need to allow for a building to be refurbished more often than is the case now rather than a redevelopment.
- Sharing of rental income
Freeholders typically receive an agreed percentage of the rent that the long leaseholder receives from the occupational tenants (the “gearing”), often subject to a minimum fixed rental level. Freeholders prefer to charge rent as a proportion of “rents receivable”, as opposed to “rents received” as the latter can be reduced by occupational vacancy This encourages the long leaseholder to periodically refurbish the building as the freeholder is implicitly carries some of the cost of the void and re-letting risk. The ESG credentials of a building directly impact the rental income received and this impact will increase in the future. Thus, if a building cannot be upgraded in the future, inevitably the rental income will decline to the detriment of both parties.
Most lettings of smaller floor plates are on the basis of fully fitted out space or “Cat A+”. This is a recent trend that isn’t well catered for in older headleases, and this will create difficulties in arriving at the true rental position – arguments now ensue. Why should a freeholder benefit from the extra capital a long leaseholder has invested to increase the rental income? A modern headlease will need to cater for this.
- Investment Liquidity
Alongside rental ‘gearing’, the unexpired term of a headlease is the key determinant of investment value for a long leaseholder. Historically, provided a headlease had over 100 years unexpired, then liquidity would not be overly impacted and many new headleases were granted for 115 or 125 years. However, as investors at the point of purchase became more focussed on future sale or “exit” values, the unexpired term needs to be comfortably more than 115 years to avoid impacting value, and new leases are more typically 150 years or more as a result.
However, whilst a typical headlease restructuring will focus on the gearing level and unexpired terms, there are so many more terms that require modification to avoid damaging values. Restrictions on who can purchase an asset, the existence of forfeiture (termination) clauses and any investment sub-lease where the income from the property is divided among multiple sources are all potential sources of tension for investors that many headleases include. In the case of a forfeiture clause for example, it is essential to obtain a “remote cure” position for step-in rights to avoid eroding the liquidity or value of the headlease. This allows a mortgagee to remedy a breach of covenant, without taking on the headlease, thereby avoiding the resultant management and tax implications that could arise. The “remote cure” clause will encourage the mortgagee to take a higher degree of control in the event of a problem thereby resolving the breach to the advantage of the Landlord and Tenant. Similarly, an investment sub-lease is unpopular as it can, on occasion, lead to the freeholder losing control of the building.
In the past five years, Knight Frank’s headlease restructuring specialists have successfully renegotiated headleases based on a thorough understanding of the issues they can create. We have advised many clients but at the centre of our advice is value creation/retention and an awareness of the future to make sure the headlease will be fit for purpose for the entire term, whatever length that may be.
Our recent instructions include: 2 Aldermanbury Square, EC2, Adelaide House, EC3, 1 Leadenhall, EC3, Fruit and Wool Exchange, E1, JJ Mack Building, EC1,1 New Street Square, EC4, Arundel Great Court, WC2.