Phil Parkinson outlines the complexities in the conversion of commercial premises for residential purposes, and what to consider when advising landlords
In a post-pandemic landscape, the composition of town and city centres is going through considerable change. One such change has involved an increased desire from developers, freeholders and commercial leaseholders to convert commercial premises into residential dwellings, in order to meet a growing desire for residential accommodation within large cities in particular. It is both a sizeable opportunity and a challenge, with recent Royal Institute of Chartered Surveyors (RICS) statistics indicating that there are 40,000 vacant retail units across the UK, a number predicted to double by 2026.
The decision may appear initially to be simple, but it is fraught with complexities – even presupposing that planning consent can, or does not need to, be obtained. If the nature of ownership of the commercial premises is leasehold, the lease requires careful and substantial consideration.
This article focuses on the key issues facing clients and practitioners who hold a commercial lease and wish to develop the premises into residential dwellings.
Constraints on use
As a general proposition, the absence of any specific restriction in a lease of commercial premises means that the tenant is free to use the premises as it pleases and for the purposes of whatever business is most advantageous to the tenant at any given time. However, there are a number of constraints which mean that the tenant never has complete freedom to do what it likes with the premises. These fall into the two broad categories: external factors, such as legislation; and contractual factors, such as tenant covenants restricting use, alterations or compliance with statute.
Additionally, a landlord will invariably choose to restrict the tenant’s use of the premises to a particular purpose, whether specifically described or expressed by reference to planning use classes. In any scenario, the landlord’s objective in exercising this control is to maximise the value of its reversionary interest.
The form of the covenant(s) to be considered may be either positive or negative – for example, the tenant may covenant to carry on only the permitted use, or the tenant may covenant not to carry on any use other than the permitted use. Below, we discuss some of the significant types of lease covenant that should be considered.
Absolute covenants and Duval
It is important to note that there is no statutory modification of absolute covenants; consequently, they constitute a complete bar to any change of use. Although an absolute covenant does not preclude the tenant from asking for consent or the landlord from giving that consent, the landlord of a multi-let building should check the terms of the other leases before granting consent.
The recent and notable decision in Duval (Respondent) v 11–13 Randolph Crescent Ltd (Appellant)  UKSC 18 highlights this further. In summary, the case (as widely reported) concerned a block of flats where each lease contained an absolute covenant by each tenant not to carry out certain alterations, and a covenant by the landlord to enforce that covenant (and others) at the request and cost of any one of the other tenants. The Supreme Court held that the combined effect of these covenants was that there was an implied term within the landlord’s covenant that it would not do anything which meant that it was no longer able to enforce the tenant covenant. The principle equally applies in cases of user.
Unlike assignment, underletting and alterations, there is no implied term that consent to a change of use cannot be unreasonably withheld. Consequently, unless limited by the terms of the lease, the landlord has an unfettered right to refuse consent arbitrarily, which means that it has the same amount of control as it does with an absolute prohibition.
Fully qualified covenant
A fully qualified covenant is one which requires the landlord not to unreasonably withhold its consent to the change of use. The Landlord and Tenant Act 1988, which imposes duties on landlords to respond to applications for consent to assign or underlet within a reasonable time and providing written reasons, does not apply to change of use. There is no equivalent provision to assist tenants.
Many use clauses in commercial leases will consist of aspects of absolute prohibition together with qualified or fully qualified covenants. For example, there may be an absolute covenant against certain uses, but others may be permitted with the landlord’s consent. In such cases, the clause must be analysed carefully in order to determine its precise effect.
Defining the permitted use
As stated above, commercial leases generally restrict the tenant’s use of the property to a specific purpose or activity. Very often, there will be a defined term which describes what is permitted; this may be specific or by reference to one or more planning use classes. It must be remembered that, in this context, any defined term is purely a contractual definition that allows the landlord to control the tenant’s use of the property. It is entirely separate from any statutory planning obligations that the tenant may need to observe in relation to the property. Prior to 1 September 2020, a conventional and convenient way of setting out the required degree of landlord’s control over the tenant’s activities was to refer to one or more of the use classes contained in the Town and Country Planning (Use Classes) Order 1987. This was because it contained discrete definitions of various uses.
Those definitions were generally aligned with the landlord’s desired controls. However, as of 1 September 2020, in relation to properties in England only, broader use classes have been introduced, with sub-divisions within both those classes. From a landlord’s perspective, an as yet untested concern is whether those classes permit a broader range of activities than landlords are traditionally accustomed to. However, revocation of use classes A and B in England does not mean that those use classes cannot still be referred to for the purposes of defining the contractual restrictions which are imposed by the landlord on the tenant’s use of the property.
The issue of consent
The tenant’s ability to change the permitted use will depend on the form of the user covenant in terms of whether, and to what extent, it prevents alternative uses without the landlord’s consent. The three key common law principles that govern the reasonableness of consent are:
- the landlord cannot refuse consent on grounds which have nothing whatever to do with the relationship of landlord and tenant in regard to the subject matter of the lease
- the question whether the landlord’s conduct is reasonable or unreasonable is one of fact based on the circumstances of the particular case, and
- the landlord’s obligation is to show that its conduct is reasonable, not that it is right or justifiable.
The substance of these principles was subsequently held to be equally applicable to the reasonableness of a landlord’s decision to refuse to consent to the tenant’s proposed planning application to change the use of premises from offices to residential by the Supreme Court.
Note that an unreasonable delay in giving consent, or the imposition of unreasonable conditions when giving consent, amounts to an unreasonable refusal of consent. The burden of proving that consent has been unreasonably withheld falls on the tenant, unless the landlord has not given reasons (in which case the landlord must prove that it has acted reasonably). The courts will look at the landlord’s express reasons, but note that the landlord is not limited to what was said in the initial response to the tenant.
Remedies and potential court action
The primary concern for a tenant who changes use without ensuring full compliance of the lease terms is the threat of forfeiture action by the landlord. While forfeiture is undoubtedly the most serious threat to a tenant, other options are available to a landlord and can be extremely effective. An injunction can be sought in various circumstances. In a falling or weak market, the landlord may be reluctant to forfeit, especially if it thinks the tenant would not apply for relief. Ending the lease in circumstances where reletting is likely to prove difficult leaves the landlord without recourse to any tenant covenant and, in many cases, with liability for empty business rates. Faced with that prospect, a landlord might be tempted to acquiesce in the unauthorised use.
The landlord can, however, obtain an injunction requiring the breach to be corrected by ceasing the prohibited use (or preventing it from going ahead in the first place). Such action often results in damages being payable by the tenant to the landlord. This can include damages for the loss of opportunity to seek a premium for allowing the change of use, if applicable.
However, while a fresh breach giving rise to the right to forfeit will arise every day, the landlord may waive the covenant itself partially (rather than waiving only the right of action, such as the right to forfeit), so as to allow of the carrying on of a particular trade. A release of the covenant need not be express. If the landlord is aware of a continuing breach and acquiesces in it for a long period (as, for example, where, with full knowledge, they receive rent), it will be presumed that they have either released the covenant or granted a licence for the user. If the landlord’s conduct is not wholly inconsistent with the continued existence of the covenant, it will not be presumed that they have totally released it.
Where consent has been unreasonably withheld, a tenant is entitled to go ahead without it. Effectually, the requirement for consent no longer applies. For practical purposes, this is very unsatisfactory for a tenant. It may be uncertain whether it is correct to conclude that the refusal of consent was unreasonable (and therefore whether it will be exposed to enforcement action by the landlord) and may be concerned about the fact that no formal evidence of consent will be available.
This can lead to applications to the court for a declaration that consent has been unreasonably withheld and damages, albeit damages are usually not available for an unreasonable withholding of consent to change use. The Landlord and Tenant Act 1988 only applies to certain covenants against alienation. Therefore, a tenant is only entitled to damages in the rare case that a landlord has given a positive covenant not to withhold consent unreasonably. The usual formulation does not amount to such a covenant, being only a proviso to the tenant’s covenant not to use for the restricted purposes.
With the process of conversion being aided by the recent introduction of permitted development rights, allowing a range of commercial premises to convert to dwellings (without the need of a planning application) to ease the current housing crisis as well as restoring and regenerating local high streets and town centres, indicates that converted use remains high on the government’s agenda. It’s also a key concern for landlords seeking to preserve the value and potential of their investments. Therefore, understanding leasehold complexities is essential to ensure a safe, efficient and clear transition.