What is the right of first refusal?

Many prudent developers who construct residential blocks of flats may seek to maximise their returns by selling the freehold reversion to an investor. However, whilst such sales may sound attractive, they can often become protracted and complex – and one of the principal reasons is the right of first refusal granted to long leasehold tenants under the Landlord and Tenant Act 1987 (the Act).

There are many investors in the market who are interested in buying the ground rents of such blocks, particularly for large-scale developments. Such a sale can make good sense to a savvy developer as it can result in a cash injection to off-set construction costs and also offers a clear exit strategy from the development site. The timing of any sale can very important in the light of the requirements of the Act.

Under the Act, where a landlord intends to sell its freehold interest in a property which comprises multiple flats, the landlord may not make the sale until it has served an offer notice on 90% of the “qualifying tenants” as defined by the Act. Qualifying tenants include not only those tenants who have completed purchases of flats but also those who have exchanged contracts “off plan”. Where more than 50% of flats in a building are held by qualifying tenants, the offer notices under the Act (called section 5 notices) must be served which would allow the tenants to purchase the freehold interest instead of the intended buyer on the same terms.

In practice, the service of section 5 notices can cause considerable delays to a freehold reversion sale. The section 5 notices must set out the terms on which the landlord intends to sell the property and must provide the qualifying tenants with a timescale within which to decide whether to exercise their right of first refusal and step into the shoes of the freehold buyer. The shortest timescale which can be stipulated in a section 5 notice is two months. In the intervening time between the serving of the section 5 notices and the expiry of the prescribed timescale, the landlord may not exchange contracts for the freehold sale.

Whilst the delays to the transaction and logistical and administrative effort of serving section 5 notices on qualifying tenants are troublesome, landlords should also be aware that failure to comply with the Act is a criminal offence subject to an unlimited fine.

There are some exemptions under the Act, such as where corporate landlords sell the freehold interest to a company which is associated with them and the onward freehold sale then takes place via a share sale of the associated company rather than a straight forward property sale. It is also possible to avoid the need to serve section 5 where blocks do not yet contain 50% qualifying tenants.

It is therefore paramount for landlords to consider their freehold sale options at the outset of a development and to seek specialist legal advice as early as possible.