Levelling Up and Regeneration Bill – how proposed local authority auctions may affect lenders and borrowers

The Levelling Up and Regeneration Bill (the Bill) is proposed new legislation aiming to give effect to aspects of the government's levelling up agenda. The levelling up agenda aims to reduce economic, social and environmental disparities between and within different parts of the UK and to regenerate local communities.

In pursuit of these aims and with the intention of restoring a sense of local pride and belonging, the Bill confers new powers on local authorities to hold rental auctions for vacant commercial premises situated in high streets and town centres. The Impact Assessment for the Bill, published on 6 April 2022, stated: "The desired outcome is an attractive and lively high street with footfall and activity that attracts people and businesses, increases pride in place, and avoids long term presence of vacancy".

The measures involve an interference in the rights of landlords, not often seen other than in extreme circumstances; for example the rights afforded to tenants during the COVID pandemic. It is anticipated that they will have an effect on property investors due to the impact that the auction process is expected to have on rental income paid by incoming tenants and the deemed mortgagee consent provision, explained further below. In this article, we condense key takeaways for lenders and borrowers to assist both in preparing for the potential impact on their activities.

Summary of the proposals

• Premises situated on high streets or town centres which have remained vacant for the previous year (or for at least 366 days in the previous two years) could become subject to a compulsory rental auction initiated by the local authority. 

• The local authority would have the ability to contract with a successful bidder on behalf of the landlord to grant a tenancy of one to five years with no security of tenure. 

• Any tenancy granted will be deemed to have been granted with a mortgagee or superior landlord's consent, bypassing agreed provisions and covenants in superior leases and loan and security documents.

Where are we now?

The Bill has passed through the House of Commons and currently sits in the House of Lords. Should it pass the remaining scrutiny, we expect the Bill to become law at some point in 2023. Despite the stages it has passed, the relevant part of the Bill in circulation relating to high street rental auctions for commercial premises remains in substantially the same form as it was introduced, so far with no real deviation or notable amendments.

Impact on Investors

• The Bill would prohibit mortgagees from exercising their rights – following a successful rental auction, the local authority may enter into an agreement for lease of the premises with the successful bidder. The local authority will enter into the agreement for lease in its own name, but the agreement will bind the landlord who is obliged to grant the lease. If the landlord fails to do so, the local authority may grant the lease and it will be binding on the landlord. The lease will be granted with the deemed consent of any superior lessor and mortgagee. 
• In real estate finance transactions, it is crucially important to the lender to be able to assess the suitability of the proposed tenant given that the financing is secured against the property itself, plus the rental income from the occupational tenants. The Bill requires regard to be had to "the terms on which short term tenancies are typically granted on a commercial basis" and to any representations made by the landlord but otherwise does not impose requirements on the selection of the tenant in terms of financial strength.

The conditions of a Qualifying Premises

To be caught under the remit of the Bill, a commercial premises must be a Qualifying Premises, which requires it to be the following (all explained further below):

• located in a designated high street or town centre
• suitable for high street use
• beneficial to the local economy, society or environment for it be occupied for high street use (the Benefit Condition)
  
• vacant for the previous year (or for at least 366 days within the previous two years) (the Vacancy Condition).

Located in a designated high street or town centre

The Bill allows local authorities to designate:

• a street in its area as a designated high street if it considers the street is important to the local economy due to a high concentration of high street premises
• an area within its town centre if it is characterised principally by a network of streets and it considers that area important to the local economy because of a concentration of high street use premises.

Suitable for high street use

The Bill gives examples of shops, offices, bars, cafes, restaurants, communal halls, premises of public entertainment and those used for the provision of services to the public. Premises used as a warehouse are excluded.

The Benefit Condition

The local authority considers the occupation of the premises for a suitable high street use would be beneficial to the local economy, society or to the environment.

The Vacancy Condition

• Premises that have been vacant for the whole of the previous year or for at least 366 days of the previous two years will fall under the scope. The Bill is retrospective, so will immediately apply to any premises vacant in the year preceding its enactment. What remains unclear is whether 366 days of the previous two years is intended to refer to consecutive vacant occupation or not.
• When looking at whether a premises can be said to have been vacant, the Bill states 'occupation' must be "substantial", "sustained" and involve the "regular presence of people at the premises". Any occupation by a trespasser or person living in a premises not designed or adapted for residential use is not to count for these purposes.
• The Secretary of State is given a "Henry VIII power" to pass regulations to amend the relevant section and change how long premises must have been vacant for before the Vacancy Condition is satisfied. This has prompted discussion during the reading of the Bill but is currently retained as part of the Bill. 

Procedure to bring a Qualifying Premises to auction

Initial notice

The local authority may serve the landlord of a Qualifying Premises with an initial notice giving it a minimum of 8 weeks to let the premises, with the notice expiring after 10 weeks. Once served, an initial notice prevents a landlord from granting (or agreeing to grant) any agreement resulting in another person becoming entitled to possess or occupy the premises without first obtaining the local authority's consent (to be given or refused within a "reasonable time"). Without consent, any tenancy or occupation so granted is void. However, a landlord is not prevented from granting a tenancy pursuant to an obligation that bound the landlord before the initial notice took effect.

The local authority must give consent to let if the three conditions below are satisfied:

• the term of the proposed occupation would begin within 8 weeks of the initial notice
• the term would last at least one year (with no break clause except due to tenant or licensee default)
• the local authority is satisfied the occupation of the premises is likely to be for high street use.

Final notice

If the landlord is unable to let the premises within the 8 week period from the initial notice, the local authority can serve a final notice within up to 10 weeks of serving the initial notice. The final notice starts a 14-week period where:

• the same restrictions on letting as under the initial notice apply
• restrictions on works to the premises without local authority consent apply (unless urgently necessary for repair or preservation or necessary to fulfil an obligation of the landlord)
• the local authority can run a rental auction to find a tenant.

Counter-notice and appeals

The landlord can serve a counter-notice, which must be received by the local authority within 14 days of the day on which the final notice takes effect, on the following grounds:

• the conditions of a Qualifying Premises have not been met
• the local authority failed to give consent where it should have
• the landlord intends to carry out substantial works
• the landlord intends to occupy the premises for its own business or residential purposes.

If the local authority does not revoke the notice, any time up to 28 days from receipt by the local authority of the counter-notice the landlord may appeal to the County Court, which must confirm or revoke the final letting notice.

Rental auctions and power to contract for and grant tenancy

• After service of a final letting notice, it being no longer possible for that notice to be revoked and no tenancy having been granted, the local authority may arrange a rental auction to find a prospective tenant for the premises. Secondary legislation will set out regulations in respect of this process, although the local authority must have regard to any representations made by the landlord about choice of procedure, but essentially could ignore these.
• After locating a successful bidder, the local authority is afforded power to grant a one to five year (but only as long as the landlord's interest) high street use tenancy under terms it can decide in place of the landlord. The only restrictions on the local authority are that no security of tenure is permitted and the terms of the tenancy must contain a number of standard provisions that you would expect as part of a short-term commercial tenancy, for instance repair obligations and the supply of utilities to the premises.

Summary and comment

The controversial proposals do not only interfere in an owner's rights over properties but affect any lending transaction secured, or to be secured, on high street premises which are or may become vacant. They bypass a lender's ability to review the credentials of a prospective new tenant before granting consent, ignore agreed covenants and potentially trigger default scenarios under any finance documents. Where any real estate investment finance is secured against a property or a portfolio of properties and the requisite income generated from those assets, the identity and covenant strength of those occupational tenants will be of vital importance. The Bill does not set out any special requirements about a tenant's financial strength.

Recommendations

• Lenders and borrowers should review their security portfolios and identify any potentially Qualifying Premises. 
• Lenders and borrowers of such premises are urged to review covenants in loan agreements which require lender consent in respect of letting and the likely default scenarios which may be triggered by local authorities entering into a letting without lender consent, despite the deemed consent afforded by the Bill. 
• The Bill also currently contains no obligation to notify any mortgagee, so should the Bill pass into law, lenders should include compulsory notifications from borrowers if any notice is received or rental auction process is initiated in respect of the Bill. 
• Borrowers of potentially Qualifying Premises should look to make sure the conditions cannot be satisfied so as to retain control over prospective new tenants and the terms on which that tenancy is granted.

A final word

Factors affecting the retail sector such as business rates, demand, planning permission and wider market forces, such as economic decline and shifting consumer habits in a post-COVID world, are all reasons why high street or town centre premises can remain vacant. The Bill assumes landlords of vacant properties are unwilling to seek tenants, but landlords of vacant properties lose rental income, face higher insurance premiums and are liable for full business rates after three months of vacancy. Where lettings are already offered at a peppercorn or nominal rent and still remain vacant, it is unclear how much effect the Bill will have in practice. This goes without mentioning the fact that enactment of the auction process is ultimately reliant on the ability, time and resources of the already stretched local authority.

Find out more
To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance team.