McDonalds Real Estate Ltd Liability Partnership v Arundel Corporation

MR JUSTICE LEWISON: On the corner of Colindeep Lane, Edgware Road in London there was, until 1985 or thereabouts, a factory built in the 1930s. It was used by the Brick Development Association for training bricklayers. Its gross external area was in the region of 27,000 square feet and its gross internal area was in the region of 25,000 square feet. Some 20,000 square feet was used for industrial purposes, 3,000 square feet for offices, and the remaining 2,000 feet for storage. The total site area was 1.3 acres.

In the mid 1980s McDonalds became interested in acquiring the site for the purposes of developing its first drive-through hamburger restaurant in the UK. The freeholders were not interested in selling, but ultimately it was agreed that McDonalds would acquire the lease held by the Brick Development Association and would take a new lease of the site for a term of 50 years. It took McDonalds about a year to obtain planning permission, but, having obtained it, they set about the redevelopment. There is now a drive-through restaurant on the site constructed at McDonalds’ expense.

On 10^th September 1986 Norfolk Holdings Limited granted McDonalds a lease of the site. The term of the lease was 50 years and one day from 29^th September 1985. Clause 2(11) of the lease contained a covenant to comply with the Planning Acts. Clause 2(15) of the lease contained a covenant to use the demised premises only as a restaurant, together with ancillary office accommodation, storage, staff facilities and car-parking space in connection therewith, or for such other retail purposes as the landlord might authorise in writing, such authority not to be unreasonably withheld or delayed.

Clause 5 of the lease contained a rent review clause. There was to be a rent review on 29^th September 1990 and every five years thereafter. The last review will take place on 29^th September 2030.

Clause 5(L) of the lease contained the valuation formula. It reads as follows:

“The full market rent of the demised premises at the relevant review date shall be determined in accordance with the following formula, namely whichever is the higher of:-

(a)

the yearly rent which in the market conditions prevailing at the relevant review date or (if earlier) at the time at which the revised rent is agreed or determined disregarding any restrictions imposed by or pursuant to any counter-inflation or other similar legislation might be expected to be obtained for the demised premises immediately prior to the relevant review date on the basis that the demised premises were ready for immediate occupation and were on the relevant review date to be let on lease with vacant possession by a willing landlord to a willing tenant without a fine or premium being taken for a term of 20 years commencing on the relevant review date without provision for a rent-free concession and in all other respects with and subject to the covenants conditions and provisions contained in this lease (other than that as to the amount of the initial rent but including the provisions for rent review as provided for in this present clause) and on the assumption that all the covenants on the part of the Tenant contained in this lease (including all covenants to carry out works and all covenants relating to the repair decoration and condition of the demised premises) had been duly observed and performed down to the relevant review date disregarding:

(i)

Any effect on rent of the fact that the Tenant or any assignee or undertenant of the Tenant has been in occupation of the demised premises or any part thereof

(ii)

Any goodwill then attaching to the demised premises or any part thereof by reason of the carrying on on the demised premises or on some part thereof whether by the Tenant or any assignee or under-tenant of the Tenant of any business being then carried on on the demised premises

(iii)

any restriction as to the permitted use of the demised premises or

(b)

the yearly rent calculated as provided for in sub-clause (a) of this clause but on the basis that the buildings on the demised premises were a modern single storey warehouse comprising 20,000 net useable square feet of which 15% in area were useable as ancillary offices and constructed to a high standard in accordance with all statutory and other relevant consents with all usual amenities including adequate parking and loading facilities.”

The reversion immediately expectant on the determination of the term has now passed to Arundel Corporation.

The dispute between the parties concerns the second method of assessing the rent. McDonalds’ contention is neatly encapsulated by Mr Paul Crowson, who says that a warehouse means both a physical structure and a use. Arundel’s contention is that the word “warehouse” as used in the rent review clause describes a physical entity and says nothing about the use to which that physical entity may be put.

It is common ground that, in interpreting the lease, the court’s primary duty is to the text. In the case of a contract the text must be interpreted as at the date when it was written. If the meaning of a word or phrase has changed since the date of the contract, the court must interpret it in the sense it bore at the date of the contract. In interpreting the contract, the court must take into account not only the words as they appear on the printed page, but also the objective background facts known to both parties. The experts, Mr Crowson for McDonalds and Mr Nick Howe for Arundel, have helpfully agreed a memorandum which sets out the relevant background and much more besides. From that memorandum I regard the following as being of particular relevance.

The warehouse market in the 1980s covered a number of things, including building characteristics, uses, occupiers, developers and funds. Buildings that could be termed “warehouse” were being put to a multitude of different uses including industrial research and development, storage and distribution, bulky goods retail warehousing such as DIY furniture etc, cash and carry, motor dealerships, places of worship, community halls and education. Building types varied from the multi storey depository dating from Victorian times through inter-War low-headroom buildings to high-tech buildings that featured high office contents, atria, and plenty of steel and glass.

By 1986 the characteristics of buildings being constructed for the warehouse market had reached designs that have changed little since. Estates of buildings designed to be capable of various warehouse uses were being built speculatively in close proximity. The common specification included eaves’ heights of between 18′6″ and 22′, floor loadings of 500 pounds per square foot, office contents of 10% to 20%, and car parking at around one space per 1,000 square feet.

The retail warehouse market in 1985 to 1986 was an established market. That market had first started to emerge during the 1970s. The early stages of the retail warehouse market can be referred to as “first generation”. The buildings had a close affinity with the warehousing sector. The first retail warehouse occupiers took mainly standard warehouse units of around 20,000 to 30,000 square feet on industrial estates. These units often had no visibility from passing traffic and were generally the only retail warehouse on the industrial estate. Stand alone units, i.e. not on an industrial estate, were very rare.

This period very roughly covered the 1970s through to the early 1980s. As more retail occupiers entered the out of town market and competition became greater, visibility and physical suitability of the site as a purpose became of greater importance. There was also a preference from retailers in the furniture, carpet and DIY sectors to group together on arterial roads, as there was synergy in their offer.

Around the beginning of the 1980s property developers entered the retail warehouse market and the first units and estates designed specifically for retail warehouse occupiers were constructed. However, in most cases developers still constructed buildings with a view to reversion to standard warehouse use should the retail occupier fail or move on. The period through the 1980s could be called “second generation” retail warehousing and covered 1985 to 1986.

During the first generation the design of retail and non-retail warehouses was the same, with eaves height of 18 feet and floor loadings of 500 pounds per square foot. The buildings at that time were measured on a gross internal or gross external floor area basis. During the second generation the physical construction of the buildings remained similar, but important differences had emerged that differentiate the generations. Retail warehouse operators were now operating in a market where there was far greater competition and they had evolved their requirements to sophisticated designs that could not be found within the speculative market. They required the best visibility, access and parking for customers. The position of the building on the site, therefore, became important. The building needed to be prominently visible from the main road. Customer car parking had to be easily accessible from the road and potentially, but not always, there needed to be loading from a discrete yard that was not visible to customers.

As the second generation developed, requirements began to standardise. Most retail warehouses built in the mid 1980s were designed with front surface parking, a rear loading facility and separate customer access. Site coverage ratios (the amount of the total site which is covered by the building) were different for retail and non-retail warehouses due to the different requirements for customer parking. A retail warehouse required one car park space per 200 square feet of building, whereas a non-retail warehouse required one car park space per 1,000 square feet of building. Industrial required one space per 500 square feet of building.

It is also common ground that the planning background is relevant. At the date of the lease the Town and Country Planning (Use Classes) Order 1972 was the instrument governing planning uses. The expression “shop” was defined by article 2.2 of that order as meaning a building used for the carrying on of any retail trade or retail business wherein the primary purpose is the selling of goods by retail. Class 1 consisted of shops with four irrelevant exceptions. Class 10 consisted of use as a wholesale warehouse or repository for any purpose. The courts had said in that context that it was a question of fact and degree whether the existence of some sales of goods from a building turned that building from being a warehouse into being a shop. However, in Monomart Warehouses Limited v The Secretary of State for the Environment [1977] 34 P & CR 305 Lord Widgery CJ said:

“…in my judgment the word ‘warehouse’ has a very well-known meaning in ordinary English. It is a place where goods are stored preparatory to their being taken elsewhere and sold. A warehouse is not a building where retail sales are actually carried out. At all events it is not a building where retail sales of that kind are the principal activity in the building.”

With the growth of retail warehouses, the Use Classes Order 1972 was thought to be unsatisfactory and unreflective of the actual trends in land use. At the date of the lease it was well known that a new Use Classes Order was on the way because it had been the subject of extensive discussion and consultation. That eventually led to the making of the Town and Country Planning (Use Classes) Order 1987. Under the 1987 Use Classes Order, Class A1 includes the retail sale of goods where the sale is to visiting members of the public. Class B8 is “use for storage or as a distribution centre”. The Department of the Environment circular accompanying the new Use Classes Order said that Class B8 was intended to reproduce the old Class 10 and that retail warehouses would fall within Class A1.

Against that factual and legal background, I turn to the rent review clause. As is clear, there are two alternative bases of valuation. The first looks at the actual buildings on the site. There is no disregard for the tenant’s improvements. The demised premises are to be assumed to be ready for immediate occupation. The assumed term is 20 years from the rent review date rather than the unexpired residue of the actual term. The terms of the lease are, in all other respects, to be the same as the terms of the actual lease. However, although the lease contains a clause restricting the use of the premises, the rent review clause contains the express instruction that any restriction as to the permitted use of the property is to be ignored. It is common ground that this instruction applies only to restrictions imposed by the lease itself. It does not entitle the valuer to ignore the impact of legislation relating to town and country planning. The first basis of valuation thus follows a conventional structure for a rent review clause. It begins by describing the physical entity to be valued, proceeds to specify the terms of the letting, and terminates with certain particular instructions to the valuer.

The second basis is exactly the same as the first, but with one difference. The difference is that instead of valuing the buildings that are actually on the site, it is to be assumed that the buildings on the demised premises are a modern single-storey warehouse comprising 20,000 net useable square feet, of which 15% are useable as offices and constructed to a high standard.

Fitted into the structure of the first basis of valuation, what the draftsman has done is to alter the physical entity to be valued. He has not altered the terms of letting. Moreover, as Mr Gaunt QC points out, the express instruction that all restrictions as to the permitted use of the demised premises are to be disregarded applies just as much to the second basis of valuation as to the first. In my judgment, all that the draftsman is doing is describing a building type.

What then does the draftsman tell us about that building type? The first thing is that it is modern. It is common ground that the instruction that the building is modern means that it is modern as at the date of each review rather than modern as at the date of the grant of the lease in 1986. Given that a warehouse has a limited life and that the last review is due to take place some 45 years after the date of grant, this seems to me to be right.

Mr Gaunt said that the rationale for the second basis of valuation was that it was a quid pro quo for the landlord having given up the right to redevelop the site for its most valuable potential use for the whole 50-year term and that this consideration should inform the interpretation of the remainder of the clause. If the valuation had been on the basis of valuing a site for development, this point would have had considerable force, but its force is blunted by the fact that the landlord is entitled to the value of a modern building, and modern as at the date of each rent review, without having had to incur the expenditure of erecting the building during the term of the lease.

Second, the draftsman tells us that the building consists of 20,000 square feet. Both sides made something of this element of the description. Mr Seitler QC, by reference to agreed planning standards relating to the ratio of car spaces to floor space of retail warehouses, said that it would not be possible to fit a retail warehouse of 20,000 square feet on the site. Mr Howe said that the usual site coverage was 35% and that, on that basis, a retail warehouse of approximately 20,000 square feet could be accommodated on the site.

A more precise mathematical calculation, however, showed that 35% of the site area was only 19,819 square feet. Using the agreed planning ratio of car spaces to a warehouse used for storage, the site would have accommodated a building of 20,000 square feet comfortably. It could have accommodated a larger building.

I did not find this a strong point. First, the shortfall on a mathematical basis, although not de minimis, is very small. Second, it was not established that the agreed ratio between car parking spaces and floor space was immutable in particular circumstances or incapable of slight adjustment. Third, the rent review clause itself requires the assumption of adequate car parking. Mr Gaunt, by reference to the fact that the building on the site before its redevelopment was 25,000 square feet, said that the reduction in area of a notional building went to show that the parties contemplated a more valuable use than the former factory. I did not find this persuasive either. On any view, a modern building is more valuable than an old factory, and a building that is notionally modernised from time to time during the term may well be more valuable than a slightly larger building actually constructed at the beginning of the lease. To draw any inference from the fact that the notional building has an area of 20,000 square feet would, in my judgment, be simply speculation.

Third, the draftsman tells us that the notional building has 15% of space useable as offices. Mr Gaunt rightly said that “useable” does not mean the same as “used”, but it is also right to say that the space which is useable as offices is assumed to have been constructed to a high standard and, because of the incorporation of the first basis of valuation, is also assumed to be ready for immediate occupation.

In the course of his cross-examination, Mr Howe agreed that a 15% office content is higher than the norm for a retail warehouse, although there are examples of special cases in which this proportion of office content is not unknown. On the other hand, it is agreed that the characteristics of buildings constructed for the warehouse market had office contents of between 10% and 20%. This instruction, to my mind, points towards the conclusion that what the draftsman had in mind was a conventional warehouse building. In other words, what the experts have called a “second generation standard warehouse unit”. Mr Seitler also relied on the ordinary meaning of the word “warehouse”. I have already quote Lord Widgery CJ. Mr Gaunt said that this observation was made in the context of planning. That is true, but Lord Widgery was explaining what he understood to be the meaning of an ordinary English word. Moreover, I do not accept that the context of the rent review clause is so different that his observations are unhelpful.

Mr Seitler also relied on the dictionary definition in the Shorter Oxford English Dictionary current in 1973. The definition thus given is:

“A building or part of a building used for the storage of merchandise; the building in which a wholesale dealer keeps his stock of goods for sale; a building in which furniture or other property may be stored; a government building (more fully BONDED warehouse) where goods are kept in bond.”

Somewhat gnomically, the dictionary adds that the word is used as a more dignified synonym for “shop” (or at least it was in 1857).

Thus, Mr Seitler said that the word “warehouse” as defined both by Lord Widgery and also by the dictionary described not only a building type, but also the use to which it was put. In my judgment, there is considerable force in this point. However, the force of the point is that it helps to identify the building type, i.e. the physical entity to be valued. It is, in my judgment, a further pointer to the conclusion that the building type to be valued is a second generation standard warehouse unit. The experts agree that the physical characteristics of such buildings has not changed significantly since 1986.

The draftsman also tells us that the building has been constructed in accordance with all statutory consents. This must include planning permission. But planning permission for what? Is it for use within Class B8, or use within class A1, or both? Here, I think, it is necessary to remind oneself that what we are dealing with is a counter-factual assumption. There is no warehouse building on the site and there is no planning permission for one. There is a principle of interpretation of rent review clauses that goes by the name of the presumption of reality. Shortly stated, the presumption is that a valuation should adhere as closely as possible to reality and depart from it only to the extent that the rent review clause so requires either expressly or by necessary implication. In short, a minimalist approach is what is required.

Applying that presumption, there is no express requirement that planning permission for retail use exists. Nor is there any necessary implication to that effect. The clause will work perfectly well if it is assumed that the warehouse has been constructed in accordance with the planning permission granted for a B8 use. I hold, therefore, that what is to be valued is a second generation standard warehouse constructed in accordance with planning permission granted for B8 use. But that is not the end of the journey. In the real world, the owner or tenant of a warehouse constructed in accordance with the planning permission such as I have described would be entitled to apply for planning permission to use that building for a use falling within Class A1, i.e. as a shop. Is there anything in the rent review clause which would preclude the valuer from taking into account the potential for such a change of use?

Although I have accepted Mr Seitler’s submission that the building type is that of a warehouse used for storage, I do not consider that this necessarily means that the building must continue to be used for that purpose for ever. The experts agree that a second generation standard warehouse is physically capable of being used for a retail trade. The rent review clause expressly requires there to be disregarded any restriction on the permitted use of the premises. This forms part of the instructions applicable to the second basis of valuation. In any event, the terms of the lease themselves permit retail use with the landlord’s consent which cannot be unreasonably withheld. All this militates against interpreting the lease in such a way as to preclude the potential for retail use of the notional building from being taken into account. In my judgment, there is no express term of the lease which confines the future use of the notional building to use for storage and distribution and to imply a term to that effect would contradict the express instruction that restrictions on the permitted use are to be disregarded. I hold, therefore, that although the building type to be valued is a second generation standard warehouse building, the prospect of obtaining planning permission for the use of that building for retail purposes may be taken into account in the valuation.

I will of course hear counsel on the precise relief to be granted, but I think it follows that I should make the first of the two declarations sought by McDonalds but refuse the second.