Beyond The Sale Price – The Role And Relevance Of Overage Clauses In The UK Property Market
The sale price of a property is often the main focus during negotiations between a buyer and seller. However, other important clauses in property sales contracts can have a significant financial impact on both parties. One such clause is the overage clause, which relates to potential future profits from a property. This article will examine the purpose, use and enforceability of overage clauses in the UK property market from the seller’s perspective.
What is an Overage Clause?
An overage clause, also known as a clawback clause, is a contractual provision that allows a property seller to receive additional payments in future if certain conditions are met after the sale.
The overage is usually calculated as a percentage share of any increase in the value of the property or profits from its development above an agreed threshold. It acts to allow sellers to share in future uplift in value.
For example, an overage clause could state the original seller is entitled to 50% of any profit over £200,000 if the buyer sells within 5 years of purchase.
Key Purposes and Benefits of Overage Clauses
There are several reasons why a property seller may wish to negotiate the inclusion of an overage clause:
Share in Future Profits
The main purpose is to allow sellers to share in significant future profits if the buyer or subsequent owners can profitably develop or sell the site. The seller rewards the buyer for taking the development risk, while still benefiting if their initial sale price turns out to be undervalued.
Maximise Initial Sale Price
An overage clause can enable a seller to secure the highest initial sale price possible, while still being able to benefit from future development potential. This makes the inclusion of an overage clause attractive to sellers in buoyant markets where initial sale prices reflect existing use values rather than potential development values.
Relatedly, overage clauses provide sellers an avenue to avoid under-valuing a property by providing an opportunity to secure a share of the future value. This can give sellers more confidence to complete sales where there is uncertainty over the exact development potential and timescales.
By deferring some of the value through the overage clause the seller also creates an incentive for the buyer to proceed with the development of the site to recoup the deferred value. This can facilitate the development of stalled sites.
Key Situations Where Overage Clauses are Used
While overage clauses can be applied to any property sale, they are particularly useful in certain situations:
Land with Development Potential
The most common situation where overage clauses are used is sales of land where the buyer intends to develop the site. This includes residential development sites, commercial land, and mixed-use regeneration sites. The seller wishes to share in profitable future development.
Sale and Leasebacks
Overage clauses may be used where the seller sells a property but then leases it back. The clause allows the seller to share in any capital appreciation from future sales.
A seller may use an overage to sell an under-utilised or poorly configured asset to a buyer who can redevelop the property into a more valuable form. For example, selling a low-density retail warehouse site for residential redevelopment.
Sale of Business Assets
When a business sells property assets, an overage can allow it to participate in the future value created by the new owner. This is common during corporate restructurings and the sale of surplus operational sites.
Key Commercial Terms in Overage Clauses
For an overage clause to be effective, the seller should pay close attention to the commercial terms written into the clause. Key terms include:
Calculation of Profit Share
The percentage share of profits due to the seller must be clearly defined, for example, 50% of any uplift in value above £2 million. There are various options for calculating the profit pool due to the seller.
Period of Overage Rights
The clause should specify an end date after which no further overage payments are due to the seller. Typically this ranges from 5 to 15 years post-sale.
The conditions that trigger a requirement for overage payment should be carefully defined, such as obtaining planning permission, sale of the site, or commencement of development.
Exemptions and Exclusions
It can be specified that certain types of buyer expenditure will be deducted before calculating the overage payment. There may also be exemptions if the buyer sells to a connected party.
This includes the timeline for payment following trigger events and whether the overage is settled in cash or as a percentage share of sale proceeds. Interest may be charged on late payment.
Challenges and Limitations of Overage Agreements
Despite the benefits to sellers, overage clauses also present some challenges:
Buyers will often resist overage clauses, either seeking to eliminate them or limit their scope during negotiations. Buyers are concerned about uncertainty, delays to development, and limiting upside profits.
Administration and Monitoring
Overage clauses require more long-term administration and monitoring to identify trigger events and validate payments due. This imposes time and cost burdens for both parties.
Changes in Ownership
If the property is sold to subsequent owners, the original seller still requires overage rights to be binding and enforceable on future buyers. This requires careful drafting of contractual obligations.
Poorly constructed overage clauses can create perverse incentives for buyers. For example, incentives to demolish existing buildings rather than refurbish, to minimise overage payments.
Valuing potential future overage liabilities is complex. This can deter buyers, and make obtaining financing more difficult if lenders cannot quantify the risks and liabilities involved.
Legal Position and Enforceability
For overage clauses to be effective, they must be constructed with care and attention to English law governing contractual agreements. Some key legal considerations are:
Satisfy Legal Tests
Like any contract clauses, overage clauses must satisfy the tests of contractual validity, including offer, acceptance, intention to create legal relations and consideration.
Certainty of Key Terms
There must be sufficient clarity and certainty over the key terms and conditions that will apply, such as the calculation methods, timeframes and triggers. Ambiguous clauses may be unenforceable.
Bind Successors in Title
Overage clauses in property contracts derive their enforceability by binding successors in title to the burden of the clause. Careful legal drafting is required to achieve this.
Registration of Overage Interests
To remain enforceable on third parties, it is advisable to register overage interests against the title records of the property at HM Land Registry.
Continued Monitoring and Administration
The original seller needs to actively monitor the status of the property and retain evidence to identify trigger events requiring payment under an overage clause.
If carefully constructed and actively managed, overage clauses can generally be made enforceable against future buyers of a property. However, sellers should still be aware of the time and costs associated with actively enforcing their overage rights even where legally valid.
Strategies for Using Overage Clauses
When considering using overage clauses, sellers should keep the following strategies and precautions in mind:
Seek Professional Valuation Advice
Obtain professional advice from valuers, lawyers and tax advisors when assessing whether to use an overage clause and constructing the overage terms.
Link Overage to Planning Consents
Linking overage payments to obtaining planning permission often provides greater certainty over the uplift in value and makes the clauses easier to enforce.
Focus on Clear Triggers
Define unambiguous trigger events based on actions within the buyer’s control, such as obtaining permissions, substantial site development, or disposal of the site.
Offer Incentives to Buyers
To help negotiations, consider offering staged overage payments or sliding scale percentages to provide incentives to the buyer to develop early and enable higher returns on riskier early investments.
Build in Review Processes
Include contractual processes to review and re-negotiate overage terms if initial timeframes become unreasonable or to address unintended consequences.
Register and Monitor Overage Rights
Remember to actively register, monitor and administer the overage rights throughout their duration for them to remain enforceable.
Alternatives to Overage Clauses
In some cases, overage clauses may not be appropriate or sellers may wish to consider alternatives:
Agree on Profit Share Joint Venture
Rather than an outright sale, the seller and buyer can establish a joint venture vehicle to develop the site, with pre-agreed profit share percentages. This reduces future uncertainty for both parties.
Package Deal with Share of Equity
The buyer can offer the seller a portion of the equity in the development vehicle or a share of developed units as part payment for the site, ensuring the seller participates in future profits.
If the overage clause is considered unworkable, deferred consideration could be used where some of the payment is deferred for a period as a warranty that profit will be achievable.
Conditional Upfront Payment
The initial purchase price could include an upfront overage component as a conditional lump sum payment, only payable in full if certain conditions are met in future.
Retention of Part of the Site
The seller could retain ownership of a portion of the development site. The retained portion would then benefit directly from any uplift in value.
Overage clauses are a useful mechanism for property sellers to negotiate to participate in the future development potential and profits that ownership of their land may unlock after its disposal. When constructed clearly around well-defined triggers and calculation methods, overage clauses can allow sellers to maximise sale prices, while still sharing in the upside from development.
However, overage clauses also present challenges in terms of valuation uncertainty, administration burdens, legal enforceability and potential unintended consequences. Sellers should carefully assess the pros and cons and seek extensive professional advice when considering whether the benefits of overage clauses outweigh the drawbacks in their particular situation. When utilised in appropriate circumstances, they can be an effective component of a profitable property disposal and risk management strategy.