What is this all about?
Recent speculation on development land and residential area scarcity are no longer solely in the realm of experts. The general public has also been increasingly focused on the application of municipal pre-emption rights as laid out in Sec. 24 ff. of the German Building Code (Baugesetzbuch – BauGB). Even on the tamer side of radical demands such as socializing large real estate holdings, buzzwords like “community protection” have been becoming much more commonplace. Both sellers and buyers of real estate, as well as real estate agencies, are now often faced with challenges arising from these pre-emption rights.
This new “unknown” can pop up in unexpected places throughout the sale of a real estate property, in the scope of a development plan or in real estate deals involving protected redevelopment areas. The article takes a close look at the purpose of pre-emption rights and select details of their implementation as well as transaction structuring when municipal pre-emption rights may be a factor. It examines in particular the issues of “deadline traps” in the enforcement of pre-emption rights, protectionary measures in preservation areas, the form and consequences of so called waiver agreements (Abwendungserklärung) and finally the means of price limitation in pre-emption applications.
One of the primary reasons for municipal pre-emption rights to be exercised under the legislation of the BauGB is the risk of increased displacement of residents from certain areas of a community. Such developments also have the additional effect of changing existing infrastructure and requiring new infrastructure to be created in other places. Parliamentary studies have shown that these displacement trends are particularly noticeable among tenants of older established inner city properties which may require some renovation works but which are then upgraded to a condition far exceeding normal renovation standards – the so-called luxury upgrades. The result of these renovations is a significant increase in the average rents in these areas which the legislature views as a contributing factor to the displacement of long-term residents. The communities (or local districts in the city-state of Berlin) are therefore tasked with ensuring that the desperately needed residential spaces in larger cities continue to be available through exercising municipal pre-emption rights.
There are many losers when pre-emption rights are applied. Depending on how an agency agreement is structured, the effective enforcement of a pre-emption right can result in the loss of broker fees. The seller of a property is restricted in its choice of buyer. The buyer in turn loses out on an otherwise secure investment and in some circumstances may be stuck with the costs of inspecting and appraising the property.
It is therefore somewhat comforting that despite the political allure, communities typically try to avoid exercising pre-emption rights since the communal takeover of property can often have undesirable effects. More commonly, communities will enforce pre-emption rights to the benefit of third parties as is provided for under Section 27a BauGB or pursue their political aims through the application of so-called waiver agreements. If a waiver agreement does not lead to the desired goal, a community may decide to exercise its pre-emption right over a property at a limited price as allowed under Section 28 para. 3 BauGB. This price limitation in such cases is primarily a means of budget control.
Pre‑Emption’s intricate web of deadlines – Risk of Deadlock
The exercise of a pre-emption right is basically dependant on the notification of the efficacy of the purchase agreement between the seller and the initial buyer.1 The seller is only obliged to inform the community holding the pre-emption right of the contents of the purchase agreement once the agreement has legal effect. However, the notification of the binding purchase agreement does not mean that the pre-emption right can be exercised without any limitations. There is a deadline stipulated in Section 28 para. 2 sentence 1 BauGB which places a limitation on the exercise of the pre-emption right to two months after the notification of the efficacy of the purchase agreement.2
In practice, the validity of the purchase agreement may depend in part on public permits. The deadline under Section 28 para. 2 sentence 1 BauGB does not begin until these permits are available. The community may however declare its intention to exercise its pre-emption right while the applications for the public permits are still pending. During this time, the purchase agreement does not fulfil the prerequisites of Section 28 para. 2 sentence 1 BauGB and as such is not fully legally binding. Case law and legal literature state that the community is entitled in such cases to declare that the exercise of its pre-emption right will take effect at the time the permits are issued without waiting for the purchase agreement to become fully effective.3
In explaining its rationale for its decision, the German Federal Court of Justice refers to the wording of Section 463 of the German Civil Code (Bürgerliches Gesetzbuch – BGB) (formerly Section 504 BGB). The wording of Section 563 BGB merely requires that a purchase agreement is signed with a third party over an object subject to a pre-emption right. The signed agreement defines the contractual terms and is not modified by an public permits to be issued. The agreed terms of the purchase agreement are sufficient for deciding whether to exercise the pre-emption right.
First and Second Purchase Agreements – caught between the lines?
There is another hidden trap lurking in the “side by side” contracts that arise from the two distinct purchase agreements that appear in connection with pre-emption rights. If a community declares its intention to exercise its pre-emption within the deadline described above, this results in a second purchase agreement between the seller and the community under the same terms as those contained in the purchase agreement between the seller and the first buyer. This presents a problem for the seller because it is now bound to two legally binding contracts but is unable to fulfil the primary obligation of transferring ownership to the first buyer. The seller does not however need to be concerned about its liability towards the first buyer due to breach of contract. If a pre-emption right is exercised on the basis of Sections 24 ff. BauGB, there is a statutory restriction of the ownership which the seller cannot control. Failure to fulfil the terms of the first purchase agreement with the initial buyer is not the fault of the seller if a municipal pre-emption right is exercised. The contractual withdrawal rights of the first buyer, at least in regards to the fulfilment claims, are therefore merely declaratory.
Exercising Pre-emption rights in preservation areas – neighbourhood conservation
Communities are increasingly viewing Section 172 para. 1 sentence 1 BauGB as a legal basis for neighbourhood conservation. The goal of neighbourhood conservation areas is to preserve residential areas which have an established population structure and to prevent displacement of the residents. Modernisation measures and changes in the use of properties often pose risks of increased rents with negative consequences for resident populations. For this reason, buildings in preservation and development areas may only be modernised or renovated with the approval of municipal authorities.4 The granting of the required permits is usually bound to an obligation to refrain from increasing the rent by more than a reasonable amount after the renovation works, thereby ensuring that the tenant structure is preserved and the displacement through “luxury modernisation” is avoided.5 Community authorities may also set additional requirements for the restoration, modification or change of use and couple them to the required public permits.
Under Section 24 para. 1 sentence 1 no. 4 BauGB, local municipalities are also entitled to pre-emption rights in areas that are designated neighbourhood conservation areas by incorporation. The incorporation deed may for example include terms for securing the “preservation of the residential composition” pursuant to Section 172 para. 1 sentence 1 no. 2 BauGB.
The Berlin Senate has for instance agreed on a concept for exercising pre-emption rights in order to establish more systematic and improved procedures.6 The Senate’s aim is to optimise the proper exercise of pre-emption rights within the statutory framework. The concept seeks to focus on socially oriented urban development and the protection of tenants within the communal structures. The exercise of pre-emption rights in neighbourhood conservation areas appears at first glance to be a well suited means of protection against skyrocketing rents. In practice though there are limitations to a community’s ability to use its pre-emption right.
Attention must be given to the resulting consequences which may have statutory effects under Section 26 BauGB. The legislation has determined a range of variations that are deemed to not be beneficial to the general welfare and therefore block the exercise of a pre-emption right. The “preventive” factors are laid out in Section 26 para. 1 no. 1-4 BauGB, but this provision does not contain all factors which may circumvent the application of a pre-emption right with respect to the BauGB. In addition to the preventive factors of Section 26 BauGB, the sale of a property through enforced foreclosure or an insolvency administrator also remove the legal basis for the exercise of a pre-emption right.
Effects of Averting the Pre‑emption right – Waiver agreements
In practice, the so-called waiver agreements (Abwendungsverinbarung) or preservation warranties between the holder of the pre-emption right and the (initial) buyer of the property play an important role in cases where Section 26 BauGB does not apply. These agreements are an additional tool for pursuing communal urban preservation goals. The legal basis for such agreements is found in Section 27 para. 1 sentence 1 BauGB. This clause stipulates that the buyer has the right to avert the exercise of the pre-emption right by the community. If the buyer is successful in pursuing this right, the community is obligated to issue a waiver of the pre-emption right in order to facilitate the effective execution of the purchase agreement.7 This procedure serves to ensure that the community is not excessively involved in the property transaction if the buyer is able to fulfil the communal preservation aims itself. The buyer assumes the obligation to create or maintain a property in a certain condition which meets the agreed standards of public welfare.
As a method of transaction structuring, the execution of a contractual waiver agreement is often laid down as a condition in addition to the statutory provisions of Section 27 BauGB. Such an agreement lays out the rights and obligations of the buyer and warranties for the community if the obligations are not fulfilled as promised. The terms of such waiver agreements usually regulate the creation or maintenance of a specified condition in the affected property as required to meet the goals of the public welfare and the community’s preservation strategy. The waiver agreement may take the form of a unilateral declaration by the buyer or a contract signed by both the buyer and the local community or municipality. In order for the buyer to reasonably implement the terms of a waiver agreement, the community authorities are obligated to provide all necessary information in regards to their maintenance targets and grant the buyer access to any provisions which have been made in respect to the community’s preservation goals.
The waiver agreement may in such cases be the only remaining possibility for the potential buyer to enter into a purchase agreement for the property. Communities are seeking to reduce the risk of rising rents through luxury renovations and displacement of tenants through the spread of condominiums. They are taking a critical view of new owners and weighing the interests of the buyer against the community’s own interest in neighbourhood preservation. As a result, buyers are facing the decision of whether to enter into a waiver agreement or (assuming the legal conditions allow) accepting the community’s exercise of the pre-emption right.
Purchase Price Limitation and adjustment pursuant to Section 28 para. 3 or 4 Baugb
A final possibility for avoiding displacement of the established residents in particular (and as a concern of some political groups) is the exercise of the pre-emption right by the community in connection with a limitation of the purchase price. In a case where the market value is significantly exceeded, the community can deviate from the basic rule laid out in Section 28 para. 2 sentence 2 BauGB in connection with Section 464 para. 2 BGB. The community is entitled to adjust the purchase price for the property if the agreed purchase price exceeds the market value by a considerable and obvious degree. There may be unclear and diverging views on whether a given purchase price can be considered excessive, but it is generally agreed that the excess must extend beyond a threshold typically viewed at around 20 to 30% above the market value.
Special case: Pre-emption purchase at the compensation value pursuant to Section 28 para. 4 BauGB
Section 28 para. 4 BauGB offers a further exception to the principle that communities exercising the pre-emption right must enter into the rights and obligations specified in the purchase agreement and therefore pay the agreed contractual purchase price (see Section 28 para. 2 BauGB). This provision is only applicable to cases where Section 24 para. 1 sentence 1 no. 1 BauGB is applied, namely within the scope of a development plan which designates areas for public use, compensatory measures or substitutionary measures. Its aim is to protect the community from excessive property prices while at the same time avoiding expropriation and maintaining the principle of equal treatment as codified in expropriation law. Contrary to the general statutes of pre-emption law, the purchase price is determined to the compensation value in such cases. Consequentially, paragraph 4 may be applied in cases where the purchase price may undercut the market price, since the purchase price can be set at the compensation value. In practice, this form or pre-emption right exercise is common with partial land plots which are to be dedicated to a public purpose. The pre-emption right under paragraph 4 should be exercised when it is apparent that the property will be expropriated at some point under the terms of a development plan.
If the conditions of a price adjustment are fulfilled, the price of a property which is subject to a pre-emption right under Section 24 para. 1 sentence 1 no. 1 BauGB and which could be expropriated is not determined in accordance with the BGB. Since this statute is so closely affiliated with Section 28 para. 4 BauGB, the purchase price is determined according to the provisions of the BauGB defining the compensation sum in an expropriation case. If agreement on the purchase price cannot be reached, the seller is entitled to a statutory right of withdrawal pursuant to Section 28 para. 3 sentence 2 BauGB, and the respective terms of the BGB apply. If the seller does not withdraw from the transaction, the pre-emption right under a price limitation pursuant to Section 28 para. 3 and 4 BauGB can only be disputed through judicial proceedings. The building law chambers of the regional courts have jurisdiction over these disputes.
The growing demand for affordable residential space will only increase the pressure on the market caused by the exercise of pre-emption rights in preservation areas. It is therefore vital that participants in the real estate market as well as real estate project developers monitor these developments carefully. Proactive structuring of purchase agreements and development contracts is a key factor in any case. Careful preparation may not avoid pre-emption rights in every single instance, but it offers a critical buffer against planning uncertainty and other unwanted effects.