Mark Hawthorn: Ground Rent Investors
There is a market where a small group of professional landlords buy up freeholds as long-term investments. Leasehold Life is very pleased to collaborate with new guest contributor Mark Hawthorn, owner and Director of Bolton-based Landmark Investment Group where he explains this little understood market further.
There are 4 main areas of a lease where the ground rent investor can capitalise on his investment, starting with the most obvious; ground rent. The value of the freehold interest, i.e. ground rent, is composed of a multiple of the current ground rent which in turn depends on how many years are left unexpired on the lease, any future increases in the level of ground rent, (either fixed or geared through the rent review clauses), market interest rates and the chance of default by the leaseholder as the owner of the ground rent will have precedence over all other creditors, including mortgage lenders and HMRC.
This is true but ground rent is exactly that – rent for the ground. We are buying land with the benefit of a rental income stream, the principle is exactly the same as any other property investment – buy asset, receive income. The reviews are typically to RPI which allows the rent to track inflation. If you moved into a rental property 10 years ago it is highly likely you will be paying more rent now and also in the future. I appreciate there are some review clauses which are overly aggressive but these are relatively rare and can be challenged. We would stay away from anything we thought too “racy” as it leads to issues with leaseholders which slows our whole business down.
2: LEASEHOLD LIFE: LEASE EXTENSIONS
Individual leaseholders have the right to demand that the freeholder sell them a 90-year lease extension (added onto the present unexpired term) under s42 of the Leasehold Reform Housing and Urban Development Act 1993. This extension must be sold at a fair market value which is determined by the current value of the property The only variation (apart from any which the parties agree to or which an LVT allows) is the the reduction of ground rent to a peppercorn rent. This actually means no rent at all as immediately after an extension there is no ground rent to pay.
The potential for increase in the value of the flat arising from the grant of a new lease is known as marriage value (a component of a lease extension valuation). It is payable when the lease drops below 80 years and the legislation requires that this ‘profit’ be split 50/50 between landlord and leaseholder.
When the lease length drops below 60 or 70 years many lenders will then refuse to lend against a leasehold property making them un-mortgageable. Ground rent investors know only too well that flat owners will be willing to pay well above the market price to extend their leases or buy the freehold.
This reverts back to the freeholder owning the land and the leaseholder the property. There are some freeholders who will acquire the leaseholders property to gain value rather than grant extensions, particularly the Landed Estates who want to own as much of their estate freehold (ie without leases) as possible. As with Point 1 I appreciate that some freeholders will abuse this process .However it must be considered that the freeholder has made an investment, owns the land and by definition exists to make a profit. You will find that many taxpayer owned entities are large owners of ground rents and will look to earn from lease extensions with main examples being local authorities and more famously the Crown Estate, where all surplus revenue is paid to the Treasury.
Leasehold Life: Outside of the Act
If a lease is negotiated and extended outside of the 1993 Act, freeholders often seek to not only increase the ground rent but strengthen the existing rent reviews to increase the value of their investment.
There are time and cost benefits to all involved but I can sympathise where this circumvention is used simply to generate a higher price.
3: LEASEHOLD LIFE: BUILDINGS INSURANCE
One of the biggest bones of contention for leaseholders is paying for buildings insurance because they can’t source it themselves. They have to accept that not only do a number of freeholders and managing agents buy insurance in bulk and direct from the insurer through a specially established broker, they don’t pass the discount on in terms of cheaper premiums. Instead they add them to the cost of the policy as a markup, allowing them to charge anything up to 200% above what the leaseholders could get in the market place if the lease (and the law) allowed them to!
Below is an example extracted from a C.A.R.L (Campaign for the Abolition of Residential Leasehold) newsletter of how insurance scams work:
- The insurance broker, authorised and regulated by the FSA charges the managing agent or landlord £1,121 for buildings insurance;
- The broker levies Insurance Premium Tax (IPT) at 6% at a cost of just over £56, which is paid to Revenue and Customs;
- A demand for £2,768 is sent by the landlord to all of the leaseholders under the heading ‘Property Insurance’.
- The leaseholders then divide the cost amongst them, unaware of the disproportionate fee the landlord has included.
It should also be remembered that in 2004, legislation was supposed to extend the remit of the Financial Services Authority (FSA) to regulate landlords/ managing agents that provide insurance services but was never enacted. Why? Because the Royal Institution of Chartered Surveyors (RICS) opposed it and so because there is still no legal obligation to disclose insurance commissions, the less scrupulous agents and landlords aren’t disclosing!
The reason insurance responsibility is placed with the freeholder is to offer security to all involved, including mortgage companies. The theory is that the freeholder is independent of the residents, has a vested interest in the building/site and therefore will always ensure insurance is maintained. There are many sites where we have to fund the insurance as there are insufficient service charge funds. If the insurance was the direct responsibility of the residents it would likely make the properties un-mortgagable as the mortgage companies would not wish to place the insurance for their security in the hands of the residents/public.
We are aware that in some instances managing agents will place the insurance on behalf of the resident management company. However, I think you will find in most instances the managing agents are operating the same as the freeholders and earning a commission. Worse still is the managing agents don’t always have the same level of understanding of insurance risks as the freeholder as they don’t have a vested interest like the residents/freeholder and can walk away.
Many freeholders have access to beneficial rates due to the amount of insurance they place. I see this as a wholesale/retail split the same as a supermarket is able to buy stock at discount due to volume and then price it accordingly for the customer. Our ethos is that the residents shouldn’t be able to get the same cover as us at the same price therefore commission becomes irrelevant as they are getting better deal than they otherwise would. I am well aware of some freeholders charging well “over market” for insurance simply to generate commissions – I think this is very short term thinking as it drives residents to seek a solution such as LVT/RTM.
If the above takes place then I agree it is a scam. There are also FSA restrictions on what freeholders, managing agents and brokers ican charge by way of maximum commission, irrespective of RICS.As you may expect brokers are keen to deal with freeholders/managing agents due to the amount of stock under control, often running into the billions. The charging simply works (as far as I understand) in that the broker invoices the managing agent/residents who pay and then the commission is shared with the freeholder for introducing the business. It is not the landlord adding to the premium more the broker/insurer sharing their earnings.
4: LEASEHOLD LIFE: FREEHOLDER CONSENTS
Most leases require consent from the freeholder in order to carry out any alterations/repairs but there are no statutory guidelines on what the freeholder can charge for granting such consent.
Freeholder consent to alter covers any of the following:
- Changing the face of the building such the changing windows or the insertion of a skylight;
- The cutting through of any walls;
- The removal of either the whole or part of any wall, regardless of whether it’s internal, external or a partition;
- The installation of a new kitchen, bathroom, toilet, shower etc which is likely to increase the amount of waste water/sewage being removed from the flat; modification to communal services such as the re-routing of a radiator attached to a communal heating system or removing a radiator attached to a communal heating system.
There is the “reasonableness” element but this is difficult to determine. Its not an easy one because if the lease contained provisions for all eventualities it would be a nightmare to understand/review. As with insurance the clauses are for the mutual benefit of other residents and the freeholder, as a third party serves to enforce the lease.
We have seen examples of supporting walls being removed, DIY electricians, residential units being used for business purposes, holiday/short term lettings etc etc. There is work involved in considering the consents which is where the charge comes from, and again some freeholders exploit what is a genuine clause for the benefit of the residents.
If your neighbour decides to acquire five dogs and play his music all night it has no effect on the freeholder but under the terms of your lease you can request action is taken to protect your position.
The developers will also want to maximise their profits so they often sell ground rents (pre-packaged in bulk) to ground rent investors before construction starts with the investors paying a large deposit up front which will be used to fund building costs. The sale and exchange of contracts is agreed upon very early in the process because one of the conditions will usually be that completion takes place on a notice served by the developers at a fixed period after the sale of the last flat. If developers don’t want the building of the development slowed down by having to issue Section V notices to the leaseholders under the Right of First Refusal, as long as the sale of the ground rents occurs before half of the flats are sold, the need for serving such a notice is by-passed. It’s not actually illegal because legislation requires there to be a majority of leaseholders willing to accept the right. If less than half of the leases have been granted then such a majority simply does not exist!
The sale price to an investor is less than it would be to the residents. The motivation isn’t to circumvent the residents ,it’s simply to generate funds. In an ideal world all freeholders would sell all of their assets to the residents as they will always pay more due to their “special purchaser “ status – ie they live on site and have an emotional interest in it rather than a purely financial one. We do see a lot of conspiracy theory type suggestions surrounding all areas of freeholder/leaseholder relationships the majority of which are entirely wrong.
Establishing a Resident Management Company
Developers will also be advised to have tri-party leases written in order to establish a Resident Management Company to be run by the long leaseholders. The leases will contain a clause that clearly separates the management responsibilities of the common parts (which are transferred into the name of the resident management company, commonly via a headlease) from the ownership of the freehold. Each leaseholder becomes a member of the company, and a group of leaseholders will be established as the new company Board. They will take responsibility for complying with the management covenants set out in the lease.
We do not manage sites, instead we pass them out to our panel of professional managing agents. There are a large number of freeholders who also own block management companies who therefore buy ground rents to gain control of the block management/service charge. If you consider a block of 100 flats paying £200pa ground rent and £1200pa service charge there is £20k of ground rent coming in and £120,000 of service charge. The ground rent is structured and transparent in terms of what it is and what it is for. The service charge is quite ambiguous and can be heavily manipulated, there are also a wide range of areas for profiteering – this covers almost any expense leaving the management company. In many instances the agents charge, say £200 per unit per annum management fee and can generate many times more in rebates, employment of their own contractors (ie wage of £250 per week, charged out to residents at £500 a day!) etc etc etc. This applies to independent managing agents as much as “tied” ones
There are still valiant attempts being made to make leases fairer for leaseholders but the fact remains that the only way to make things fair is to give purchasers the third choice of residential property purchasing that legislation introduced: that of commonhold.
An interesting sales pitch one particular ground rent investor uses is that they are ‘adept at the irritating features which often make people sell, such as leaseholders refusing to pay ground rent/service charges, constant correspondence with little reward and high capital value but little income’.
Interestingly these same ‘irritating’ features are sold to leaseholders as ‘rights’!
Freehold and leasehold will never be equal. If leaseholders have ground rent investors as freeholders then surely they will be destined to be in and out of court defending the cornerstone of their rights that demands for payment to be ‘reasonable’, something which is the complete polar opposite of the needs of the investor to maximise profits!
I cannot see commonhold ever happening and I think there have been around 10 examples which were likely publicity stunts. Developers are businesses which exist to generate profits, if there is a way to do so they will consider it. I have also read about the variety of issues faced with commonhold, many of them linked to lending – if there’s no finance there are no sales!
Nevertheless I can see where you are coming from and your general perception is difficult to argue against. Our view is that the public/leaseholders are the customers of the developers (ie Barratt, Wimpeys etc) and the developers are our customers. If we upset our customers (developers) customers (residents/public) then they will very quickly stop dealing with us. It is also worth considering what I call “ratios” – we can manage as diligently as possible and provide a good standard of customer service but with 7,000 units under management, projected 10,000 by end of year, by simple “ratio” we are going to have serial complainers and people we can never please – as would any large business. I am involved with a large charity as a board member and they have complaints – one person who was on an event to raise money for the charity and sustained an injury sued them! You cannot please all the people, all the time and nor are “all the people” normal!
DISCLAIMER: This article does not constitute legal advice.