Ground rent is a regular amount of money collected by the freeholder from leaseholders as the annual consideration payable to the freeholder in return for granting the long leasehold interest to the lessee. So whilst on the surface ground rent appears to be exactly what it say on the tin, (payment to the freeholder for the ground on which the building stands) it’s reality is very different because it has been a low risk, long-term investment vehicle for years.
When developers draw up leases they create tangible and transferable investment value for freeholders by allowing ground rent to increase incrementally over time with greatly varying amounts.
The common features of modern residential lease clauses are:
- Lease Term: 125 to 999 years with the moat commonly found lease length being 125 years;
- Initial Rent: £100 to £250 per annum in increments;
- Rent Review Frequency: 5 to 33 year intervals;
- Rent Review Type: Fixed uplift (the most common) a regular rise according to the Retail Price Index which allows the rent to track inflation, the House Price Index, or the percentage capital value of the property.
Residential ground rent investment portfolios are usually traded on a multiplier (years’ purchase, commonly known as YP) or a gross yield applied to the ground rent income. However, unlike both traditional
residential and commercial assets, the return generated from the investment does not come from rental income and capital appreciation alone (hard income). Other forms of ancillary income (soft income) come fro provisions within the lease such a lease extensions and buildings insurance.
Developers also often sell ground rents (pre-packaged and in bulk) to ground rent investors before starting construction. These investors will pay 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 avoided. 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.
- 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;
- The chance of default by the leaseholder as a ground rent owner will have precedence over all other creditors, including mortgage lenders and HMRC.
An interesting legal challenge as to how freeholds are valued came with the case of Sloan Stanley Estate v Mundy which centered on the Parthenia model which used pre-1993 Act facts to show relativity in a “no-Act” world. It apparently produced an impossible result because the open-market value of the leasehold property was shown to be lower than the “no-Act” value. Evidence given by valuers on behalf of the freeholder stated that in their opinion “Act rights” do have a value so that the market value of a property without rights must be less.
The decision by the Upper Tribunal for the Parthenia model not to be used again has been upheld by the Court of Appeal in January of this year, a summary of which can be read here.
Many leaseholders don’t see why they have to pay ground rent as they do not see how such a payment is of any benefit to them and a scandal of “doubling” ground rents on freehold houses has seen the building of freehold houses now banned. This came about because the freeholds of these properties were sold on to another party without the knowledge of the new leaseholders. They only became aware of this when they saw their ground rent demands (with another company name on them) doubling every 10 or 25 years, rendering the properties un-sellable.
Regarding Government intervention in this area, an interesting point came from Paul Winstanley, FRICS entitled ‘Be Careful What You Wish For: The Unintended Consequences of Political Intervention in the Ground Rent Market’ who holds the opinion that for such a responsibility taken on by freeholders, the existence of a ground rent payment by leaseholders to a reasonable upper limit is justified but trying to balance profits over the cornerstone of leaseholders rights, that of ‘reasonableness’ has gone horribly wrong.
In fact Paragraph 5.14.19 of the Council of Mortgage Lenders Handbook (CML) states that ‘we have no objection to a lease which has provision for a periodic increase of the ground rent provided that the amount of the ground rent is fixed or can be readily established and is reasonable. If you consider any increase in the ground rent may materially affect the value of the property you must report this to us’.