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On the surface, ground rent is a regular amount of money collected by the freeholder from leaseholders as an annual payment for granting a long lease. A freehold interest has no intrinsic value other than the ground rent paid to the freeholder for the ground their property stands on and the reversion (the handing back of the property after the terms of the lease have expired).
Freehold property is therefore normally valued on an investment basis with its value at any given moment based on a calculated present value of the future income. It is the loss of the future income that the freeholder has to be compensated for.

Ground rent is also a key part in freehold valuations in both collective enfranchisement and lease extensions and it’s value (freehold interest) is composed of the following elements:

  1. A multiple of the current ground rent which in turn depends on how many years are left unexpired on the lease;
  2. Any future increases in the level of ground rent, (either fixed or geared through the rent review clauses);
  3. Market interest rates;
  4. The chance of default by the leaseholder as a ground rent owner will have precedence over all other creditors, including mortgage lenders and HMRC.

Developers

Developers often sell ground rents (pre-packaged and in bulk) to ground rent investors before actually starting construction. These investors will pay a large deposit up front which will be used to fund building costs with the sale and exchange of contracts agreed upon very early in the process. When they draw up the new leases they allow these ground rents to increase incrementally over time with greatly varying amounts. This is not new because ground rents have been classed as a long-term investment vehicle with the total returns available seen as being considerably higher tthan those achieved from gilts, fixed income annuities and long-dated bonds.

They 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 just come from rental income and capital appreciation (which are known as hard income). Other forms of ancillary income (know as soft income) come from two other provisions within a lease: lease extensions and buildings insurance.

Risks

Ground rent investment is however subjected to a number of risks (in addition to lease extensions and collective enfranchisement) which include:

  1. Portfolio size:  the rents payable are relatively low so a large portfolio is needed to be able to maximise all the investment benefits;
  2. Intensive Management:  there is a significant management responsibility and cost involved with responding to leaseholder’s requests and queries often being both time consuming and costly (which is why tri-party leases were created so the resultant RMC’s would deal with this element themselves);
  3. Index Linked Rent Review Uplifts : a significant proportion of ground rent investment rent review clauses are index linked. Common
    index linked provisions include: RPI (Retail Price Index) uplifts, HPI (House Price Inflation), and uplifts based on the average earnings index;
  4. Political /Legal Risk: Government intervention is an issue because 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 Point 4, Government intervention, 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’.

SUMMARY

The method used to value freeholds, that of the Parthenia method was challenged in 2016 with the case of Sloan Stanley Estate v Mundy because the method 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.

 

 

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