A lot can happen in a year but 2020 has been unlike any year in recent human history. Less than six months ago the investment status of Residential Ground Rents, which historically have been compared to AAA Bonds or even gold, had become surprisingly more uncertain. This was a result of the continued prospect of far reaching Leasehold Reform which has been under Government review since December 2017; with final recommendations having been put forward by the Law Commission this July. Of course it remains unclear as to exactly what basket of reforms will finally be implemented by the Government – and when it will find the legislative time in Parliament to effect the changes – but the horizon is certainly becoming less blurry for investors who can now at least price in a risk premium for what they perceive to be the extent of the likely reforms. During the last three years it’s fair to say that existing Freeholders have also gone through a period of price recalibration and have largely accepted that certain reforms in the sector are inevitable. In a climate when almost every sector of the real estate market seems to be facing major uncertainty (and therefore risk) for one reason or another, it is not surprising that we are currently seeing a renewed focus on Ground Rents from both private investors, property companies and even institutional funds. Following the lockdown and the Law Commission’s report publication, we witnessed a significant increase in the demand for Ground Rent investment opportunities, with several private treaty sales currently in solicitors’ hands and the volume of sales at auction hitting particularly high success rates with 93 ground rents sold in July and August.
So why were Ground Rents so popular?
Ground Rents historically provided Freeholders with a solid and almost certain income, excellent underlying collateral, known rent review patterns (many tracking the cost of living via RPI/CPI or doubling review clauses) and the opportunity to receive a premium for a lease extension when the unexpired term of a lease typically falls below 80 – 90 years. What was not to like?
Could this popularity return?
Time will tell, however, providing the reforms are implemented fairly for both Freeholders and Leaseholders, it is difficult to see why investor demand will not return to pre-2016 levels, albeit at risk adjusted YP levels. The Law Commission has been very clear in its recommendations that these reforms should by no means be a land grab for Leaseholders. It states that Freeholders should receive sufficient compensation to justify the interference in their legitimate property interests following the reforms. The Law Commission also recognised that Freehold ownership of residential blocks is broad and not just a benefit of the ‘gentry’, for example Pension Funds, Charities, Housing Associations and Local Authorities are all major Freeholders and the unfair diminution in the value of their legitimate property interests would have far reaching financial consequences on many areas of society and unsuspecting individuals.
So what recommendations were put forward by the Law Commission this July?
Though not exhaustive, in short the more significant recommendations are as follows:
- Lease extensions should be by 990 years, not the current 90
- Landlord retains redevelopment break rights every 90 years
- Houses should get lease extensions of equivalent length as flats (currently houses only get 50 years)
- No distinction in law between houses and flats. The new legislation will refer to both as a ‘residential unit’.
- Leaseholders can extend their lease without changing their Ground Rent
- Right for leaseholders who already have long leases (and do not wish to extend) to buy out their Ground Rent
- Right of a leaseholder who owns all the units in a building to buy the freehold
- Collective freehold enfranchisement to extend to part of a block, not the whole (i.e. if there were a series of blocks in an estate, one block could enfranchise)
- Increase in the non-residential floor area to 50% from 25% that qualifies for enfranchisement
- Abolition of the two year occupancy requirement before extending a lease/enfranchise
- Proposal that the low rent test and the rateable value test should be abolished
- Proposal that shared ownership leases (previously excluded) should have the same rights as normal leaseholders
- Elimination of the leaseholder’s liability for landlord’s costs.
- Recommendation that the Government regulates lease extensions that are negotiated outside the Act
A last bite of the cherry for Freeholders?
Without a doubt the two biggest changes would be to legislate that lease extensions would be for a period of 990 years and not the current 90 years, and also to give rights for lessees to buy out their Ground Rent if the lease is already extended. Such a change will clearly shift the balance of power to leaseholders over time, which is arguably one of the main objectives of the reforms, but at least this risk and transition could be priced in by investors. Logically, the vast majority of lessees in the UK will continue to pay their Ground Rents until new legislation arrives and even once it is in place, providing they are not set at unreasonable levels it is unlikely they will be changed, so Ground Rent arrears should remain minimal with lessees wanting to avoid all the problems of falling into arrears. Inevitably Freeholders will be called upon to extend leases at a premium to enable the smooth sale and re-mortgaging of the lessees’ leasehold interests. I have asked a number of contacts and clients if they would purchase a freehold Ground Rent investment now (ahead of the potential changes in legislation) providing the Ground Rents were not onerous (i.e. being no greater than 0.1% of the flat values) and the rent review pattern was not unreasonable. The general consensus was that most probably would, while applying an appropriate risk premium of course!