Blog | Ground Rents | Residential Auction

The foundations remain solid for freehold ground rent investments

Freehold investments can be a rather arcane, yet lucrative, asset class. However, this corner of the market was shaken up at the beginning of this year as a new law was passed, making it illegal for developers to charge ground rent on new build homes. In addition, a few other reforms are being proposed to the laws governing the relationship between freeholders and leaseholders.

So, what does this shaking of the foundations mean for freehold ground rent investors – attracted to the steady, long-term returns, opportunities for capital appreciation and the relatively low risk this asset type has traditionally provided?

Freeholds: income and capital streams

Firstly, for those who may be less familiar with this often-overlooked sector of the market: some background into freeholds.

Freeholds, meaning free of obligation, grant ultimate ownership of land and the properties built on it in perpetuity to their owner and heirs. They provide a plethora of rights to the owner, including the granting and sale of leases for the use of a property, for example a flat and communal areas, for a limited duration (in the terms of the lease).

Freeholders, in compensation for leaseholders using their land and property, can charge them a ground rent. Then there are service charges for the maintenance and repair of buildings, landscaped grounds and facilities used by leaseholders, as well as the provision of insurance. The freeholder can also benefit from any development, for example, an additional floor on a block of flats, and receive compensation for deferring their rights on reversion of a lease when extending it.

All this can mean a multitude of income streams – covering ground rents, management fees and commissions, as well as capital payments from lease extensions and the sale of spaces – which can make freeholds a strong investment opportunity indeed.

Freehold reforms

The abolition of ground rents for new build homes has arrived after a string of scandals. In recent years a number of developers sold new build houses with leaseholds containing onerous clauses, with ground rents doubling over 10 years or similar terms, to maximise the value of their freehold interest. On top of this is the fallout from the Grenfell tragedy in 2017, where leaseholders have been hit by remediation costs for replacing unsafe cladding, waking firewatches and price gouging by property management companies. There has also been a growing number of complaints by leaseholders about the cost of extending their leases. All of which has made it difficult, if not impossible, for some leaseholders to sell.

As a result, early last year the government promised “the biggest reform to English property laws in 40 years.” Understandably, this has caused some concern among investors.

Early in 2021, the government announced leaseholders would be given the right to extend their leases up to a maximum of 990 years at zero ground rent. It would also make the process simpler to extend leasehold interests, abolishing marriage values on the extension of leases of flats with less than 80 years to run (described as reversionary to freehold owners). Additionally, zero ground rent was proposed to apply to retirement leasehold properties.

Despite property law once again being on the government’s agenda, the market for ground rent investments has seen little disruption. In 2020 the average year’s purchase (YP) multiplier (price to income) for long-dated (over 80 years) ground rent investments sold at auction in the UK was 21.4, with an average yield of 4.7%. This breaks down to 26YP (3.85%) for sales within the M25 and 19.4YP (5.1%) for sales elsewhere. Given that this excludes income from sources such as management and gains from re-development, the returns are attractive, particularly when compared to bonds, let alone savings accounts.

Moreover, between February 2020 and December 2021, the level of freehold ground rent transactions at Allsop’s national auctions, despite the uncertainties of the pandemic, saw a drop of only 16%, compared to the previous equivalent period between 2018 and 2019. We attribute this to some owners of ground rents electing to hold on to their investments pending forthcoming legislation. Despite this restriction in supply, Allsop has not detected a fall in demand. Investors in this sector seem to be as keen as ever to acquire new stock – although bids from seasoned buyers have been adjusted to reflect the risk of leasehold reform excluding marriage value from enfranchisement pricing.

But pressure continues to mount. At the end of January 2022, the government announced that it intends to allow leaseholders the right to buy freeholds of properties that include commercial units within them. Unsurprisingly, freehold investors including large pension funds and the landed great estates are pushing strongly back against this.

With freehold ground rent investments being a well established and popular asset class, any property law reform finally enacted is unlikely to be drastic. And, due to the legal complexities involved, the status quo we’ve been witnessing for years may hold for months if not years to come. This will be a relief to investors, at least temporarily, but shows building your freehold ground rent investments can still be well worth it.

More from this Author

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