Leasehold reform – what’s it all about ?

There has been significant press coverage relating to an ongoing leasehold reform. Alan Collett, residential property adviser to the TM home investor fund at Hearthstone Investments explains it all.

Key points:

• Some house builders have over the past years started to charge disproportionate ground rents as a way of gaining additional revenue
• As a result, the Government are expected to implement new regulations in early 2019 to better protect lessees
• Properties in the TM home investor funds are not impacted by these changes.

FREEHOLD AND LEASEHOLD IN ENGLAND AND WALES

Land and buildings can be owned either freehold or leasehold, and in theory blocks of flats can also be owned Commonhold. The simple definition are:

Freehold – ownership of land and any buildings standing on it in perpetuity (for ever) and free of any restriction except anything recorded in the Land Registry or Title Deeds (the documents recording the ownership). This ownership may be subject to:

• Restrictive covenants – a restriction placed on the use of land, generally to protect other adjoining land. For example, land for up market housing is sometimes sold with a restriction stopping the houses being split into flats, or new housing being built in the gardens.
• Easements – permissions given for utilities such as water, gas and electricity to pass beneath, or over the land.
• Leases – one person can own the freehold of land and other people can own leases of some or all of the land and/or buildings erected on the land. This is the case where developers sell houses or flats on leases and retain the freehold of the land as an investment.

Leasehold – a contractual right to occupy land or buildings for a fixed length of time. The owner of the freehold may be known as the landlord, freeholder or lessor – generally called the “Superior Interest”. The holder of the lease will be known as the Lessee or the Tenant. A lease may contain many different conditions, but the most important will be:

• The term (length) of the lease. For commercial buildings these are often 25 years or shorter, but for residential they will generally be for at least 99 years, although today they are commonly for 125 or 150 years. Lease of 999 years do exist.
• A ground rent (literally the payment for the land and any buildings on it) Traditionally these were quite small and on estates of pre-1939 houses may be as little as £1 per annum (year).
• A rent review clause – the timing of any rent increases and the basis of the review. In the past, and looking at only housing, these were generally fixed. Common examples would be to double every 33 years in a 99 year lease, or every 25 years in a 125 or 150 year lease. After the inflationary periods in the 1970s and 1980s it became common to link the increases to inflation, generally RPI.
• Restrictions on what could be built on the land, if it was a building lease of land, on what alterations could be made to an existing building on a site. For example, it is common for the owners of houses to need permission to extend them, or of owners of flats to make structural alterations. Unless the lease prohibits it, the lessor can ask for a payment (premium) for giving their consent.
• Provisions regarding repairs. The norm is for the lessee of a house to have all of the repairing obligations. However, for flats the lessee will have responsibility for repairs inside the front door, and external repairs and shared services such as central heating, lifts and common parts to be the responsibility of the lessor.
• Provisions for the tenant to pay an estate charge, on houses, or a service charge on flats. For housing estates these are the costs of running and maintain the common areas – for example estate roads and green spaces. In blocks of flat there will be larger responsibilities for the services mentioned above.
• Insurance. Generally, the lessees of houses are responsible for their own insurance but the lessor of a block of flats will generally insure the whole building and charge the premium to the service charge.

Commonhold – was introduced to the UK in 2002, as a way of owning blocks of flats “in common” thus avoiding the leasehold system altogether. It is used in other countries, notably in Australia. Commonhold means that each flat is owned by each owner and all of the owners own the building and any land around it together. Great in theory it has hardly ever been used in the UK and may be discounted from this paper.

Why use leasehold at all – historically there were good reasons for doing so. Often large estates would grant leases, sometimes very long leases, receiving a long-term income rather than a capital sum. When flats in buildings were first sold – really starting in the 1950s – it seemed sensible to adapt the leasehold system to apply to flats as well as land and whole buildings.

The desire to produce long term income from assets is nothing new, and where there were rent review clauses at all they were first inserted to protect the lessor from suffering from a reduction in the value of their investment due to inflation. In addition to the value of the income thy also had the prospect of getting the land and buildings back in a couple of generations.  This is called the reversion, and the value of that future event known as the reversionary value.

Legislation – has been used over the years to improve the position of lessees (remember that politicians will often use the word tenants which causes confusion with the people we regard a tenant of the Fund’s properties who are people with a relatively short term contract to occupy on an Assured Shorthold Tenancy). Some of the rights given in legislation are listed below, all of the provisions are complex when looking at the detail of any one case:

• The right for the lessee of a house to buy the freehold at a price calculated by a statutory formula – this is called Enfranchisement.
• The right for an individual lessee of a flat buy an extension of 90 years to their existing lease.
• The right for the majority of the lessees in a block of flats to buy the freehold of their building – this is called Collective Enfranchisement.
• The right for the lessees in a block of flats to appoint a property manager of the building and not to stick with the one appointed by the lessor.
• The right for lessees to challenge the amount of the service charge levied by the lessor, or the managing agent on the lessors’ behalf.

Who owns the freeholds?

Some of the old landed estates such as Grosvenor, Church Commissioners and the Oxbridge Colleges try to hold on to their freeholds, but most ground rents on flats and houses are owned by either private investors or pension funds.

Several of the large investment managers such as Aviva and Long Harbour have aggressively moved into the market creating income funds by buying in the market and entering informal partnerships with house builders to forward purchase new schemes.

Ground rents are also invested in by private investors and family offices as a proxy for gilts.

What’s been going wrong –

• Lessees in blocks of flats do sometimes complain about the level of service charge in their buildings, and question whether the lessee of their managing agent is trying hard enough to get best value on the various contracts for which they are charged. In most circumstances the rights to challenge costs referred to above are adequate – although that does not mean that there are not occasional lurid stories in the press. As the Fund owns leasehold flats we do have the right to inspect, and challenge, service charges that we pay.
• Ground rents in new developments – this is the one that some will have in their minds as this has received a lot of publicity. Points to consider here:
• In recent years some house builders have started to charge disproportionate ground rents as a way of gaining additional revenue, especially, but not exclusively, in lower value area where profits are lower. In particular some introducing a rent review which doubled the rent every 10 years in a 125 year lease. No buyer, conveyancer or indeed lender seemed to have done the simple calculation which shows that the ground rent on a house worth £200/250k when purchases goes up as follows:
  • Years 1-10     £250 pa
  • Years 11-20   £500 pa
  • Years 21-30   £1,000 pa
  • Years 31-40   £2,000 pa
  • Years 41-50   £4,000 pa
  • Years 51-60   £8,000 pa
  • Years 61-70   £16,000 pa
  • Years 71-80   £32,000 pa
  • Years 81-90   £64,000 pa
  • Years 91-100  £128,000 pa
  • Years 101-110  £256,000 pa
  • Years 111-120  £512,000 pa
  • Years 121-125  £1,024,000 pa
• Due to the wonderful power of compounding the value of the house rising by 2.5% pa rises to £5.6m, but the ground rent on that formula rises to £1.024m, thus going from 1% of capital value pa to 18.3% of capital value pa.
• Unsurprisingly when owners of these houses tried to sell and the first rent review was only a few years away conveyancers started to notice and second hand house sales started aborting. Owners complained, and MPs started to take an interest.
• Where ground rents are reasonable – which I take to be in the region of 1% of the value of unit, normally between £250/£350 per annum, and have a reasonable fixed rent review of no more than an inflationary increase – we have no problem owning a leasehold house. Most of our houses are freehold.
• We have checked the leases of our leasehold houses and none have rent reviews which are disproportionate.
• We have checked the leases of most of our flats – this process is ongoing – and we have found no unusual ground rent reviews. Knowing my processor as Fund Manager I do not believe that there will be any.

What is happening now?

Government has announced the intention of legislating to ban limit ground rents to £10 pa rising with inflation, and to ban ground rents on houses in almost all circumstances. There will be an exception for sheltered schemes such as those built for example by McCarthy and Stone.

The Government have consulted with the industry on the implementation of their proposals, the British Property Federation has responded, but you can take the change as inevitable. The Consultation closed on 26th November and the results can be expected early in 2019.

Most if not all housebuilders have already changed their sales position, and many have agreed to retrospectively remove the penal rent reviews, although in practice this is complicated as in most circumstances they will already have sold the freeholds and the rights to the ground rents to third party investors.

Buyers, their conveyancers and lenders are being much more careful.

Is the TM home investor fund impacted ?

The new rules will not impact the Fund, as we have no investment in ground rents. The fund does not own any ground rents and so if values of them fall, which is possible, the Fund will be unaffected.

53% of the Fund’s assets are leasehold – largely because 45% of the assets are flats. The Fund owns no properties which are subject to unusual or penal ground rent reviews.

Our preference over the past year and going forward is to buy more houses rather than flats. However, this is not linked to the leasehold rules review, but reflects our Investment Philosophy and current market views. Where we do buy flats, we will tend to buy the freeholds of small low-rise buildings, rather than individual flats in large buildings. This is to give us direct management control of repairs and maintenance rather than to avoid paying a ground rent.

We will selectively buy a small number of individual flats where this is needed to give the Fund “representation” in key letting markets, as needed to ensure our fund is diversified across the UK.

Note: Scotland – is unaffected as it has a separate legal system, and leasehold is rarely used.