One area that is proving popular is investing in property, be it in physical bricks and mortar, property funds or residential ground rents.
Residential ground rents provide a long term secure stable income with elements of inflation protection and capital uplifts. The legal structure of freeholds and leaseholds in England and Wales create the ground rent.
When a property, primarily a block of flats, is developed the flats are generally sold on long leases, normally between 95 and 125 years.
The freeholder retains his rights to the freehold and the “reversionary” interest i.e. at the end of the lease the flat “reverts” back to him. Under the terms of the lease the leaseholder pays the freeholder a low annual rent (e.g. £200), it is this rent that is the “ground rent”.
Generating income
It is useful to focus on aspects of income, capital and investment strategies. The ground rent has a minimal risk of default. If the leaseholder (flat owner) does not pay the ground rent the freeholder can, after following legal procedures, forfeit the lease and ownership reverts back to the freeholder. Given the small monetary amount of ground rent, especially in relation to the value of the flat (known as over collateralisation) the ground rent is generally paid. In addition, with regard to the ground rent, the freeholder ranks above all other creditors, including mortgagees. Mortgagees will pay the ground rent to protect their collateral.
Ground rents are more often than not subject to reviews, and linked to the RPI, HPI predetermined uplifts or other easily calculable references. Review periods can range from five to 50 years. These reviews can provide investors with an element of inflation protection.
Under the terms of the lease the freeholder is often entitled to other income streams. These can include the right to levy a charge on consents to assignments (flat sales), solicitors enquiries or consent to alter a flat. The freeholder may also have the right to place building insurance or management of the building which can produce income. Such income streams are less predictable than ground rent but provide the investor with extra returns.
Capital profits are realised primarily from the sale of lease extensions or enfranchisements. Residential lessees have a statutory right (subject to conditions) to purchase from the freeholder lease extensions of up to 90 years anytime during the lease term. If agreement on the amount payable (the “premium”) cannot be agreed then the premium is set by the Leasehold Valuation Tribunal, who follow a set publicised valuation methodology.
Lease extension
Leaseholders are incentivised to extend their leases. A shorter lease terms often results in a lower value for the flat. Purchasers tend to be wary of short leases and so leaseholders often consider extending their lease as they approach 80 – 85 years. Mortgage lenders generally insist on a minimum lease length (55 -65 years), so leaseholders selling their flats tend to purchase lease extensions.
When the remaining lease term of a flat falls below 80 years the cost of purchasing the lease extension is higher as the freeholder is entitled to half the “marriage-value” – simplistically, the increase in the value of the flat arising from the granting of a new extended lease.
The legislation regarding lease extensions and the predictability of premium calculations results in the process being smooth and provides freeholders with potential capital profits.
Enfranchising
Leaseholders in a building can group together and subject to conditions, “enfranchise” – purchase the freehold of the building. The valuation methodology is set out by the Leasehold Valuation Tribunal and follows a similar pattern to that of lease extensions.
When a lease is not extended at the end of the term the flat reverts to the freeholder. The leaseholder has a statutory to remain in the property but at on open market rent. Such a scenario provides the freeholder with a substantial capital profit.
Realised and unrealised capital gains stem from the passage of time and increases in residential values, As the lease length shortens the reversionary value increases. The increase in value of the reversion is exponential (geometric progression). Valuations take account of the underlying flat value and so increases in residential values are relevant. This exposure to HPI can provide investors with inflation protection. Profit are released through lease extensions or enfranchisements.
Strategising
A basic appreciation of the valuation in methodology of ground rents assists the investor in deciding which investment strategy to follow.
The longer the length of lease the more the valuation is related to a simple multiple of ground rent and a lesser reference to the underlying flat value. This results in income yields being substantially more than that for short leases. The shorter the length of the lease the more the valuation relates to the underlying flat value.
Investment strategies tend to focus on short leases (50-80 years) or long leases (95 years plus).
The acquisition of relatively short leases has the aim of benefiting from the reversionary interest. The valuation of such investments bears a higher correlation to the value of the underlying property. Investors should view such a strategy as more akin to a residential real estate investment.
Investments in longer dated leases offer an income from ground rent with little initial exposure to residential values. For investors long dated ground rents provide a fixed income type investment with elements of inflation protection and capital appreciation. Providing a good opportunity for advisers and their clients.
