As the appetite for fast-growing ground rents increases, Jill Carey and Clare Harman-Clark consider the knock-on effects of going beyond the traditional peppercorn.
Traditional residential ground rents have recently undergone something of a transformation. Once mere peppercorns, albeit often rising with inflation, capital value leaseholds are now being sold with ground rents that rise faster and further than ever before as developers and institutional investors realise the income potential. But as the practice matures and the effects are publicised, developers would be well advised to consider the impact of such rents in the round.
A peppercorn… or some such trifle
The annual payment of a peppercorn is a centuries-old nod to the ongoing relationship of landlord and tenant where a leasehold interest may be long term and often have capital value. It had perhaps some significance when imported spices were exotic rarities, but certainly by 1616, when a tenant of a 100-year leasehold agreed to pay an annual peppercorn rent, it was apparently equated to “a nut, a bunch of may or some such trifle”.
Five centuries earlier, in return for the grant of Suffolk land, Henry II’s court jester, Roland the Farter, was required to perform a (no doubt) hilarious routine each Christmas Day.
The point is the same: the institution of a gentle, periodic reminder that the land is held with some obligation.
But when is a rental obligation too onerous? It may become increasingly politically challenging to generate ground rent profits during the term of the lease; however, lucrative windfalls are expected from reversionary values in the longer term. In limited circumstances, a lucky landlord might even see this happen earlier, as a result of an unintended consequence of the assured shorthold tenancy (AST) regime.
Certainly the number of affected properties is substantial. Government figures suggest that a fifth (4m interests) of all private homes in England are owned on a long lease. Most are flats, but developers wise to the value of ground rents have started to sell new-build estate houses on long leases. Campaign group HomeOwners Alliance reports that, UK-wide, 43% of new builds in 2015 were leasehold. In London, that figure rises to a massive 90%.
An end in sight to reversionary windfalls?
Higher ground rents mean higher marriage values, which affect the cost of lease extensions under the Leasehold Reform, Housing and Urban Development Act 1993. These landlord windfalls might not be expected to be paid for many years, but lenders are already tightening their rules, requiring longer unexpired terms for mortgage finance.
As this affects people’s homes, the issue is an emotive one and developers need to weigh rental income against reputational risk. The government is also aware of the issue: in the recent housing white paper, communities secretary Sajid Javid vowed to end “all unfair and unreasonable abuses of leasehold”. Labour’s housing spokesman, John Healey, referred to “rip-off” ground rents as “little more than legalised extortion”.
A few big-ticket developers and ground rent investors such as Taylor Wimpey, Bovis and Gateway have already faced unflattering press reports when unsuspecting leaseholders found out too late that both the ground rents and the cost of upgrading their leasehold interest were prohibitively expensive. Those individuals affected are seeing the resale value of their properties fall and, as time goes on, buyers will ask more pertinent questions. Indeed, Taylor Wimpey has just apologised to leaseholders and has announced that it has set aside £130m to try to deal with this issue, which will include trying to vary leases where possible.
The days of creating uncapped ground rents could eventually be numbered.
What if a capital value lease becomes an AST?
It’s worth thinking one step ahead of another consequence to rising rents: the possible classification of a capital value leasehold as an AST under the Housing Act 1998.
If an individual tenant occupies the property as his or her only or main residence, and if they pay a ground rent of more than £1,000pa in greater London or £250pa elsewhere, then even a long lease potentially tips into AST territory. Rights to buy under the Landlord and Tenant Act 1987 might theoretically be affected, but another consequence is that it is significantly easier for a landlord to take possession if the ground rent is unpaid.
In practice, it is hard to conceive that a tenant would risk losing their property, or that a court would be willing to allow a landlord to take back a valuable asset for a (relatively) minor breach. However, under ground 8 in part 1 of schedule 2 to the Act, it may not have any choice. Designed as a fast-track fix for defaults by short-term tenants, the provision removes the court’s discretion: if the tenant owes more than eight weeks’ rent at the date of the hearing, the court must terminate the lease and award possession to the landlord. Although tenants would be able to pay the outstanding sum and thus avoid the penalty, any tenant who missed the opportunity could lose their interest.
On the face of it, the potential for windfall might seem attractive to landlords, but it is easy to see why mortgagees are starting to raise questions and why valuers will be under increasing pressure to factor in the risk. This could make these properties less attractive.
The property investment world is highly adaptable and innovative, and this threat to value can be mitigated. Unless and until the legislation is amended, developers have other ways to keep their leaseholds attractive. Carefully worded mortgagee protection provisions could enable a swift step-in should the tenant fail to make a ground rent payment, thus enabling mortgagees to remedy the breach long before possession proceedings are even entered into.
Nonetheless, developers, landlords, buyers and lenders should all be alive to these issues. Where marketability is key, it is worth considering all the consequences of baking banquets from humble peppercorns.
Jill Carey is a real estate disputes senior associate and Clare Harman-Clark is a real estate professional support lawyer at Taylor Wessing
