Seasoned investors often diversify, especially when markets dip – a commercial element as part of a mainly residential portfolio, or vice versa, is the most obvious example. Yet one investment avenue often overlooked even by experts is ground rents.
Do not be deterred by recent publicity over ground rents and government moves to outlaw abuses. While there have been some unreasonable practices by a few, this does not diminish the potential returns from responsible ground rent investment.
So first, let’s look at the basics. Many properties, including many new-builds and conversions, have their ownership split into freehold and leasehold interests. The leaseholder owns the house or apartment, while the freeholder owns the land on which the property sits. In return for occupying the land the leaseholder pays the freeholder a small annual “ground rent”.
A long history
This is a peculiarly British institution, with roots in early Norman times when a commoner’s right to build on an aristocrat’s land was verified through the granting of a lease and rental payments.
Key considerations
■ Lease-length: typically, the shorter the lease the better, to optimise an uplift in ground rent when the lease is extended.
■ Contracts: do they offer scope for periodic or event-driven rent increases?
■ Are there development opportunities on the site, providing more future ground rents?
■ Have you appropriate legal knowledge and administrative infrastructure to manage and collect multiple ground rents?
Traditionally these rents are small (sometimes called “peppercorn rents”). Some are fixed at, say, £100 a year while others escalate automatically every 10 years, say, or every 33 years – a third of a typical 99-year lease. However, recent investigations have found some that housebuilders, either directly, or through third-party firms, levy escalating rents, making some homes almost unsellable. This is where the government is targeting new legislation.
For individuals, however, ground rents remain a viable investment option offering the closest thing to bond-style investment that property can offer. But for the investor, research is crucial.
A 2016 analysis by Direct Line for Business revealed that ground rents now average £371 a year on new-builds and £327 on other leasehold properties. Unsurprisingly, these returns, especially on high-density blocks of 100 or more units, have attracted institutions and property funds such as Aviva Investors and Brooks Macdonald.
However, such institutions shun small schemes, thus opening the market to small-scale investors, according to Richard Watson of Allsop’s residential team, which sells ground rent lots at its auctions. “In a low-interest return environment such as we have experienced for a good number of years, they offer a safe and secure income stream,” he says.
Ground rents are available for as little as £10,000, and could potentially yield returns of 3%-10%.
Security
Added security for the small-scale investor is provided by the fact that default rates are low – lessees are unlikely to risk credit ratings and ownership of their home by not paying token sums. And if default does take place, mortgage firms often step in if their customer fails.
Another appeal is a possible capital sum or enhanced ground rents if owners of properties with leases of 80 years or less seek to extend – “reversionary payments”, as they are called.
Many ground rents are bought at auction, where the usual rules apply. You pay a 10% deposit immediately, with the rest payable shortly afterwards, along with a small fee to the auction house. An alternative is to buy ground rents through specialist websites.
Income opportunities
■ Ground rent: this is the core income.
■ Insurance: if leases allow or insist that the freeholder insures the building, an investor could earn money through commission from the brokerage.
■ Short leases: lenders consider 80 or fewer years on a lease as too short, so owners or buyers will seek to extend, giving a legitimate opportunity to increase ground rent.
■ Exploiting hidden value: adding additional units on top of the building or converting some communal space into new accommodation.
The costs of the rents themselves will depend on their potential return. In Savills’ July auction, for example, ground rents for a block of eight units in Walthamstow sold for £57,000; they produce £2,000 a year in rent. Ground rent for 24 apartments at Gillingham in Kent sold for £170,000; they produce £8,800 a year in rent.
However, the ground rent for a single flat in Fulham, SW6, sold for £86,000; with only 18 years left to run on the lease, the buyer will build “reversionary payment” into his expectations, seeking a lump sum or higher ground rents when the lessee seeks to extend.
“Remember, ground rents are also subject to stamp duty as per all house purchases,” says Savills’ director of auctions, Chris Coleman-Smith. This does not kick in, however, until the sale price hits £125,000; most small-scale investors will escape the charge.
For those thinking of entering this rarefied market, the advice could be “the sooner the better”, given the government’s desire for reform, starting with a possible ban on leases on new homes.
In 1996, just 22% of new-builds in the UK were sold as leasehold but this has doubled to around 45%. In London, nine out of 10 new-builds
are leasehold. Over 42,500 new-build leasehold properties were sold in the UK in 2015, the most recent year on which data is available, but this is likely to diminish because of the controversy surrounding onerous ground rents.
“If new-builds no longer have such leases, the ones in existence are going to be more scarce,” says Monica Tepes of investment bank Cantor Fitzgerald. “That is no bad thing for the person who holds them.” She says that since the banking crisis began in 2007, with fewer new homes built as a result, there has in any case been a relative shortage of ground rent opportunities available to investors, adding further to the investment growth possible.
In every area of property, the shrewd investor keeps an eye on policy changes. But for those seeking long-term, low-risk returns, few sectors are as reliable as ground rents.
Case study: building and managing a portfolio
Devon-based Alan Watson, 47, a senior executive in a national charity, turned to ground rents because he wanted to avoid putting all his faith in traditional buy-to-let.
“It was 2011 and I thought buy-to-let returns may fall. In fact, over the intervening six years they have risen, but now taxes are higher, so overall my decision to diversify was justified. As with buy-to-let, my primary objective was to secure a long-term, stable income” he says.
“After three successful auctions, and one unsuccessful bid, I now have ground rents on more than 40 properties, which together bring in £17,000 a year. I haven’t had any requests for extended leases, but two properties now have leases of fewer than 80 years, so I am expecting those in the next few years.”
His biggest challenge remains handling the leaseholders. Each has a different payment date and requires a bespoke letter, although computer software can reduce the hassle.
He adds: “I am tempted to use a managing agent but, touch wood, so far I have handled all requests for ground rent myself. I have had only one default, and that was relatively minor.”
