Lease extensions and premiums A threat to residential investment values - Dewar Hogan

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Lease extensions and premiums

A threat to residential investment values

Lease extensions and premiums A threat to residential investment values

Lease extensions and premiums A threat to residential investment values

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As most readers will know, long leaseholders of flats are entitled to extend their leases upon payment of a premium.

The Court of Appeal is presently considering its decision in the case of Mundy v Mundy v The Trustees of the Sloane Stanley Estate, which concerns the method of arriving at the premium a leaseholder has to pay to extend his lease. A judgment in favour of the landlord will probably amount to the preservation of the status quo, whereas a judgment in favour of the leaseholder could have a serious effect on the investment values of residential landlords.

In principle, how that premium is arrived at is not difficult. Say the lease is presently 42 years with a ground of rent of £100 a year, and it’s going to become a 132 year lease with no ground rent.

You start off by working out what the flat would be worth, just as a freehold with no lease. Then you use that to work out the value of what the freeholder presently has (i.e. the expectation of having the vacant freehold back in 2059, and the right to receive £100 a year for 42 years). You also work out the value of what the freeholder will have once the lease is extended, i.e. the expectation of getting the vacant freehold back in 132 years , and the right to receive nothing per year meanwhile. Probably this will not be a very large value.

The difference is the freeholder’s loss, so the lessee has to pay him that amount.

That’s not all, however.  A long lease, and the freehold subject to that lease, are seldom worth as much, put together, as the freehold would be on its own if the lease did not exist. And the shorter the lease, the greater the gap.

The question therefore arises: since, after the transaction imposed by statute, the value of the landlord’s interest and of the tenant’s interest, added together, will be greater than they were before, who should benefit from that.

If the leaseholder were simply to compensate the freeholder for the amount by which the freeholder’s interest has shrunk in value, the leaseholder would receive the whole of this benefit. After considerable lobbying back in 1993, the government, taking its cue from Solomon, decided that in the case of leases under 80 years this benefit, the so-called ‘marriage value’, should be shared.  It follows that extending a lease which has 79 years and 364 days to run is significantly more expensive than extending a lease which has 80 days and 1 day to run, but there we are.

So our 42-year leaseholder, in addition to compensating the freeholder for his loss, has also to pay the freeholder half of this ‘marriage value’.

To determine that, you need to value the existing 42-year lease, and add that to the existing freehold value. Then you value the new 132-year lease, and add it to the new freehold value. The difference between those two figures is the marriage value, and half of that is the other element of the premium the tenant has to pay.

The principle is not too difficult, but arriving at the actual figures involves delving into a world of valuation which few lawyers are too familiar with. Unless one has a working knowledge of ‘hedonic regression’ and can say immediately what ‘heteroscedastic’ means, the finer details are likely to remain obscure.

However, basically you have to be able to arrive at the vacant freehold value and then plug that into three constants in order to be able to derive the other figures.

The first constant is the ‘capitalisation rate’, which is needed to calculate what the right to receive £100 for £42 years is worth. In lay terms, this is how much money the market wants to receive every year in return for an investment of £1. If the answer is 8 pence, then the capitalisation rate is 8%, and one has a basis for calculating what the value of the right to receive 100 a year for 42 years is.

The second is the ‘deferment rate’, which tells you what a hypothetical investor would pay now for  the right to get a freehold worth £400,000 but only this time next year. This gives a basis for working out what the value of the reversion is. Between them, these two enable you to assess the value of the freehold subject to any given lease.

The third is the ‘relativity rate’. This tells you, roughly speaking, what percentage of the value of the freehold with vacant possession a 42-year lease (or any other length of lease) should have. So this will enable you to calculate the value of the 42-year and the 132-year leases, and armed with that information you can calculate the marriage value and complete the numbers you need.

The question is what those rates should be. One might think that this was a matter for valuers not lawyers, and that the appropriate rates would differ over time and perhaps also according to location. In reality valuers tend to use fixed numbers. What those numbers should be is the subject of a polite yet intense struggle between valuers representing the central London estates and those who generally represent tenants. The former naturally have the upper hand, largely because a shift in the rate may mean a lot of money to a party which owns, say, most of Westminster, but does not mean nearly so much to a single lessee, and consequently the former tend to deploy greater resources.

Every now and then, however, a particularly wealthy and stubborn tenant makes his way to the law courts. A few years ago the Lands Tribunal, in a case called Sportelli, was troubled with the deferment rate, and ‘fixed’ it, at any rate for some time thereafter.

In the Mundy –v- The Trustees of the Sloane Stanley Estate, the relativity rate is coming under attack. There is an interesting personal twist to the case, since leading the charge for the tenants on the valuation side is a surveyor called James Wyatt, who used to be head of valuation at one of the major estates’ valuers, before leaving to set up his own firm which seems mainly to advise tenants – the classic gamekeeper turned poacher. So far the little man is having a bad time, since the Upper Tribunal pretty much came down on the side of the big battalions (assisted, in a nice touch, by the Grosvenor Professor for Real Estate Finance at the University of Cambridge).

The tenant, however, is appealing, and should he succeed the great estates will, it is said, diminish substantially in value, so we may expect a good deal of comment both informed and uninformed – Sir Peter Bottomley, for example, has already expressed his support for the tenant.

It is not simply a question of whether the rate for a lease of so many years should be x% or y% (otherwise the CA would not take an interest). On the contrary, the issue is a conceptual one: should valuers in general adopt the ratios expressed in an index compiled in 1996, largely by valuers representing the great estates, or should they travel still further back in time to an index compiled in 1989 to 1993, as the tenants would prefer?

On the face of it either seems strange – what’s wrong with present day data?

The reason is that the relativity rate is complicated still further by a statutory twist which we’ll discuss in a further blog once the judgment comes out, which should be some time within the next two months or so.