When news stories began to circulate in late 2016, newspapers focussed on a couple of headline-grabbers:
- the explosion of leasehold ‘houses’ being sold by developers; and
- The practice of granting leases with geometrically increasing ground rents (e.g. where the rent doubles every ten years). This can make an initially modest sum of a few hundred pounds a year become several thousand pounds a year in as little as 30-40 years’ time.
The government has recently announced its intention to legislate to prevent what are described as “…feudal and entirely unjustifiable..” leasehold practices in the market – but what are these? The reality is that there are a number of ‘mini-scandals’ caused by a combination of market practice and the hotchpotch of residential tenancy legislation which have unwittingly opened a Pandora’s box of problems.
How did we get here?
Leasehold structures are nothing new. In fact there are good practical and legal reasons why, for instance, a block of flats comprises a freehold building and structure (owned and managed by an owner or management company) with each tenant having a long lease of an internal ‘footprint’ in that building. Sometimes it’s even necessary to sell leasehold houses, not so much to enable management of common parts, but simply because the developer only holds a long leasehold itself and the freeholder is not prepared to part with outright ownership.
However, from this logical start-point, the market-place has evolved into something rather different, because (at least in the writer’s opinion):
- ground rent incomes (and the freeholds that come with them) have become very marketable assets in their own right. For an investor in a low interest rate environment they provide a relatively secure income stream with built in (and readily ascertainable) increases in that income over time; and
- (arguably) it helped to reduce the selling prices of residential properties to hard-pressed purchasers. By selling a ‘lesser’ interest, coupled with the investment asset which was tradeable elsewhere, developers were able to restructure their income stream.
What went wrong?
Blaming the whole thing on ‘greedy’ developers sells newspapers, and bears an element of truth, but is almost certainly an overly simplistic view of the issue. Unfortunately the government’s consultation response does little to dispel this view, and is based overwhelmingly on responses given by members of the general public (94% of those who responded to the consultation online were private individuals). Nonetheless the explosion in the rate of increase of new leasehold properties (according to Land Registry’s data, leasehold made up 43% of all new-build registrations in 2015 compared to 22% in 1996) has drawn more attention to the potential problems and shortcomings with leasehold structures and the law around them.
Let’s start with the obvious one. Legislation protects residential tenants from all sorts of ‘unfair’ practices in relation to services charges, but not the amount of ground rent they pay. At least not if it’s subject to a predetermined rent review formula such as the fixed increases we talked about at the start. A recent case, Arnold v Britton, (ironically about geometrically increasing service charges) made it all the way to the Supreme Court and established that a court wouldn’t rescue a tenant from a bad deal. So the simple fact that there are leases around with escalating ground rents are not going to be struck down, just because they’re not ‘fair’ on the tenant in 40 or so years’ time.
A well-advised tenant will be wise to this issue, but often their negotiating position is considerably weakened (especially on a ‘hot’ development where the developer has a queue of buyers waiting in the wings). They might feel pressured into going ahead; after it probably won’t be ‘their’ problem by the time they come to sell, so why worry? However, the issue is now on the radar of lenders who are increasingly unwilling to lend against properties considered depreciating assets (the lease becomes shorter over time but the cost of the ground rent moves ever upwards). Lenders including the likes of Nationwide and The Mortgage Works are already specifying ‘minimum’ acceptable terms for lease length, initial ground rent levels and the rent review requirements. It seems inevitable that others will follow suit and developers need to be alive to how that may impact purchasers going forwards.
The Government’s response document suggests they will press on with legislation to set all ‘new’ ground rents at a notional sum. This could affect developers with schemes currently under development where more substantial ground rents have already been imposed on other plots. By the same token, buyers will increasingly become more ‘alive’ to the dangers of paying a ground rent if they perceive that a blanket ban will come into force in the future. The danger is that the government’s announcement may actually cause more problems for the market as buyers (both developers and those buying plots on developments) stall on transactions while they wait and see what happens. At present there is no timetable for these proposals, and they may prove more difficult to implement than the Government supposes. In the short term if developers move early to take ground rents out of their scheme pricing the most likely impact is that the ‘value’ of that ground rent income will be shifted into a higher asking price. Equally there is a danger of a two tier market for leasehold properties; those subject to a ground rent and those that are not.
A less well known ‘side-effect’ of increasing ground rent relates to the ‘status’ of the lease in housing law. If the ground rent exceeds certain limits (£1,000 per annum in Greater London, £250 per annum outside that area) and the tenant occupies the property as their home (as opposed to renting it out as an investor) then the lease becomes an ‘assured tenancy.’ Without getting into the technicalities too much, that sets off a rather unexpected chain of events including (but not limited to):
- the landlord gains the right to seek an order for ‘possession’ of the premises. In effect the landlord gets the property back to re-let it to a new tenant. This is quite distinct from the forfeiture clauses that you would usually see in a long residential lease. The Housing Act 1988 prescribes possession grounds which fall into ‘mandatory’ and ‘discretionary’ grounds for the court to make a possession order. One of the mandatory grounds is non-payment of ground rent for a prescribed period (and which remains outstanding at the date of the possession hearing). Unlike forfeiture there is no ability for an affected party (such as a sub-tenant or more likely here a mortgagee) to apply to the court for ‘relief’, in effect to reinstate the lease subject to the relevant breach being put right. That is catastrophic from a lender’s perspective as their security is rendered largely redundant. The fact that the landlord acquires an asset completely out of proportion to the loss they suffer (some unpaid ground rent) is irrelevant
- an assured tenant is not entitled to seek a statutory extension to its lease (nor the landlord seek a statutory premium for granting such an extension) under the enfranchisement legislation. As you can see this can be a problem for both parties
- an assured tenant has no right to be served with notice of a landlord’s intention to sell the building or to exercise statutory pre-emption rights to buy the freehold.
To make things even harder for everyone it is perfectly possible for the status of a lease to ‘float’ between being an assured tenancy and a regular protected one from time to time, purely depending on the legal status of the tenant. There is some comfort that the government proposes to specifically address this issue, and we believe it could be relatively easily achieved without the need for complex legislation so it could be resolved in a much shorter timeframe than the more substantive proposals.
The consultation response sets out a number of clear objectives from the Government’s perspective. What is much less certain is the amount of time it will take to deliver on the rhetoric. In a number of instances the government has enlisted the Law Commission to undertake more, in depth, research with a view to tabling more comprehensive changes in due course, though this could be anything up to a couple of years’ away. Prevention is better than cure so we suggest considering some of the following;
- Developers, consider your current and proposed developments: it seems very likely that all new ground rents will be set at a notional peppercorn (in effect mirroring the current legislation on flat lease extensions) which may significantly affect future land values. Any existing arrangements may become subject to some sort of capping, or other curb, on the rate at which the ground rent can increase and this will affect market sentiment about the value of existing structures. Consider taking steps now to alter ground rent levels or limit increases to inflation-type ones rather than geometric increases.
- Discuss drafting to mitigate the effects of the ‘assured tenancy’ problems: there is more than one possible approach from reducing ground rent levels to contractually restricting the landlord’s right to seek statutory possession of the property which can head off a future legislative change.
- Buyers and owners need to consider existing leases or those about to be taken: engage pro-actively through your advisers with developers and landlords - it’s unclear whether the government will (or can) legislate retrospectively for any defective arrangements. In some case it may be possible to secure defective title insurance but at best these will only protect a lender against the risk of a lease being subject to possession proceedings. In any event the lack of certainty about what the future may look like can create its own issues, so it is as well to hedge against those uncertainties as much as possible at an early stage.