Real Estate Talking Points: Residential leasehold reform - is change on the horizon?

Freehold and leasehold – what is the difference? Let’s start by going back to basics. In theory – and notwithstanding how illusory it may appear today – all land in England and Wales belongs to the Crown. As such, land cannot be “owned” by individuals or companies; instead, the somewhat abstract concept of a legal “estate” (in essence, comprising a bundle of rights over land) can be owned – although, at least in practical terms, this equates to ownership of the land itself. There are two forms of legal estates in land; namely, the freehold estate and the leasehold estate. Generally speaking, the owner of a freehold estate (typically referred to as a “freeholder”) owns all of a parcel of land in question – from the soil right up to and including all the air above it, and any buildings in between – absolutely, exclusively and forever. The freeholder may choose to occupy the land itself, keep it vacant or grant a lease permitting a third party to occupy it (in which case some of the rights within the freehold bundle are passed on, but only for a finite period – ultimately, full ownership will revert back to the freeholder). The owner of a leasehold estate (also known as a “leaseholder” or “tenant”) has a contract (or “lease”) pursuant to which it is granted the exclusive right to occupy a parcel of land for a specified period of time – typically, the leaseholder pays rent to the freeholder in return for that right. The lease sets out the respective obligations of the parties during the lifetime of the lease. Ownership in the residential market In the residential market in the UK, houses are typically sold on a freehold basis; in contrast, apartments are invariably sold on a long leasehold basis, with a capital sum paid upfront by the tenant in return for a right to occupy the property for a certain period of time (typically around 125 years but ranging up to 999 years – although statute affords residential tenants the right to extend the term or buy the freehold), coupled with an obligation to pay an annual ground rent (historically, this has been a token sum amounting to so little that freeholders often do not request payment). A hybrid creature also exists in the form of leases of residential houses, although these are rare – indeed, the Ministry for Housing, Communities and Local Government has estimated that a mere 8% of residential houses in England are owned on a long leasehold basis. In the last couple of decades, however, there has been a growth in the number of leasehold sales of new-build houses, with sales increasing from 7% of transactions in 1995 to 13% in 2017 – this has been particularly evident in the north west of England where, in 2017, 31% of house transactions were leasehold. The residential leasehold ownership model By virtue of a lease, the owner of a long leasehold interest in a residential property will be in a landlord and tenant relationship with the freeholder, and both parties will be required to comply with the terms of the lease. Typically, the lease will impose obligations on both the freeholder (for example, to repair and maintain the structure and common parts of the building in which the leaseholder’s apartment is situated, or the estate on which the leaseholder’s house is located, and to effect and maintain insurance of the same) and the long leaseholder (for example, to pay a service charge in respect of the cost of any such repair and maintenance works/insurance, to seek the freeholder’s permission in respect of any alterations or extensions to the property and to pay a ground rent). The inclusion of a ground rent within a long lease of a residential property is standard market practice, and a service charge is generally accepted as being a neat and efficient way of ensuring that buildings and estates are kept in repair and are insured, with the responsibility for such costs being spread equitably between the various owners. A recent spate of consultations on residential tenancies looks set to change the landscape for residential long leases, which may have significant consequences for developers and investors in portfolios of leasehold ground rents. In June 2019 this stepped up a gear, with the Competition and Markets Authority throwing its hat into an already crowded ring. You could be forgiven for being confused – so, what are the key points to be aware of? Residential leasehold reform: is change on the horizon? Too often, leaseholders – particularly in newbuild properties – have been treated by developers, freeholders and managing agents, not as homeowners or customers, but as a source of steady profit. The balance of power in existing leases, legislation and public policy is too heavily weighted against leaseholders, and thus must change. Excerpt from the 2019 Report Real Estate Talking Points So, what is the problem? A tide of discontent amongst the owners of long leases of residential properties (both of apartments and of houses) has been rising, resulting in a wave of complaints – including allegations of unscrupulous behaviour on the part of developers and freeholders – and calls for statutory intervention. In particular, the sale of leases of residential new-build houses has been described as a “scam”, with reports of homeowners being trapped in “toxic leases” which banks refuse to lend against and which owners are unable to sell. Such is the scale of the issue that it has attracted much press and political attention, with the residential leasehold system being rechristened “fleecehold” and the issue being described as the “PPI of the house-building industry”. What has led to this outpouring of anger? Residential long leaseholders have been reporting a range of problems: that the ground rents in their leases have been set at what they consider to be exorbitant levels, and are escalating by virtue of regular reviews (in some cases, doubling every 10 years), with some claiming that it amounts to “legalised extortion”; that the service charges are substantial and opaque; that hefty charges are imposed when leaseholders seek freeholder permission to undertake home improvements (e.g. adding a conservatory, or installing a new front door); and that the cost of acquiring the freehold, or extending the length of their lease, is unreasonably expensive. Residential long leaseholders allege that they were not informed as to the risks and obligations their leases would impose; in addition, some have claimed that they were deliberately misled with “partial sales information and false promises”. What are the new proposals? This perceived unfairness has triggered various waves of consultations and reports which have been commissioned by the Government (see timeline for details), culminating in a report issued in March 2019 by the Housing, Communities and Local Government Committee (the “2019 Report”) which concludes that the “balance of power in existing leases, legislation and public policy is too heavily weighted against leaseholders” and contains a number of radical, wide-ranging and leaseholder-friendly proposals. Such proposals include: (a) a ban on the sale of new leasehold houses; (b) in respect of existing residential leases, the introduction of legislation to: (i) remove onerous ground rents (being ground rents which become “disproportionate to the value of a home, such that it materially affects a leaseholder’s ability to sell their property or obtain a mortgage”); (ii) limit ground rents to 0.1% of the present value of a property, up to a maximum of £250 per year; and (iii) restrict “onerous permission fees”; (c) for new residential leases, the imposition of a statutory cap of a peppercorn on ground rents; and (d) the use of a standardised “key features” document, which is to be provided at the outset of the sale process, outlining the tenure of the property, the length of the lease, any ground rent and consent fees and the price at which the developer is willing to sell the freehold. Since the 2019 Report was published, more than 40 leading property developers and freeholders have signed a governmentbacked pledge committing to change behaviours in relation to ground rents in both existing and new leases, and – amid mounting political pressure – the Competition and Markets Authority has recently announced that it will be launching an investigation into potential breaches of consumer protection laws in respect of the residential leasehold market, with the investigation focused on two areas in particular, namely: (a) potential mis-selling: this will examine whether people who bought a residential long leasehold property were given the information required to understand fully the nature of the interest they were acquiring (i.e. leasehold instead of freehold) and its terms (e.g. ground rents which are subject to regular increases); and (b) potential unfair contract terms: this will seek to ascertain whether residential long leases contain unduly onerous provisions. Time for change? In the most recent developments: (a) the Communities Secretary Rt Hon James Brokenshire MP delivered a speech at the Chartered Institute of Housing conference in Manchester on 27 June 2019 (a day ahead of the publication of the Government’s formal response to the October 2018 consultation) in which he confirmed plans to introduce legislation which would (amongst other things) reduce ground rents in all new leases to zero, and require all new-build Real Estate Talking Points houses to be sold on a freehold basis (save in “the most exceptional circumstances”), vowing to “press ahead as soon as parliamentary time allows”; and (b) on 3 July 2019, the Government published its response to the 2019 Report – it welcomed the 2019 Report, expressly agreed with a number of its recommendations and reiterated its commitment to “cracking down on unfair practices in the leasehold market”. In respect of existing leases, it may well be the case that developers and freeholders will address the issues by voluntarily agreeing to amend existing leases which are perceived to contain onerous provisions, without the need for legislative interference – indeed, certain developers have already entered into deeds of variation with leaseholders to replace doubling ground rent clauses in their leases with alternative provisions, and have committed to ensuring that no such terms are included in future leases. If, however, the Government does choose to intervene by introducing legislation – particularly that which is intended to have retrospective effect – such legislation will require careful consideration, and it will undoubtedly take some time for it to reach the statute books. For example, the proposed introduction of legislation which would vary existing leases is likely to face challenges on the ground of it being incompatible with human rights law: it could be argued that legislating for the removal of what are perceived to be onerous ground rents in existing leases would amount to the deprivation of a possession (in this case, a freeholder’s contractual right to receive rent). The 2019 Report concludes that “while it would be difficult … it would not be impossible” to do this, particularly if coupled with compensation in favour of freeholders – although this begs the question as to how any such compensation would be funded. Others have raised objections to such an approach on the basis that it could undermine the rule of law and long-established principles of freedom of contract. Exactly how the interests of leaseholders and freeholders will be balanced is yet to be determined but this is certainly a key driver behind the recommendation in the 2019 Report that commonhold (a form of freehold ownership of apartments first introduced in 2002) should be reinvigorated as the primary form of ownership of residential apartments in England and Wales. What is clear, however, is that the residential leasehold market remains subject to ever-increasing scrutiny and – set against the backdrop of a groundswell of pro-tenant sentiment, not to mention the housing crisis – this issue is likely to remain firmly on the Government’s agenda. Certainly, those investing in portfolios of reversionary ground rents should keep close watch as this controversial issue evolves. Knowledge of what the law entails, and confidence that the law will be upheld, is essential to maintain the stability of complex markets such as the property market… Any threat to this stability could have a significant adverse effect on consumers and property owners which could (depending on what form any retrospective legislation were to take) have an impact on property values, property transactions, housing supply and the wider economy. Law Society of England and Wales, as quoted in the 2019 Report Siobhan Burton Counsel, Real Estate Linklaters LLP Emily Dodge Trainee Solicitor, Real Estate Linklaters LLP Real Estate Talking Points 8696_F/06.19 February 2017 Housing White Paper entitled “Fixing our Broken Housing Market” is issued, which includes a commitment to “consult on a range of measures to tackle unfair and unreasonable abuses of leasehold”. A consultation paper is released by the Department for Communities and Local Government, entitled “Tackling unfair practices in the leasehold market”. The consultation attracts around 6,000 responses. July 2017 The Government issues a report setting out its response to the July 2017 consultation, stating that “real action is needed to end [the] abuses”. December 2017 December 2018 Law Commission Consultation on Commonhold is published. October 2018 A consultation paper is released by the Ministry of Housing, Communities and Local Government entitled “Implementing Reforms to the Leasehold System in England”. Government response to the October 2018 consultation is published. June 2019 March 2019 Government-backed pledge is signed by over 40 leading property developers and freeholders, which commits to stopping leaseholders being “trapped in unfair and costly deals”. Report entitled “Leasehold Reform” is published by the Housing, Communities and Local Government Committee. Timeline July 2019 The Government issues a report setting out its response to the 2019 Report. Real Estate Talking Points