Articles

In these difficult times Developers are understandably seeking ways to increase their return on sites. One way that some have adopted is to offer the Development as long leasehold reserving a modest but not a peppercorn ground rent, rather than selling as freehold.

From the builders point of view, the build cost is exactly the same, the legals may cost fractionally more, the value achieved for the properties is exactly the same as a freehold and, if there is public open space or similar on the Development it may well be that enforcing covenants in relation to contributions to that are better achieved through a leasehold tenure.

However, a significant factor in the decision to offer houses as long leasehold is the ground rent reserved. Typically, this will be between £150.00 and £250.00 per annum (i.e. ranging from less than three pounds to less than five pounds per week). This level of rent has no effect on the valuation compared to freehold but it does provide a significant and increasing capital value in the freehold reversion retained by the Developer.

The value of this reversion obviously depends on the level of ground rent, the size of the Development and frequency of rent review. As the builder has already achieved the same capital return on the sale of the houses as he would have got anyway, the thousands that are received for the freehold reversion go straight to the bottom line.

The problem for RSL’s stems from the rent review provisions on the ground rent and these need to be looked at very carefully if a medium to long term problem for the RSL is to be avoided.

The first thing that needs to be considered is the question of frequency of review. If the reviews are too frequent, the ground rent, even from a relatively modest start can become significant. Anything less than a 25 year review cycle should be resisted.

The second issue is the formula for review. Typically, these are often simple doubling of the ground rent previously applying but they can be linked to RPI etc. They need to be considered very carefully.

The builder will look for a formula and a review frequency as well as an initial level of ground rent which does not impact on the open market value at first sale but which provides an attractive prospect for the sale of the reversion. In basic terms the quicker the rent increases, the more valuable the reversion.

The problem for RSL’s is that they have their rent levels set centrally and, crucially, the rate of increase is also dictated to them, taking no account of individual expenditure on particular Developments. In effect, with social rented units, the RSL pays the ground rent to the freeholder and collects its normal rent from the householder tenant. The RSL is not allowed to inflate the householder’s rent to recover the ground rent expense.

Typically, RSL rents have been pegged to increase by no more than .5% above RPI. There is the real prospect, in the current climate, that rents could come down. The ground rent will not.

When being offered new leasehold houses where the rent is anything other than a peppercorn, the RSL should do “its sums” and see how quickly the ground rent is likely to increase compared to a reasonable projection for the rental income it will derive on the same units from its tenants. If there is the potential of the ground rent increasing more quickly than the rental income, the scheme will provide an increasingly poor return for the RSL and, in extreme cases, may prove to be financially unviable in the long term.

It is important to remember that Developers have taken up this model of tenure to increase profit, not specifically to cause problems for RSLs. Accordingly, they will usually be willing to be flexible if the RSL draws the potential problem to the Developer’s notice at the earliest possible stage in the course of negotiations for the acquisition of the units. Typically, these units may well be coming across pursuant to the terms of the Section 106 Agreement and that Agreement is not normally too specific about the way the Developer structures the tenure.

Most Developers will be willing, for a suitable additional consideration to sell the units as freehold rather than leasehold or to sell the RSL units with a peppercorn rent. The additional payment required from the RSL is usually fairly modest per unit because the Developer is accelerating the capital receipt that they would have got from the sale of the freehold reversion.

It would also be prudent for RSLs to engage with their partnering Local Authorities to suggest that Section 106 Agreements, going forward, are adjusted to take account of this potential problem by limiting ground rents to a peppercorn if freehold is not being offered.

Douglas Oliver