The Potential Legacy Impacts of Leasehold Reform

The Government has promised changes to leasehold reform as part of a once in a generational review of English property law.  These changes will have winners and losers in a legacy and charity context in the longer run and these different impacts may, overall, even themselves out. 

In the shorter run, however, they have heaped further uncertainty onto an already uncertain market as Einar Roberts, from Cluttons LLP and Anna Phillips from Foot Anstey LLP explain below.

The background

In the past, many more properties were let on long residential leases including houses as well as flats. The lease allowed a party to use the house or the flat for a set period of years (often 99 years) in return for paying to the owner of property (the ‘freeholder’), an initial purchase price for the lease as well as a yearly rent (known as ‘ground rent’).  As Anna explains, the history to the ownership structure is that the freeholder owned the land in places where people wanted to live; granted building leases to developers to construct homes on that land, the developer in turn granted individual leases of those homes (the bricks and mortar if you like) which would become obsolete and those leases reserved a rent to the freeholder for the land on which the buildings sat.  At the expiry of the leases, which were typically managed location by location, the freeholder had the ability to change the wider use of that location to suit changing demand.

Leasehold reform has been with us since 1967. In that first incarnation, it gave a statutory mechanism for owners of relatively low value houses (relatively few in central London but more common outside of central London) to extend their leases or acquire the freehold so that their interest did not simply ‘decay away’.

Those initial rights were extended by the Leasehold Reform Housing and Urban Development Act 1993. The Act gave owners of higher value leasehold houses rights to acquire the freehold interest subject to payment of a price (or premium).  The premium was calculated on a set calculation reflecting the income and reversion foregone by the freeholder and a share (50% in practical terms) of the ‘marriage value’ released by combining ownership of the freehold and leaseholds interests.  The marriage value arises because the value of the leasehold interest in possession and the reversionary freehold interest are lower when added together than the value of the freehold vacant possession value in possession.  Marriage value it is said proves that 2+2 = 5!  The reason for this is that opportunities to redevelop, alter in terms of layout and use and transact are greater for the owner of the freehold in possession.

The 1993 Act also gave leaseholders of flats the right to extend their lease for a further 90 years at a peppercorn ground rent subject to the payment of a premium calculated using the same general mechanisms.

On 21 July 2020, the Law Commission published a far-reaching set of reports on a number of key aspects long residential leasehold and alterative structures for property ownership.  A key part of this report was the element entitled Leasehold home ownership: buying your freehold or extending your lease, which included proposals to make the process by which long leaseholders could extend the term of their leases or acquire the freehold simpler and less expensive. Following on from that report, on 7 January this year, government issued a statement of intent regarding the future for leasehold reform and what it described as “the biggest plans for leasehold reform for a number of decades”. You can view the statement here.

However, the government announcement was scant on detail and the key valuation impacts which will be of key interest to legacy officers are not yet possible to quantify clearly.

Impacts for Legacies

In the legacy context, estates may include either:

• freehold properties subject to long residential leases; or
• the long residential leasehold properties themselves (houses or flats).

For estates including houses or flats held on long leaseholds, the key message is that the process of extending a lease is likely to become cheaper with more control around the costs which a freeholder can recover as well as changes to the calculation of the premium.  Where, for example, a deceased party had a right to extend a lease (a right which a leaseholder acquires after 2 years ownership), the personal representatives also have that right for 2 years from the grant of probate either:

1. to extend the lease themselves / acquire the freehold (either themselves for houses or together with others in the case of flats); or
2. to serve notice exercising that right but then assign the benefit to a buyer who can complete the lease extension / acquisition of the freehold themselves.

In either scenario, any reduction in cost or simplification of process is likely to be positive for legatees.

By contrast, for estates which include freeholds subject to long leases (held by others), there are likely to be value falls as a consequence of the proposed changes. There would seem to be risks to the premium freeholders receive in the following three main areas:

1. Capitalised ground rent

The statement said: “A cap will also be introduced on ground rent payable when a leaseholder chooses to either extend their lease or become the freeholder.”

The inference of this in the context of the previous Law Commission paper, is that ground rent that is perceived as ‘onerous’ will not form part of the landlord’s compensation.  There is no consensus on what defines an onerous ground rent, but rents over 0.1% of the freehold vacant possession value have been mentioned.

2. Marriage value

The statement said: “The government is abolishing prohibitive costs like ‘marriage value’ …”

If marriage value were removed this would reduce the value of freeholders’ interests.  However, Einar’s view is that ‘abolish’ is really the wrong term.  Marriage value (or synergistic value) will exist whether or not it is recognised and included by government within the compensation.  Its removal as a component of the compensation may well present the single biggest threat to receipts and values for charity owners of reversionary freehold interests or portfolios.

3. New determination of valuation rates to be used in the calculation

The statement said: “… and set the calculation rates to ensure this is fairer, cheaper and more transparent.”

To start to quantify the risk associated with this statement, we need to understand who is to set those rates and their terms of reference.  We do not have an answer to either of those questions.  Arguably, some of the pressures that led to the recent announcement were a result of oversimplification of the discount rate as a consequence of case law.

Of less immediate concern within the proposals are the prospect of an online calculator and the proposed ability for leaseholders to voluntarily agree to a restriction on future development of their property to avoid paying ‘development value’.

At present, particularly for those parts of the UK house market that are in retreat, the statement seems, almost incredibly, to be either neutral or bad for charity owners of both leasehold and reversionary freehold interests.  Leaseholders because in the central London market where we are watching progress most closely; prospective purchasers seem to view this as a will-o’-the-wisp promise on top complicated legislation making that legislation harder to interpret.

In the longer run, to the extent this is bad for freeholders, it should be good for leaseholders – or more particularly the cohort of leaseholders who hold leases that will benefit from the legislation at the point the valuation impact of that proposed legislation is crystallised.  This is because, to understand the value of a short lease is to first understand the freehold value and then deduct the cost of extending/ acquiring the freehold.  As presently described, the proposals therefore seem to point to a one-off transfer of wealth.

Key Take-Aways

The good news is, given that estates may include both freeholders and leaseholds, that impact in the overall the legacy context may even out.  However, the reforms are likely to give rise to questions in relation to individual estates in particular regarding the timing and structure of transactions.

Einar and Anna will be speaking in more detail around this issue, and much more, at our property seminar on March 4th. Find out more and how to book here.

Authors

Anna Phillips Legal Director Foot Anstey LLP

Einar Roberts Partner Cluttons LLP