Are you overpaying for your lease extension?

Linz Darlington, managing director of Homehold, which offers an end-to-end lease extension service, explains how leaseholders end up paying too much for a lease extension

When you do a statutory lease extension, the amount of ground rent you pay under your current lease is important – because it affects the price you will pay your freeholder.

This is why leases with high ground rents, or those which rise significantly over time, make it so expensive to extend your lease.

Currently, many leaseholders are paying over the odds for their lease extensions.

However, all is not lost! New evidence suggests that one of the variables in the lease extension calculation is outdated – and this evidence can be used to argue for a lower price.

Why does your ground rent matter when you do a lease extension?

The law gives you the right to extend your lease by 90 years and reduce the ground rent to “a peppercorn”, which is legalese for £0.

However, once you’ve extended your lease, your freeholder is going to miss each one of your annual payments. As a result, the law requires you to “compensate” your freeholder for their loss.

This can be explained more simply as “buying out” each one of your future ground rent payments – by paying a single sum up front.

Imagine you have a lease with 125 years remaining, and a ground rent fixed at £100 per year. The sum total of all of your future ground rent payments would be £12,500 – i.e., 125 years x £100 per year.

However, you don’t have to pay £12,500 when you do a lease extension.

This is because you get a discount – simply because you’re paying all the payments upfront.

Money now is worth more than a set of annual payments – some of which won’t be paid for decades into the future.

What discount do you get?

In the scenario above, with a commonly accepted discount rate, you might only expect to pay about £1,665 to buy out your ground rent – but this is still too much!

The £1,665 is based on a discount rate of 6%, which is most commonly used by valuers working in leasehold enfranchisement for flats with fixed ground rent rises – because it is the most common rate that the tribunal system use. The bigger the discount, the lower the price you pay.

This 6% discount rate (also known as the “capitalisation rate”) is a compound discount, which means it gets applied for each year into the future that the ground rent payment is due.

For example, in the lease extension calculation, you might pay £100 for this year’s ground rent payment. But you only have to pay £94 for next year’s, £88.36 for the year after and about 4 and a half pence today for the last ground rent payment you miss – i.e., the one in 125 years’ time.

As you can see from the graph below, most of the lump sum payment is made up of the compensation for the payments that will be missed in the near future.

Why is the discount too low? And why are we overpaying?

The 6% discount rate is commonly accepted between valuers and the tribunal system, but that doesn’t mean it is right.

The law requires the leaseholder to compensate the freeholder for the market value of their asset.

The correct way to work out the discount rate is to look at market transactions.

Imagine a freeholder is considering buying a freehold asset at auction. To keep things really simple, imagine the block has just one flat in it, with a 125-year lease and a fixed annual ground rent of £100.

If the freeholder is prepared to pay £1,665 for the freehold title at auction, that would equate to them valuing the future income stream at a discount rate of 6%.

If they were only prepared to pay £1,110 for the freehold title at auction, that would mean that they would be valuing the future income stream at a discount rate of about 9%.

Our research

At Homehold, we have been analysing Allsop Ground Rent Auctions since February 2019 to understand what investors are paying for the ground rent in the freehold titles.

We do this by reviewing each sale and excluding those where it is not possible to “separate” the ground rent from other elements of the value. For example, if a freehold title includes the ground rent from 10 flats, but also includes a retail unit, we would it exclude it from our analysis. This is because it is not possible to work out what the investor paid for the ground rent and what they paid for the retail unit.

If it is possible to analyse a transaction, for each flat in the block we apply a calculation to ascertain the value of the ground rent.

Our conclusion is that investors are valuing ground rents at a much lower level (and higher discount rate) than the 6% which is commonly used.

This can be seen below in a dataset of small blocks (with seven or fewer units) which have ground rents that rise at fixed increases. It is noteworthy that bigger blocks and ground rents that rise with retail price index or house prices tend to be more attractive to investors, so they pay a premium (and a lower discount rate) for those.

For example, we recently completed a lease extension for a Victorian maisonette in an attractive terrace in Bromley (below).

The ground rent was £250, but it doubled every 20 years – so by the end of the term it was a whopping £4,000 a year!

The freeholder used the discount rate of 6% and asked for a premium to buy out the ground rent of £10,400. Our opening calculation was 9%, which valued the income stream at £5,300.

In that case neither side wanted to go to tribunal and to reach a settlement our client accepted a sum of £6,990 – or reduction of about £3,400 from the freeholder’s opening position based on the status quo.