By Liam Spender
Liam Spender is a Trustee of the Leasehold Knowledge Partnership. Personally affected by the cladding scandal, Liam is a Solicitor-Advocate and Senior Associate at Velitor Law practising commercial litigation and arbitration in the City of London. Views in this article are personal and do not constitute legal advice.Why not define “ground rent” in the new law?
The government has chosen to draft the bill without a fixed definition of ground rent. The bill merely defines a permitted ground rent as one peppercorn and says any other rent in any residential long lease is not permitted.
The issue is that this definition may catch service charges defined as “rent”. Most modern leases typically define the service charge and any separate insurance charges as “rent” under the terms of the lease. This is done because non-payment of “rent” entitles the landlord to start forfeiture proceedings without first serving a notice under section 146 of the Law of Property Act 1925 and thereby giving the leaseholder a chance to pay up.
The historic advantage of defining a service charge as “rent” is not so clear today because there are various restrictions on forfeiture even if “rent” has not been paid. For example, a residential landlord must demand a ground rent payment in writing and with certain prescribed information before being able to exercise forfeiture. There are other restrictions on the age of a debt and the monetary amount of a debt, including whether it has been admitted by the leaseholder or assessed by a court, which also mean forfeiture for non-payment of rent is no longer as straightforward as it was when the 1925 Act was drafted.
Whilst it is possible to commence the forfeiture process for non-payment of charges other than rent, breaches of non-rent covenants (for example, subletting without landlord consent when not permitted by the lease) does require preparation and service of a section 146 notice in addition to complying with the modern statutory restrictions on rights of forfeiture in residential leases.
The bill as currently drafted appears to catch service charges defined as rent and reduces them to a peppercorn. The easiest way of solving that problem is for future leases to stop defining service charges as “rent” under the terms of a lease. Landlords may object to that on the basis that it makes forfeiture (slightly) harder because they then definitely have to go through the section 146 process, but this particular form of drafting appears redundant given the other restrictions on forfeiture.
A neater solution still would be to abolish forfeiture, thereby avoiding the need for any section 146 notices. This would also obviate any drafting differences between “rent” and non-“rent” charges under residential leases.
Leaving aside whether the bill includes service charges in its definition of “rent”, the key issue with the government’s current drafting approach is that it relies on the commonly understood meaning of “ground rent” as a payment for which nothing is received in return. That understanding may change in the future as case law changes. Case law can also change in the future in ways not intended or foreseen by Parliament.
There are also risks in relying only on current case law because the current case law does not distinguish clearly between ground rent and service charges.
Indeed, in Arnold v. Britton  UKSC 36, the Supreme Court held that a payment that walked like an indexed ground rent quacked like a fixed service charge. In that case, the leaseholders of some holiday chalets in Gower found that a lease term obliging them to pay £90 a year toward the landlord’s costs increasing by 10% each year for the term of their leases was enforceable. The term functioned as a ground rent even though it was described, and found to be, a service charge. The landlord would gradually collect more and more money under the term regardless of the cost of services provided, similar to a ground rent. Leaseholders would end up having to pay more than £1 million per year by the end of their 99 year leases.
Now, the court in Arnold v. Britton was not being asked to decide whether the charge in question was a ground rent subject to a peppercorn cap or a service charge. This bill, when in force, would oblige a future court to consider that issue. That may have produced a different decision.
Any such future decision would depend on both the wording of the contract (i.e. the lease) and the final wording of the bill once enacted. Parliament only has control over one of these variables, being the final wording of this bill. It is therefore vitally important to get the restrictions in the bill right to avoid any risk of them being bypassed later.
It seems that on the current drafting of the bill there is a material risk that a charge of the type seen in Arnold v. Britton, which was linked to services provided by the landlord in exchange for the payment, would not be deemed a “rent” subject to a peppercorn cap. Future leaseholders are currently being asked to take the chance that charges of this nature would be caught by the cap.
As the law currently stands, if such charges are found not to be ground rents subject to a peppercorn cap, leaseholders’ right to challenge the reasonableness of service charge expenditure under the Landlord and Tenant Act 1985 will be of no assistance.
Service charges must be variable before the right under the Landlord and Tenant Act 1985 to challenge the reasonableness of a service charge can be exercised.
In The Anchor Trust v. Waby  UKUT 370 (LC), the Upper Tribunal held that a fixed service charge includes a fixed charge that increases by reference to an index. In that case it was a management charge at 31 December 1994 increased by RPI inflation for each year of the remaining term of the lease.
The risk is that if ground rents are replaced by fixed service charges then, without other reforms, leaseholders will not be able to challenge them.
Won’t developers just give up trying to create new ground rents if this ban comes in?
If there is to be no fixed definition of ground rent in the new law, any repeat of the sort of decisions mentioned above would be welcome to landlords looking to recreate ground rents in another form.
Such charges would be sufficiently certain to offer up as security for loans that would enable them to continue the debt-financed leverages model currently employed by the largest players in the ground rent investment industry.
The workings of the development industry and leveraged finance give a powerful incentive to both developers and landlords to recreate ground rents, if they can.
Developers have an incentive to try and perpetuate the ground rent model because it means they can continue to earn extra profit from the sale of the freehold after residential developments have been completed. As things currently stand, the freehold over a few hundred flats may fetch a few hundred thousand pounds of extra revenue in addition to sale revenues from the flats. These freeholds are only easily marketable if there is a certain income stream, like a ground rent, attached to them.
Developers, who control the drafting of leases offered to buyers, have every incentive to continue to draft them in such a way as to maximise value of the freeholds so long as there is someone willing to buy them.
Not all freehold investors operate a leveraged business model, but some of the largest investors in freehold property do. Some developers prefer to retain the freeholds and pass them over to their own in-house asset management arms to earn both ground rents and service charge. Other investors are not using leveraged finance, but instead are investing all of their own money in freeholds. Each group of investors has different incentives in relation to ground rents.
In the case of large investors employing the leverage model a typical ratio of debt finance to equity is 6:1. Meaning that for every £100 the landlord puts in by way of equity (i.e. landlord money at risk) it can borrow a further £600 from a lender to be able to buy £700 of property. The costs of servicing the interest and repayments on the £600 of debt are met not by the landlord, but by income from leaseholders in the form of current ground rents and other charges, but which in the future could be called service charge.
Freehold investors like this model because, in addition to capturing the surplus income above loan repayments and loan interest, the landlord keeps all of the capital gain when the property is sold. This is a lucrative business model. It is not one that landlords will not be keen to give up easily.
In our example of a 6:1 to leverage ratio above, if the property acquired for £700 using £600 of bank borrowing and £100 of the landlord’s money is sold for £1,000 then, after repaying the £600 of debt, the landlord makes a return of £300 on a £100 investment as well as receiving back the £100 put at risk. That is a return of 300% before any other expenses. In the meantime, the landlord has not had to put in any other money beyond the £100 initial investment because the costs of interest on the £600 loan have been met by ground rents and other charges paid by leaseholders.
The government may consider that the risk of ground rents being recreated in other forms is sufficiently low to justify not taking steps to amend the definition of ground rent in this bill.
That seems to be taking an overly optimistic view of the sector’s behaviour, particularly given the attractive nature of freehold sales to developers and the prospect of leveraged returns for freehold investors described above.
Steps also need to be taken to prevent developers who run their own freeholds and/or investors who do not rely on leverage financed to deter them from attempting to create charges similar to ground rents.
Not acting runs the risk of repeating historical mistakes witnessed in past reforms of the sector. For example, once the government announced an intention to ban the sale of leasehold houses, the sector moved quickly to introduce schemes of estate rentcharges to recreate something equivalent to a ground rent income stream applicable to freehold houses.
Wouldn’t defining ground rent just create an easy target to be drafted around?
The government is right that there are risks associated with creating a fixed definition of “ground rent”. The issue is whether the benefits of a clearer definition outweigh the risks.
If the government were to expand the definition of what counts as a “ground rent” a future court may interpret that as meaning anything not within that definition is not a ground rent and therefore not subject to the peppercorn cap. The risk of that happening varies with the quality of the drafting of the definition adopted. A well drafted definition should defeat any attempt at circumvention.
There is certainly room for amendments to prevent circumvention of the laudable aim of banning cash ground rents and any cash payment equivalent to ground rent. Some of the work can be done by amending the text of the bill itself.
Other improvements could be made by making simple changes to the definition of service charge under the Landlord and Tenant Act 1985. This could make fixed service charges either subject to a ban altogether or else subject to the same reasonableness criteria as variable service charges.
The risks of allowing the sector to get away with are too great not to act in improving the definitions in the bill.
Why not abolish current ground rents?
Lord Blencathra made the point yesterday that the government should be protecting current leaseholders by abolishing ground rents in all residential leases, not just future residential leases.
It is within Parliament’s power to abolish all residential ground rents. It would be a welcome reform solving, at a stroke, all the terrible burdens associated with doubling ground rents and inappropriately indexed ground rents. The issue is whether there is a liability for the taxpayer in so doing.
Under Article 1, Protocol 1 of the European Convention of Human Rights (“A1P1”), an income stream is deemed to be property. A1P1 provides that an owner of property is not to be deprived of that property except in the public interest and according to law. A1P1 is binding on the UK government under the Human Rights Act 1998.
The case law created by the European Court of Human Rights since A1P1 was introduced in 1948 has recognised that depriving a property owner of his property requires the payment of at least some compensation (see: https://www.echr.coe.int/Documents/Guide_Art_1_Protocol_1_ENG.pdf)
If this bill is to abolish current ground rents then it is likely going to have to provide for at least some compensation payable to landlords for loss of their future income. It could set out a fixed formula for this compensation, perhaps payable by leaseholders. Any payments from leaseholders would have to be modest to make it worthwhile.
There are ways of doing this in line with suggestions already made by the Law Commission in relation to leasehold enfranchisement, for example severely limiting the multiples that can be applied to future ground rents and fixing very high discount rates to reduce the effect of loss of ground rents over 999 year term leases.
This “abolition plus compensation” solution has already been deployed twice in Scotland in the past 20 years. Once in 2004 when the annual feu duties were abolished by the Abolition of Feudal Tenure etc (Scotland) Act 2000 (see the explanatory notes to the law: https://www.legislation.gov.uk/asp/2000/5/notes/contents and this report of the Scottish Law Commission explaining the issue: https://www.scotlawcom.gov.uk/files/1712/8015/2730/26-07-2010_1458_725.pdf).
The same model was deployed again when Scotland’s few remaining leaseholds were converted to freehold under the Long Leases (Scotland) Act 2012 (see this briefing note from the Scottish Parliament: https://archive2021.parliament.scot/ResearchBriefingsAndFactsheets/S4/SB_12-11.pdf)
In both Scottish cases, compensation for loss of ground rent equivalents was calculated by multiplying the lost income by the interest yield that could be earned on 2.5% Consolidated Stock, a form of government debt, on a certain date. The former landlord had to apply for this compensation to be paid by 27 November 2006 or else lose the right to receive the payment.
Both Acts provided for this compensation to be paid by the former tenant, but with fixed repayment terms depending on how much compensation was owed, with larger amounts automatically spread interest free over several years.
Any attempt to abolish current ground rents in England and Wales would be very welcome and long overdue. The abolition of ground rents would, however, leave the current leasehold structure in place. That would still leave leaseholders at the mercy of freeholders and their managing agents, with no meaningful control over how their money is spent.
The same freeholders who would lose their ground rent incomes would doubtless scour current leases for ways of replacing some or all of their lost ground rent income, perhaps by massively increasing the commissions already charged (typically 15-20%, but sometimes more than 40%) on buildings insurance premiums.
Any attempt to abolish current ground rents is also likely to provoke a strong rear-guard lobbying and legal action from the sector and its current investors, who would stand to lose potentially billions of pounds in value from their freehold investments. They would therefore have little to lose by spending millions on lobbying and litigation against any abolition.
That said, the government has accepted a similar legal risk in other leasehold reforms it proposes to make. The government promised in January 2021 that it would implement the Law Commission’s recommendations on wider leasehold reform, including that marriage value should be abolished. This reform engages the same A1P1 issues. Currently anyone seeking to extend a lease with under 80 years to run has to make this often substantial extra payment to the freeholder as part of the price of an extension. Abolishing marriage value carries with it the risk of an A1P1 challenge.
The Law Commission obtained a legal opinion from Catherine Callaghan Q.C. on the legal risk of a challenge by landlords to abolition of marriage value, which discusses the A1P1 issues and is available here: https://s3-eu-west-2.amazonaws.com/lawcom-prod-storage-11jsxou24uy7q/uploads/2020/01/Opinion-of-Catherine-Callaghan-QC-on-valuation-reform-FINAL.pdf. The Opinion concludes that the risk of a successful challenge by landlords to most aspects of the Law Commission’s leasehold enfranchisement proposals is no more than around 50%.
Why is this bill in the Lords first?
Bills can be started in either House but must go through all stages in both Houses of Parliament to become law. The government of the day typically manages its legislative business so that each House is kept fully occupied without waiting for the other House to send legislation.
What is a Grand Committee?
In the House of Lords, each bill passes through 5 stages: First Reading, Second Reading (which happened yesterday), Committee, Report and Third Reading. If both Houses cannot agree the same text then there is a further stage called “ping pong”, which we saw for several months over the Fire Safety Bill and attempts to protect leaseholders.
A Grand Committee is open to any member of the House of Lords. Grand Committees proceed by unanimity, meaning there are no votes on amendments. This means a backbench amendment can more easily make it into the bill.
This differs from procedure in the Commons where bills are typically sent to public bill committees of a fixed number of MPs mirroring the political make-up of the Commons. The Commons public bill committees are open only to the MPs selected as members and vote on amendments.
You can read further information about the passage of a bill through Parliament here: https://www.parliament.uk/about/how/laws/passage-bill/
When will the Grand Committee take place?
The Committee stage normally happens about 2 weeks after Second Reading. We do not know the dates for this bill at the moment.
The bottom line?
There is much to do to improve the bill before it reaches the statute book. The indication in yesterday’s Second Reading debate of strong cross-party support for the measure generally and the particular improvements discussed above suggest that improvements can be made to further enhance leasehold protection.
LKP will continue to report on the bill as it proceeds through Parliament.