Why it is going to be so important to shout in 2025 – and loudly – when government sets the leasehold Deferment Rate

Introduction

Linz Darlington, managing director of Homehold, which offers an end-to-end lease extension service, explains why the government should not bow to pressure to increase lease extension costs

The Leasehold and Freehold Reform Act 2024 was passed just before the last general election, but it isn’t yet in force.

To implement this law the Government must pass additional secondary legislation. One of the things it needs to do is to set the key percentage rates that are used to calculate the cost of lease extensions and freehold purchases.

The government announced last Thursday that it is going to run a consultation during the summer of 2025 and to invite comment on what these rates should be.

If these percentage rates increase from the current levels, the cost of lease extensions will go down. If these rates go down, the cost of lease extensions go up.

Fairly small changes in these rates can have a huge impact on lease extension prices.

Leaseholders who have leases below 80 years should find that the 2024 law makes their lease extension cheaper because the additional payment of Marriage Value that they presently need to pay will be removed:

Marriage Value: How your freeholder hitches a ride on the uplift of value on your flat

However, if the Deferment Rate were decreased at the same time, it would reduce the benefit that these leaseholders would receive from the removal of Marriage Value.

Leaseholders who have more than 80 years on their existing leases don’t benefit from the abolition of Marriage Value – because they don’t pay it. Accordingly, a decrease in the Deferment Rate would make their lease extensions more expensive than they are now.

The Deferment Rate is one of the two key rates in the lease extension calculation. The freehold community will argue that this rate should be reduced. This article explains why there is a strong counter-argument: it should be increased.

Why does the Deferment Rate matter?

When you extend your lease, you must pay a sum of money to compensate freeholders for the fact that they will no longer get your valuable flat back in the future. This is known as paying for the loss of their reversion.

Let’s use an example of a £200,000 flat with 80 years to run on the existing lease. How much do you need to pay freeholders now for a lease extension to compensate them for the loss of the flat back at the end of the lease?

The easiest way to explain it is as follows: imagine you put £4,000 in a bank account at 5% and leave it there for 80 years. Over that period, it will compound and grow to about £200,000!

For this reason, it is considered that £4,000 now is worth the same amount as £200,000 in 80 years’ time. £4,000 is the compensation you need to pay your freeholder for the loss of reversion as part of the lease extension.

It’s worth noting that your lease extension price will be higher if you have a ground rent. This is because in addition to the reversionary element the overall sum will need to include money to buy out the ground rent.

Are you overpaying for your lease extension?

The 5% Deferment Rate

You’ll notice in my example above that I’ve used a 5% Deferment Rate. This rate was first set in 2006 by a decision by the Upper Tribunal which is known as Sportelli.

Before the Sportelli decision, the Deferment Rate was often agreed at a higher rate (particularly outside of London) and this meant that lease extensions were cheaper for leaseholders than they are now.

We’ve already mentioned that you’d need to deposit £4,000 in the bank at 5% for the next 80 years for it to grow to be £200,000. If the rate was 6% the money would compound more quickly, and you’d only need to bank £2,000 for it to grow to £200,000 over the same period. Accordingly, the lease extension would cost half the amount.

Who sets it now?

Nearly 20 years on from Sportelli and it is time for a change: the rate is now to be set by the Secretary of State for Housing, Angela Rayner. It will then be reviewed every 10 years, by whoever is the Secretary of State at that point.

Freeholders, unsurprisingly, want the rate to be decreased as it will push lease extension costs up. There was an Upper Tribunal case in 2021 where the freeholder’s valuer unsuccessfully argued that the Deferment Rate should be reduced to 3.5%.

To put it in context, if the rate was 3.5%, you’d need to pay nearly £13,000 to compensate your freeholder for the loss of a £200,000 flat back in 80 years, compared with about £4,000 when the rate is at 5%.

How is it set?

The Secretary of State is obliged to set this rate at “market value” – but exactly what is market value is very tricky to decide.

In principle, the rate is set by looking at the equation from the freeholder’s perspective as an investor. What would they pay now in 2024 for the right to receive a flat back in 80 years?

The 5% Deferment Rate in Sportelli had three components and we assume that these same three components will be considered now when setting the rate. If you add each of the components together you get the 5% Deferment Rate.

This article goes through each in turn, explains how it was set in Sportelli, and how it might be different if the rate was set today.

Component 1: The “Risk Free Rate”:

The first component was the “Risk Free Rate”. This is the return any investor would expect from an investment if they were prepared to accept no risk at all!

In Sportelli, this rate was based on the opinion of a collection of experts. Their opinion was largely formed by the historic yields of Index-Linked Government Bonds, which are very low risk Government securities. It was set at +2.25%.

In 2021 there was an Upper Tribunal Case called Llangewydd Court, and the freeholder’s valuer argued that the Risk Free Rate should be reduced. This would have decreased the Deferment Rate and increased the lease extension premium.

The freeholders’ argument was anecdotal. For example, they argued that the Bank of England rate (at that point in time) had dropped a lot since Sportelli and the Risk Free Rate should be reduced accordingly. This would have made the lease extensions much more expensive.

The tribunal felt that the freeholder hadn’t provided sufficient evidence to argue for a lower Risk Free Rate, but it did leave the door open for a future challenge.

Three years on, we know that the Bank of England Base Rate (and bond yields more generally) are now similar to when Sportelli was decided in 2006 – so arguably the freeholder’s argument is somewhat undercut by this.

Component 2: The “Risk Premium”:

The next component is the “Risk Premium”. This is the additional return that investors would require to incentivise them to invest in freehold reversions, rather than putting their money in super-safe Index-Linked Government bonds.

The tribunal in Sportelli decided that a Risk Premium of 4.5% was appropriate, with an additional 0.25% for flats.

It considered the risk of owning freehold reversions, over Index-Linked Bonds and it felt that the following things were:

1/ Volatility:
The property market goes up and down. This means if you want to sell your interest in a freehold title you might have to sell it at a lower price than you’d like.

2/ Transaction Costs:
If you want to sell a property interest, you need to market it (i.e. via an Estate Agent or auction) and pay their fees and that of your solicitor

3/ It can become obsolete
If you buy into a building, it might not fare as well over the years as you expect, or the location it is in might become less desirable.

4/ Management Hassle
If you own a block of flats, you may well incur costs related to its management, and you might struggle to recover your costs from the leaseholders.

Over the last 20 years there have been several positive changes to leasehold that benefit leaseholders – and much credit must go to the Leasehold Knowledge Partnership for its part in this.

Three examples include:

The Building Safety Act / Fire Safety Act: This legislation puts new obligations on freeholders to make sure that their buildings remain safe for the leaseholders who live in them

More Management Risk: Leaseholders have become better informed and are prepared to challenge bad practice and unfair lease terms

Insurance Commission Scandal: For years freeholders have been lining their pockets by adding big commissions on top of the insurance premiums they collect from leaseholders – but the Financial Conduct Authority is making this more transparent, and leaseholders are fighting back. [Government secondary legislation under the 2024 Act is also to address this – LKP]

While these changes are rightly positive for leaseholders, from the freeholder’s perspective they increase the risk / hassle of managing blocks.

Because the risk of managing freehold blocks has gone up, the corresponding Risk Premium must have increased as well. This must lead to a higher Deferment Rate, and lower lease extension premiums.

Component 3: The “Real Growth Rate”:

This component is to consider the fact that the value of a flat is likely to go up over the long term of the lease. Let’s return to the example of a flat worth £200,000 in 2024. If you assume it will go up in value by 2% each year (after inflation), it would be worth about £975,000 in 80 years’ time.

To make the maths work, this is applied as a negative figure in the Deferment Rate. In Sportelli they decided it should be -2%.

However, since Sportelli the long-term Real Growth Rate of property has decreased. This is shown in the Chart below.

Accordingly, there is a strong argument that the Real Growth Rate should be set at a lower level now than it was in 2006.

If the Real Growth Rate is lower, it would lead to a higher Deferment Rate, and a lower cost of lease extensions.

Adding up the component parts

If you add up the component parts above you get 5% – although our argument is that it should now be higher!

In Conclusion

Small changes in the Deferment Rate make a huge difference to lease extension premiums – but ultimately setting it is not an exact science.

Accordingly, the Deferment Rate will likely end up being a political decision.

Ahead of the Government consultation on these rates in Summer 2025, the freehold community will be vocally arguing that the Deferment Rate should be going down, and that the cost of lease extensions should be going up.

One expert commented to the Government during the passing of the Leasehold and Freehold Reform Act that he thought the Deferment Rate should be reduced to 3.5%, which would increase lease extension premiums significantly.

Seven groups of freeholders have started legal action against the Government, and it seems likely that one of their aims will be to force the Deferment Rate to be as low as possible.

The Leasehold and Freehold Reform Act 2024 has other changes that will benefit leaseholders – including removing Marriage Value, which is an additional charge paid by leaseholders with leases shorter than 80 years.

No doubt the Government will feel under some pressure to make a concession to freeholders on the Deferment Rate, to try and get the legislation as a whole implemented without risk of a protracted legal challenge.

However, a decrease in the Deferment Rate would be a very damaging concession to make, and they should resist doing so.

This article explains that there are firm arguments that the Deferment Rate should be going up (and the cost of lease extensions down) and leaseholders need to vocalise these wherever they can. Next year’s consultation on this issue will be the perfect time to do this!