31st May 2016

The deferment rate is a key input in every enfranchisement claim whether it relates to the enfranchisement of a house, block of flats or the extension of a flat lease. The current deferment rate was set by the Lands Tribunal in *Earl Cadogan v Sportelli* [2007] 1 EGLR 153. This article explains what the deferment rate is and how the Tribunal arrived at the value which has been universally adopted since the decision in *Sportelli*. It then explores the status of the decision in *Sportelli* and asks whether it is time to re-set the deferment rate. The last part of the article looks at deferment rates for shorter leases.

Enfranchisement valuers have to value the freeholder’s interest if it were sold on the open market by a willing seller and subject to statutory assumptions. It is conventional to value term and reversion separately. To value the reversion one takes the present value of the reversion and discounts it to reflect the fact that it will not fall into possession for some time. The deferment rate was described by the Lands Tribunal in *Sportelli* as “the annual discount applied, on a compound basis, to an anticipated future receipt (assessed at current prices) to arrive at its market value at an earlier date”.

The formula for calculating the present value of a right to receive a future payment, using a given compound interest rate is: Future payment/(1+i)n (where i is the compound rate of interest and n is the number of years until deferment). But that formula does not take into account the fact that the value of the landlord’s reversion will increase in real terms (i.e. over and above inflation) over the course of the term. The appropriate formula to take that aspect into account was considered by the Lands Tribunal in *Sportelli*. TheTribunal concluded that in the case of leases with unexpired terms of 20 years or more the right approach was to use a formula expressed as follows: Deferment Rate = Risk Free Rate (“RFR”) + Risk Premium (“RP”) – Real Growth Rate (“RGR”).

The first two parts of the formula, the risk free rate and the risk premium, are an estimation of the rate of return that an investor in property of this kind (a long term zero yield investment) would demand to hold this kind of investment (as opposed to Gilts or equities). The risk free rate represents the return required by investors when there is no risk of financial loss. It was derived from expert evidence as to the average index linked yields on a five year rolling basis over the decade prior to the hearing. The risk premium was judged on the basis of expert evidence as to the risks of investment in long reversions (volatility, illiquidity, deterioration and obsolescence) as compared to other investments (such as for example equities). This interest rate is used to discount the anticipated future receipt with the result that a higher interest rate will diminish the sum due to the freeholder and a lower rate will increase the sum. The formula, DR = RFR + RP – RGR compensates a landlord for growth in the value of his interest during the term by deducting the long term real growth rate in property from the sum of the risk free rate and the risk premium, thus lowering the discount rate, and increasing the sum due to the freeholder. The Lands Tribunal concluded in *Sportelli* that the components in the formula were to be given the following values: RFR = 2.25%, RP = 4.5% and RGR = 2% giving a deferment rate of 4.75%. It was held that this rate was appropriate for cases where the property was a house. In a case where the property consisted of a flat or flats, a further 0.25% (to reflect additional management problems) should be added giving a deferment rate of 5.0%. The Lands Tribunal concluded that these rates should be regarded as generic deferment rates which could be adopted for leases with unexpired terms of 20 years and above but which may need to be adjusted by reference to the facts of individual cases.

In *R. (on the application of Wellcome Trust Ltd) v Upper Tribunal *[2013] EWHC 2803 (Admin) the Wellcome Trust sought to adduce evidence to challenge the risk premium and real growth rate set in *Sportelli*. Ouseley J held that where a party seeks to call evidence to attack the correctness of a guideline case such as *Sportelli*, such evidence should only be admitted in exceptional circumstances. He also suggested that the threshold might not be so high where there has been a change of circumstance which warrants a re-examination of the guideline.

So is it now time to look again at the risk free rate? The tribunal in *Sportelli* derived the risk free rate from index-linked government bonds. The principal value of these bonds is linked to inflation and therefore does not change in real terms. Yields on these bonds indicate the return over and above inflation expected by investors on safe assets. As the tribunal in *Sportelli* was only concerned with unexpired terms of more than 20 years it might be thought that the tribunal would look at the yield on long term gilts. The tribunal rejected reliance on long-term gilts alone due to the “pension panic” which was perceived to be distorting the market in 2006. It also might be thought that that there was some sense (as one expert suggested) in matching the spot rate yield at that date for a term commensurate with the term of the unexpired term of the lease. The tribunal rejected that approach without explaining its reasoning. Instead the tribunal looked at average index linked yields on a five year rolling basis over the decade prior to the hearing. So what has happened to index linked gilts since 2006? Five-year index-linked government bond yields increased to a peak of 4.3% in November 2008, during the financial crisis that followed the collapse of Lehman Brothers in September 2008. Yields then decreased steadily until the start of 2012, with large-scale, internationally co-ordinated monetary policy intervention likely to have been a major contributory factor. Since the start of 2012, real yields have remained near zero or negative at all maturities up to 20 years. Figure 1 below shows the course of real yields since 1986.

As is evident from the graph above, there has been marked downward trend in real gilt yields since the *Sportelli* decision. This trend has been recognized by major UK regulatory authorities. For example, Ofgem’s estimate of the real risk free rate declined from 2.5% in 2007 to 1.5% in 2014. The Civil Aviation Authority has been more aggressive in its recognition of the decline in government yields and determined the risk free rate to be 0.5% for the current price controls for major airports. Were one to recalculate the risk free rate in February 2016 on the same basis as was adopted in *Sportelli* one would arrive at a risk free rate below zero, potentially as low as -1% (minus one percent), as suggested by figure 2 below.

Obviously the longer the risk free rate stays lower the more pronounced becomes the divergence from the 2.25% set in *Sportelli*. This suggests it may be time for the Upper Tribunal to review the matter. One can understand the tribunal being reluctant to allow challenges to the deferment rate too frequently, but it is a decade since the decision in Sportelli and seeking a review on the basis of changes in gilt yields would not be a direct challenge to the decision. It would rather be a matter of updating the decision due to a change in circumstances. Those against reviewing the risk free rate would say that the present market is distorted by quantitative easing. But there are respectable arguments that this is not a short term distortion and the world has entered into a secular period of low risk free returns. Gertjan Vlieghe of the Bank of England Monetary Policy Committee recently warned that the market should “be prepared for the possibility that real interest rates will remain well below their historical average for a very long time”.

Moreover, forward rates (i.e. rates at which market participants are willing to transact in the future, as implied by current yields) suggest that the risk free rate is likely to remain close to zero for the next decade at least.

The Lands Tribunal in *Sportelli* did not seek to identify a generic deferment rate for leases with unexpired terms of below 20 years. Instead, it indicated that with unexpired terms of below 20 years the rate would need to have regard to the property cycle at the date of the valuation. In *Cadogan Square Properties Ltd v Earl Cadogan* [2011] 1 EGLR 155 the Upper Tribunal followed that approach. It adopted the formula of Deferment Rate = RFR + RP – RGR, but adjusted RGR to take account of expert evidence that as at the valuation date there had been an extended period of above average growth and a period of sub-trend growth could be expected to follow. There are some criticisms of that approach. No expert can know where one is in the property cycle. In the very long term there is always reversion to mean but during a period of 10-20 years it is possible for an overvalued market to get more overvalued and for a falling market to fall further. As John Maynard Keynes said “markets can remain irrational a lot longer than you and I can stay solvent”. The second criticism is the use of the same long-run risk free rate as is used for unexpired terms of more than 20 years. It is possible to match the spot rate yield at the valuation date for a term commensurate with the term of the unexpired term of the lease. Since the spot rate captures market consensus as to the direction of the change in yields, this is a preferred approach by financial practitioners. To illustrate, current evidence from index-linked gilts of various maturities suggests that for a lease with 20 years outstanding, the appropriate risk free rate is -0.9%. In contrast, if the lease has only 5 years outstanding, the appropriate risk free rate dictated by the market is -1.21%.

The difference between the numbers in *Sportelli* decision and current market evidence may seem small, but when compounded over years has a profound impact on value. Figure 3 provides an approximate illustration of the proportion of value which a freeholder would lose today, due to an outdated assumption on the risk free rate being used. While it is difficult to predict the outcome of an update of the *Sportelli* decision, were it to happen, the figure above assumes a rate of zero for all leases. Due to current market evidence pointing to a lower value of the risk free rate, this represents a conservative assumption.

Thus, especially now, when gilt yields are depressed and are expected to remain so for some time, it seems appropriate for shorter leases to consider contemporaneous market evidence. Failure to do so runs the risk of significantly underestimating the value of enfranchisement claims and therefore materially distorting the UK property market.

*A summary version of this article was published in the Estates Gazette. This article was written by Piers Harrison and Craig Lonie.*