How to value a Residential Lease Extension
21st June 2018
Last month I spoke at the Professionalism in Property Conference whose theme was Leasehold Reform. There has been much outcry from leaseholders about the cost and complexity of extending lease and the Government has vowed to do something about it. Many interesting suggestions for reform were put forward at the conference and I will describe some of the possibilities in a later article. Before doing so, however, I thought it would be useful to recap on what the existing law is trying to achieve and how it works in practice at the moment. This article provides a brief summary of the talk I gave with Richard Murphy (of Richard John Clarke Chartered Surveyors) on that subject.
What is the current law on valuing a lease extensions trying to achieve?
A lease extension under the Leasehold Reform Housing and Urban Development Act 1993 is a form of compulsory purchase and the Act is trying to ensure that the landlord is paid a fair price for what he is obliged to sell. The new lease will be for a term of 90 years longer than what’s left on the old lease and the old rent will be replaced by a peppercorn rent.
Taking a simple example of a lease with 40 years left to run at an annual rent of £100 what does the landlord lose by replacing this with a 130 year lease at a peppercorn rent? Well he loses:
- The right to have vacant possession in 40 years and instead has to wait 130 years; and
- A rental income of £100 per year for the next 40 years.
These sums together make up the “diminution in value of the landlord’s interest in the tenant’s flat”
However, the purchase price is not limited to the investment value of the landlord’s interest. It also has to reflect the increase in the value of the tenant’s flat following the completion of the lease extension as obviously the longer lease will have increased its market value. This profit to the tenant only arises from the landlord’s obligation under the Act to grant a new lease. This “marriage value” is split equally between the landlord and the tenant so that the tenant must pay 50% of the marriage value as part of the premium for the new lease. If the lease still has 80 years or more left to run at the date of the extension, the Act says no marriage value is payable.
In some cases the tenant must also pay the landlord compensation in respect of the drop in value of any other property the landlord owns as a result of the lease extension. This is rare.
How is the premium calculated?
The value of the landlord’s interest in a flat let on a 40 year lease is higher than a flat let on a 130 year lease. To calculate the difference valuers apply a “deferment rate” to work out what the property will be worth in 40 years’ time or 130 years’ time. Say our flat would have a value of £250,000 with vacant possession and no lease, the landlord must be compensated by a sum representing the difference between:
- £250,000 deferred for 40 years at x%, less
- £250,000 deferred for 130 years at x%.
There is no mention of a “deferment rate” in the Act but this methodology has been accepted in the courts and tribunals as appropriate. For properties in Prime Central London, the Upper Tribunal has effectively fixed the deferment rate for flats at 5% – Cadogan v Sportelli  1 EGLR 153.
How is the loss of the rental stream calculated? It is not as simple as multiplying £100 x 40 years because under the terms of the lease, the landlord will only be entitled to £100 each year rather than a lump sum in advance covering the whole rent. Also the right to receive £100 in 39 years’ time is worth less than the right to received £100 now. To get round this problem a “capitalisation rate” is applied to reflect the value of the investment to the landlord. Again there is no mention of a “capitalisation rate” in the Act but the valuation principal is now universal. For modest ground rents the capitalisation rate is usually agreed at between 6 and 8 %.
The most contested part of the premium is invariably the “marriage value”. The Act requires the marriage value to be calculated as the difference between:
- the sum of the value of the leaseholder’s interest and the value of the freeholders’ interests before the new lease is granted; and
- the sum of the leaseholder’s interest and the value of the freeholders’ interest after the new lease is granted. – Schedule 13 para 4.
These sums must be determined on the assumption that the Act does not confer a right to acquire a new lease of the flat, i. e, the flat is sold in “the no-Act world”. The difficulty with this is that we don’t live in a “no Act” world – nearly all long leaseholders do have the right to extend their leases. This makes it difficult to find properly comparable sales of short leases against which to assess the value of existing lease. Where there is a comparable of a flat on a long lease “with Act rights” a deduction must be made for the value of those rights. Where no market evidence of such sales exists valuers must resort to “relativity graphs”. Yet again “relativity” is not referred to in the Act at all. It is a term which is used by valuers to express the value of the existing lease in the no Act world as a percentage of the value of the same flat as a freehold. So, for example if the existing 40 year lease is worth £65,000 and the freehold would be worth £100,000, “relativity” is 65%. The lower the relativity the higher the premium, the tenant will pay for a new lease.
There are various “relativity” graphs in circulation most of which have been prepared by firms of surveyors and are somewhat subjective. They are not entirely satisfactory and have come in for much criticism in recent times but when faced with the impossible task of valuing something that doesn’t exist (i.e. a short lease with no right to extend), they are often the only evidence available.
In my next article I will look further at some of the problems created by the “no Act” assumption and some possible avenues for the reform of this highly complex legislation.