How much should a residential lease extension cost?
30th January 2019
Published in the L. & T. Review 9
The need for the reform of landlord and tenant law is now a hot topic. The practice of selling houses on leases or imposing escalating ground rents has fuelled outrage from all quarters and put the spotlight on other areas of residential leasehold law which are long overdue for reform. While the lobbyists are unlikely to achieve their ultimate goal of the abolition of leasehold altogether, it is looking increasingly likely that the law on leasehold enfranchisement will be significantly overhauled.
As part of its 13th Programme of Law Reform, the Law Commission has produced a 546 page Consultation Paper entitled Leasehold Home Ownership: Buying Your Freehold or Extending Your Lease. The paper includes many sensible and interesting proposals for making the process of collective enfranchisement or acquiring a lease extension “simpler, quicker and cheaper”. The paper is broken down into four main topics on which consultees were invited to express their views by 7 January 2019. These are:
- What should the enfranchisement rights be?
- Who should be entitled to exercise enfranchisement rights?
- How should enfranchisement rights be exercised?
- What should it cost to enfranchise?
In this article, the writer will concentrate on the last, and probably the most emotive, of these topics—how much should it cost? Interestingly, while the Law Commission was asked to make proposals in relation to the first three topics for simplifying enfranchisement legislation and providing a better deal for leaseholders as consumers, the terms of reference from the Government in relation to valuation were slightly different. Rather than putting forward proposals for reform, the Law Commission was asked to put forward “options” for reducing the premium payable to enfranchise while ensuring that sufficient compensation is paid to landlords to reflect their legitimate property interests. The decision as to which option will be adopted is a political one, but the Government is clearly alive to the need to make sure that any reform does not offend the landlord’s human rights. In the meantime, the Law Commission has come up with essentially four “options” for reforming the current valuation methodology which attempt to meet the Government’s seemingly impossible criteria. Before considering those options, it is useful to look at how the premium for a lease extension would be valued under the current legislation and some of the problems this throws up. I have taken a simplistic case of the extension of a flat lease with no intermediate landlord and no rent increase to illustrate the issues.*L. & T. Review 10
What is the current law on valuing a lease extension 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 is left on the old lease and the old rent will be replaced by a peppercorn rent. So, on the extension of a lease with 45 years left to run at an annual rent of £100, the landlord will lose:
- the right to have vacant possession in 45 years’ time and instead have to wait 135 years; and
- a rental income of £100 per year for the next 45 years.
These sums together make up the “diminution in value of the landlord’s interest in the tenant’s flat” The purchase price, however, 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 “marriage value” is split equally between the landlord and the tenant so that the tenant must pay 50 per cent 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 1993 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 45 year lease is higher than a flat let on a 135 year lease. To calculate the difference, valuers apply a “deferment rate” to work out what the property will be worth in 45 years’ time or 135 years’ time. Say, our flat would be worth £250,000 if it was vacant with no lease, the landlord must be compensated by a sum representing the difference between:
- £250,000 deferred for 45 years at a deferment rate of x%, less
- £250,000 deferred for 135 years at a deferment rate of x%.
For properties in prime central London, the Upper Tribunal has effectively fixed the deferment rate for flats at 5% (see, Cadogan v Sportelli  1 E.G.L.R. 153), but arguments as to the appropriate rate still arise elsewhere.
Calculating the loss of the rental stream is not as simple as multiplying £100 x 45 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. The right to receive £100 in 44 years’ time is worth less than the right to received £100 now. To get around this problem, a “capitalisation rate” is applied to reflect the value of the investment to the landlord. For modest ground rents, the capitalisation rate is usually agreed at between 5% and 7 % but in one recent case, Emmanuel House (Freehold) Ltd v Berkeley Seventy Six Ltd CHI/21UC/OCE/2017/0025, where the rent was to be reviewed in line with the Retail Prices Index, the landlord managed to persuade the Tribunal that the rate should be as low as 3.5%. Lower capitalisation rates lead to higher premiums.
The most contested part of the premium is invariably the “marriage value”. The 1993 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*L. & T. Review 11
- the sum of the value of the leaseholder’s interest and the value of the freeholders’ interest after the new lease is granted: see, Sch.13 para 4.
These sums must be determined on various assumptions including an assumption that the 1993 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 do not live in a “no Act” world—nearly all long leaseholders do have the right to extend their leases. This makes it almost impossible to find properly comparable sales of short leases. Where there is a “comparable” sale of a flat on a short lease “with 1993 Act rights” a deduction must be made for the value of those rights. Again, an assessment has to be made as to the value of these “Act rights”.
The Court of Appeal confirmed in the case of Mundy v Sloane Stanley Estate Trustees  EWCA Civ 35;  1 W.L.R. 4751;  L. & T.R. 17 that marriage value should, where possible, be determined from market evidence. However, there are often no real-world transactions of short leases on which to rely. Where this is the case, valuers must resort to “relativity graphs”. Relativity 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, if, in our example, the property is worth £250,000 on a freehold basis with vacant possession and the relevant graph shows “relativity” of 73.87 per cent for an unexpired term of 45 years, the value of the 45 year lease can be calculated at £184,675. Again, 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. These graphs have come in for much criticism in recent times, but when faced with the impossible task of valuing something that does not exist (i.e., a short lease with no right to extend), they are often the only evidence available. In the writer’s experience, when market evidence is relied on the “relativity” usually comes out at a figure below the current graphs and this was recognised by the Upper Tribunal in Mundy.
Proposals for reform
As can be seen from the methodology referred to above, there are many moving parts in a lease extension valuation. This invariably means that leaseholders require the assistance of specialist legal advisers and valuers in any claim. This adds significantly to the cost of enfranchising particularly as, under the current regime, the leaseholder is responsible for some of the landlord’s costs as well. In addition to looking at ways to reduce premiums, the Law Commission has also suggested ways of reducing the professional costs payable by leaseholders. One way of reducing these costs is, of course, to reduce the number of things which can be argued about. With this in mind, the Law Commission has come up with four options for simplifying the valuation methodology. Two involve the adoption of a simple formula and two are refinements on the current valuation methodology.
The least radical option for reform is to keep the valuation method essentially as it is now but to prescribe rates for some or all of the more contentious elements, namely, relativity, the value of 1993 Act rights, capitalisation rates and deferment rates. There might still be a dispute on the freehold value of the flat, but once that is established the rest of the valuation would be relatively straightforward. There could be a limit to the extent that ground rent reviews can be taken into account to simplify the calculation of the capitalised rent. These changes would certainly save on professional costs, but they will only reduce the premium if the prescribed rates are set at a tenant friendly level. Recent cases suggest that, in fact, the traditional rates are probably already too low but, in principle, it should be possible to fix rates by statutory instrument. The Consultation*L. & T. Review 12 Paper invites views on how each of the various rates should be prescribed, by whom, how often and on whether there should be variations, for example, for different geographical areas.
A much more radical proposal is to stick with the current approach, but to ignore marriage value. The landlord would only be entitled to be compensated for the loss of the deferred freehold value and the capitalised rent. The Report uses the analogy of one of a pair of Chinese vases being smashed. The holder of the vase would still have the vase, but its value would be reduced as there is no longer any additional value referable to the possibility of it being reunited with its pair. Abolition of marriage value would significantly reduce premiums and simplify the valuation process. There is an argument that by paying marriage value, leaseholders are paying again for something they already own. However, it is undoubtedly the case that marriage value exists, and it could mean depriving the landlord of the full value for the asset being expropriated.
Alternatively, the compensation could ignore the value of the landlord’s asset altogether and be calculated as a multiplier of the ground rent. A Private Members’ Bill has been put before Parliament proposing a formula based on 10 times the ground rent. The Bill suggested that such a system already exists in many other countries including Scotland. In fact, the Long Leases (Scotland) Act 2012 only applies to leases with a rent of less than £100 pa which were granted for more than 175 years and have more than 100 years left to run, in respect of houses, and more than 175 years left to run otherwise. The premium in such cases would already be modest under our existing system.
While at first glance, a simple formula based on the ground rent is attractive, it would exclude from the enfranchisement premium any reversionary value, which may be substantial. The premium would also be wholly dependent on the level of ground rent which is often arbitrary—a flat in Skegness might have a ground rent which is significantly higher than that of a flat in Mayfair. It might work for very long leases where there is no reversionary value, but in most cases, it would lead to the taking of property without payment of an amount reasonably related to its value.
Another “simple formula” would be to set the premium as a percentage—say 10 per cent—of the freehold value of the flat. This would, however, again result in premiums which do not reflect the different lease lengths or any difference in the ground rent payable. A 25 year lease could be extended for the same cost as a 125 year lease. In the case of the latter, a premium based on capital value or a ground rent multiplier could actually increase the cost of a lease extension.
There are significant problems with these simple formulae—not least that they are unlikely to be compatible with human rights legislation. However, the Law Commission has recognised that they may have their place in low value claims where the lease still has many years to run and the reversionary value is negligible. This would lead to a two-tier regime but could be particularly useful if leaseholders would thereby be encouraged to extend their leases while they still fall within the low value criteria.
The Law Commission has also suggested that it might not be appropriate to have a “one size fits all” method of valuation in other areas. One thought was that, as the 1993 Act is intended to benefit home owners, perhaps there could be a different method for valuing flats which are homes rather than investments. This sounds suspiciously like a return to the residence test which was abolished by the Commonhold and Leasehold Reform Act 2002. The writer suspects no one will welcome that back.
The Law Commission’s Consultation Paper also includes options for the reform of the valuation methodology for collective enfranchisement and house claims. There are suggestions for reforming the treatment of hope value, development value and the discount of tenants’ improvements. While the options put forward raise lots of questions, the writer suspects the real problem will*L. & T. Review 13 be to find a solution which squares the circle which is inherent in the terms of reference. How do you reduce premiums while ensuring that sufficient compensation is paid to landlords to reflect their legitimate property interests? The answer will be one for politicians rather than lawyers.
The law is stated as at 10 December 2018.