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Leasehold enfranchisement – options to reduce the price

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26th May 2020

L & T. Review 2020, 24(3), 89-95

L & T. Review 89 Leasehold enfranchisement is notoriously complicated and expensive. The so-called “leasehold scandal”—which includes granting leases of houses when there is no need to and imposing onerous ground rents—has brought the problems with the current system into sharp focus. The issue has now become political and the Law Commission has been asked to undertake a wholesale review of enfranchisement law with a view to making it quicker, cheaper and easier for leaseholders to obtain a lease extension or acquire their freehold.

In relation to the qualifying criteria and procedure, the Law Commission was asked to make recommendations and the report on those aspects is due in the Spring. On the question of valuation, the Law Commission’s remit was slightly different. It was required to come up with “options” to reduce the premiums payable by leaseholders, not “recommendations”. It will then be a matter for the politicians to decide which option should be adopted. The Law Commission Report (Leasehold home ownership: buying your freehold or extending your lease. Report on options to reduce the price payable (HMSO, 2020), Law Com. No. 387) on those options was published on 9 January 2020.

The Law Commission’s mission was to “examine the options to reduce the premium or price payable by existing and future leaseholders to enfranchise whilst ensuring sufficient compensation is paid to landlords to reflect their legitimate property interests”. The reference to legitimate property interests is an acknowledgment of the requirements of Article 1 Protocol 1 to the European Convention on Human Rights (A1P1) and the Report has been prepared with a challenge under those provisions in mind. A1P1 provides:

”Every natural or legal person is entitled to the peaceful enjoyment of his possessions. No one shall be deprived of his possessions except in the public interest and subject to the conditions provided for by law and by the general principles of international law …”

The Consultation Paper, produced on 20 September 2018 (Law Commission, Leasehold home ownership: buying your freehold or extending your lease: Consulation paper) (HMSO, 2018), Consultation Paper 238), came up with essentially four options for reducing premiums with various variations. There were two simple options based on calculating the premium for a lease extension as, say, 10 x the ground rent or calculating the premium as a percentage of the freehold value. The more complicated options were based on the current methodology with or without marriage value. Following the advice of Ms Catherine Callaghan QC, a human rights lawyer, the Law Commission has dismissed the simple options on the basis that they would not survive a challenge under A1P1. Although these options were much favoured by leaseholders, the *L. & T. Review 90 methodology was arbitrary and did not produce a price which properly reflected the landlord’s loss.

Following extensive consultation, the Law Commission has now revised its original options for reform. It has come up with three main options and seven sub-options. Before looking at these options in detail, it may be useful to outline how valuation is conducted under the current system. In order to illustrate the concepts, the writer has taken a simplistic case of a lease extension for a flat with no intermediate landlord and no rent increase.

How are lease extensions valued now?

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. Taking a simple example of a lease of a flat 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? He loses:

1. the right to have vacant possession in 40 years and, instead, has to wait 130 years; this is referred to as “the reversion”; and
2. a rental income of £100 per year for the next 40 years – this is called “the term”.

The term and reversion together make up the “diminution in value of the landlord’s interest in the tenant’s flat”. If the lease was to run its term and the tenant did not buy a lease extension, this would be the extent of the landlord’s loss. But, of course, what usually happens is that, at some point, the tenant will want to buy a lease extension and this possibility adds value. The value of the tenant’s new 130-year lease is more than the tenant’s 40-year lease plus the landlord’s freehold value when added together. The difference is called “marriage value”. The analogy used by the Law Commission is that of a set of two matching Chinese vases. The two vases together are worth more than the sum of the value of each vase individually. Under the current legislation, 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. The shorter the lease the higher the marriage value. 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.

A similar methodology is used when valuing the price to be paid by a leaseholder to acquire the freehold of his house under the Leasehold Reform Act 1967 although there is a different regime for some low value houses—”the original valuation basis”.

Each of the elements which make up the premium for a lease extension is often calculated by reference to established rates which surveyors and economists have deemed appropriate but the question of which rates should be applied gives rise to multiple avenues for dispute.

(a) valuing “the reversion”

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 the difference between what the property will be worth on a lease which expires in 40 years’ time and what the property will be worth on a lease which expires in 130 years’ time. The value is *L. & T. Review 91 calculated by taking the current freehold value of the flat and multiplying it by the appropriate deferment rate for the required number of years.

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 per cent (see Earl Cadogan v Sportelli [2007] 1 E.G.L.R. 153. However, with decreasing interest rates, it is possible that, if there was a re-run of the Sportelli case, the market deferment rate might well be found to be lower than 5 per cent. The rate applied to calculate the appropriate damages for a fund paid under the Fatal Accidents Act 1976 is considerably lower. The lower the deferment rate the higher the premium.

(b) valuing “the term”

The next question is 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 is only entitled to £100 each year so it will have to wait 40 years to get all the rent. The rent, therefore, has to be capitalised to reflect the benefit of receiving a lump sum now for the whole rent. This lump sum is calculated using a “capitalisation rate” which is converted into a multiplier called a “Years Purchase” multiplier based on the capitalisation rate and the number of years left on the lease. If there are fixed rent review increases, the capitalisation rate can be applied to each of the increases. The position becomes rather more complicated if the rent reviews are not fixed but subject to, say, RPI increases.

Capitalisation rates have, in the past, usually been agreed—for modest ground rents the capitalisation rate is usually between 5 and 8 per cent. However, recent cases suggest that these capitalisation rates are out of step with the current market. In St Emmanuel House (Freehold) Ltd v Berkeley Seventy-Six Ltd FTT CHI/21UC/OCE/2017/0025 (known as the All Saints Case), the tribunal was persuaded that the appropriate capitalisation rate was as low as 3.35 per cent! Again, the lower the capitalisation rate the higher the premium. The prevalence of “onerous ground rents” has meant that the value of the capitalised rent is now worth fighting about. If the rent doubles every 10 years, it is potentially a very valuable asset and the capitalised ground rent can form a significant part of the premium payable to the landlord.

(c) valuing “marriage value”

The most contested part of the premium, however, is invariably the “marriage value”. This requires a comparison between the value of the flat on the existing short lease and the value of the flat on the basis that it is freehold. All this has to be done on the assumption that the leaseholder does not have the right to extend his lease or purchase his freehold under the 1993 Act. This is highly artificial because, of course, the Act does exist and purchasers in the market know that they have the right to enfranchise.

Ideally, the value of the short lease will be determined from market evidence but truly comparable sales of flats with the same lease length can be rare. Even if a comparable sale can be found, it has to be adjusted to reflect the “no Act” world. This is done by applying a percentage discount and further disputes can arise as to what that discount should be. Valuers, therefore, resort to relativity graphs. These express the value of the short lease as a percentage of the value on a freehold basis. So, for example, if the existing 40-year lease is worth £65,000 in the “no Act world” and the freehold would be worth £100,000, “relativity” is 65 per cent. The lower the relativity the higher the premium, the tenant will pay for a new lease. *L. & T. Review 92

Experts have been unable to agree on a definitive graph, so there are a number of different graphs in circulation and disputes arise as to which graph is appropriate. All of the graphs have been criticised. Again, recent cases such as Sloane Stanley Estate v Mundy [2016] UKUT 226 (LC) and thereafter, suggest that many of the graphs may currently overestimate relativity. Again, the lower the relativity the higher the premium.

How is the price of the freehold on a collective enfranchisement calculated?

In the case of a collective enfranchisement, the purchase price is essentially the sum of:

• the value of the term and reversion of the flats and other units in the building;
• marriage value in respect of the flats of leaseholders who are participating in the enfranchisement claim;
• ”hope value” in respect of the flats of leaseholders who are not participating in the claim; and
• development value.

“Hope value” is the sum which a hypothetical purchaser of the freehold might be willing to pay to reflect the “hope” that one or more of the non-participating leaseholders may wish to purchase a lease extension in the future. It is calculated as a percentage of the marriage value. The more likely it is that the non-participating tenants will want a new lease, the higher the percentage of the marriage value is payable. “Development value” is the value which the landlord might have been able to achieve by developing those parts of the estate which it can develop. Again, the potential development value is discounted to reflect the chances of the landlord actually being able to release this value. There are a number of obvious problems with the current methodology:

• it is complicated and needs an expert to interpret it. It is, therefore, expensive to operate;
• it is subjective, different experts will think different rates are appropriate to calculate the true value;
• it is artificial in that it requires a calculation to be based on “comparables” which do not exist (i.e. market sales which took place in a world which does not allow for enfranchisement). Similarly, it requires payment of development value where the landlord/hypothetical purchaser has not carried out a development and may have no intention of doing so;
• leaseholders would say, it gives rise to high premiums, particularly if they are caught up in the ground rent scandal of doubling rents.

The options for reform

The Law Commission’s Report sets out three alternative options for calculating the premium payable on enfranchisement. Within those schemes there are seven sub-options. Four of the sub-options would reduce the premium in every case and the last three would only reduce the premiums if combined with other reforms. The Commission has based its new schemes on differing “assumptions” as to who is in the market to buy the interest.

Under Scheme 1, there would be a new statutory assumption that the leaseholder was not in the market at the time the premium is calculated and will never have been in the market. This would mean that there would be no added value to the leaseholder or the freeholder of combining the two interests together (i.e, there would be no marriage value). The landlord would, therefore, only be compensated for its actual loss, namely, the term and the reversion. Scheme 1 would *L. & T. Review 93 lead to the biggest reduction in premiums. Development value might still be payable on a collective enfranchisement under Scheme 1 but, as the leaseholder himself would not be in the market, it could be less than under the current law. For example, landlords often claim an uplift to reflect the value of selling the lessee of the top floor flat the right to develop a roof void. If the lessee is not in the market, the landlord could only obtain development value in respect of the potential development if it had access to the roof space and could develop it itself.

While Scheme 1 is, undoubtedly, the most attractive to leaseholders, there is a question mark over whether it is compatible with A1P1. Ms Catherine Callaghan QC concluded that, if development value or additional value was still payable, it is “marginally more likely than not that the option would be compliant with A1P1”.

Ms Callaghan was more optimistic about the compatibility of Scheme 2. Under this Scheme, the price payable would be based on what a third party would be likely to pay for the freehold. It would be assumed that the leaseholder was not in the market for a new lease at the date when the premium is calculated but might be at some point in the future. The hypothetical third party purchaser might, therefore, be prepared to pay an uplift to reflect the fact that he could sell a lease extension to a leaseholder at some future date. In other words, the price would include “hope value”. As hope value is usually calculated as a percentage of marriage value, it would probably be necessary to prescribe a new table of rates setting out what discount to marriage value should be applied in order to determine the hope value. The shorter the lease, the more likely that hope value would be payable.

Scheme 3 is essentially the current regime with some tweaking. This regime assumes that the leaseholder is in the market and that he should pay the landlord an element of the added value he obtains by acquiring the lease extension/freehold.Prescribed rates for some of the valuation tools used in calculating premiums could ensure that premiums are reduced and easier to calculate.

The sub-options

(a) Sub-option 1—prescribe rates for certainty and predictability

Most disputed valuation cases turn on arguments as to what “rates” should be used in calculating the premium—what “capitalisation rate”, “deferment rate” and relativity should be applied and what is the value of “Act rights”. By prescribing these rates, the scope for disputes would be reduced and the valuation process will become simpler, cheaper and more predictable. There could even be an online calculator so that leaseholders would know how much their lease extension ought to cost by plugging in the details of their lease.

This is a worthy aim but the “Holy Grail” of the perfect graph plotting rates of relativity has been sought for many years without success. There would, therefore, be the knotty question of what the rates should be and who would set them. If the rates are prescribed at a level intended to reflect market values, recent cases such as Sloane Stanley Estate v Mundy [2016] UKUT 226 (LC) and Trustees of the Barry and Peggy High Foundation v Zucconi [2019] UKUT 242 (LC), suggest that premiums would actually be higher than those achieved by applying the traditional graphs. In order to reduce premiums, the Government would almost certainly have to prescribe rates which are lower than the market rate or at the lower end of the range of possible outcomes. However, the further away the prescribed rates are from the market rate, the higher the risk of the scheme not being compliant with A1P1. As regards who should set the rates, the option favoured by the Law Commission is for this to be done by the Secretary of State, no doubt with input from experts in the field *L. & T. Review 94

(b) Sub-option 2—cap the treatment of ground rent at 0.1 per cent

Onerous ground rents have formed a major part of the so-called leasehold scandal. This is the fashion for granting new leases with a ground rent which doubles every 10 years. The ground rent may look innocuous at first but, when it comes to calculating the premium payable on enfranchisement, it can have a major impact on the premium payable. The Law Commission has suggested that a practical way of mitigating this problem would be to cap the level of ground rent which is taken into account when calculating the value of the term set at 0.1 per cent of the freehold value. This would not only simplify the calculation but would also reduce premiums.

(c) Sub-option 3—no payment for development value

In some enfranchisement claims, the premium may be increased to reflect the development potential of the land being acquired. In one recent case the writer was involved with, the landlord initially claimed £34 million for the alleged potential for building a skyscraper in the front garden of the block. Obviously, such claims can be something of a deterrent to leaseholders who probably have no intention of developing. The Report proposes that a way round this problem would be to allow leaseholders to elect to accept a restriction on future development of their block instead of paying development value. If they subsequently decided to develop, they could negotiate a release of the restriction with their former landlord, no doubt, at a price. The restriction would be akin to an option. What is not entirely clear is what would happen if, say, the landlord had already obtained planning permission or was half- way through a development.

(d) Sub-option 4—favourable premiums for owner-occupiers

The enfranchisement Acts were originally intended to allow leaseholders to buy their own homes and, as originally drafted, required leaseholders to be resident in order to qualify. In order to reduce premiums for homeowners it would be possible to reform the valuation regime so that owner-occupiers benefit from reduced premiums, but commercial investors do not. This would make compliance with human rights legislation easier. However, the Commission is decidedly unenthusiastic about this proposal because it would reintroduce a level of complexity and scope for arguments which have been removed by amendments to the original legislation.

(e) Sub-option 5—remove 80-year cut off for marriage value

Under the current legislation, no marriage value is payable in respect of terms with more than 80 years left to run. This cut-off is artificial and creates a distortion in the market resulting in a significant drop in the value of leases at the point where they have around 85 years or less to run. Of course, if Scheme 1 is adopted, there will be no marriage value anyway but if either of the other two options is adopted, the 80-year cut off will remain beneficial to leaseholders. The removal of the 80-year cut-off does not, therefore, fit with Law Commission’s mission unless it is combined with other reforms, for example, prescribing relativity at below market level. It is difficult to see how relativity could be prescribed at such a level as to benefit leaseholders who currently do not pay marriage value at all.

(f) Sub-option 6—remove discount for leaseholder’s improvements

At the moment, any increase in value of a flat or house which has resulted from improvements carried out by the leaseholder is to be ignored in calculating the premium so that the landlord *L. & T. Review 95 does not benefit from work carried out by the leaseholder. This can lead to complicated arguments. For example, if the lease was granted in 1950, is the installation of a brand-new Ikea kitchen to replace the original 1950’s kitchen an improvement or keeping the premises in repair? The valuation regime could be simplified and the scope for disputes reduced, if the assumption regarding improvements was abolished. But again, the assumption is for the benefit of leaseholders so its removal would increase rather than decrease premiums. It is, therefore, suggested that the discount for improvements should be retained but the Government could remove or limit the discount in order to reduce disputes.

(g) Sub-option 7—remove discount for holding over

When a long lease comes to an end, certain statutes make provision for the leaseholder to have continuing security of tenure. The right of a leaseholder to “hold-over” is (except in the claims under the “original valuation basis” in the 1967 Act), currently reflected in the enfranchisement valuation by way of a discount to the premium. Again, although the removal of this discount would simplify the procedure and reduce disputes, the Commission concludes that the discount should be retained but it could be limited or prescribed to reduce disputes.

Conclusion

It will be interesting to see which, if any, of the options for reducing premiums is adopted by the Government. Reform of the enfranchisement legislation is long overdue, but will the Government make the legislative time available to make the necessary changes?

The law is stated as at 13 April 2020.

By Nicola Muir

First published in the Landlord & Tenant Review

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