Valuation under evaluation: proposals for reform

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Nicola Muir considers the Law Commission’s options for reforming the valuation of residential lease extensions.

There has been much outcry from leaseholders about the cost and complexity of extending leases and the government has vowed to do something about it. The Law Commission has been given the unenviable task of coming up with options to reduce the premiums payable on lease extensions and enfranchisement while ensuring sufficient compensation is paid to landlords to comply with human rights legislation.

On 20 September 2018, the Law Commission published its consultation paper setting out some options for fulfiling this seemingly impossible mission. Before considering those options, it is useful to look at how lease extensions are valued now 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.

What is the current law trying to achieve?

A lease extension under the Leasehold Reform, Housing and Urban Development Act 1993 (the Act) 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.

So, on the extension of a lease with 40 years left to run at an annual rent of £100, the landlord will lose:

(1) the right to have vacant possession in 40 years’ time and will instead have to wait 130 years; and

(2) 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”.

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% 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, 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’ or 130 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:

(a) £250,000 deferred for 40 years at x%, less

(b) £250,000 deferred for 130 years at x%.

For properties in prime central London, the Upper Tribunal (Lands Chamber) has effectively fixed the deferment rate for flats at 5% – Earl Cadogan and another v Sportelli [2007] EWCA Civ 1042[2007] 1 EGLR 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 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. The right to receive £100 in 39 years’ time is worth less than the right to receive £100 now. To get round 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 6 and 7% but some recent cases have seen much lower rates being achieved which leads to higher premiums.

Marriage value

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:

(1) the sum of the value of the leaseholder’s interest and the value of the freeholders’ interest before the new lease is granted; and

(2) the sum of the leaseholder’s interest and the value of the freeholder’s interest after the new lease is granted (Schedule 13, paragraph 4 of the Act).

These sums must be determined on various assumptions, including an assumption that the Act does not confer a right to acquire a new lease of the flat, ie, 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 almost impossible to find properly comparable sales of short leases. Where there is a comparable sale of a flat on a short lease “with Act rights”, a deduction must be made for the value of those rights.

Where no market evidence of short lease sales exists, valuers must resort to “relativity graphs”. Relativity is a term that 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 existing 40-year lease is worth £175,000, the relativity would be 70% (£175,000 divided by £250,000). 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 doesn’t exist (ie a short lease with no right to extend), they are often the only method available.

Proposals for reform

The Law Commission has been asked to propose valuation methods which are simpler and reduce premiums and costs. However, it must also have an eye to the landlord’s rights under Article 1 of the First Protocol to the European Convention on Human Rights.

The least radical proposal for reform put forward 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 Act rights, and the capitalisation and deferment rates. There might still be a dispute on the freehold value of the flat but, once established, the rest of the valuation would be straightforward. No doubt there would be much debate as to what the prescribed rates should be but, once fixed, the scope for valuation arguments would be much reduced.

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 loss of the deferred freehold value and the capitalised rent. The Law Commission’s 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 but, as marriage value exists, it would 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 formula based on 10 times the ground rent has been suggested in parliament. The problem with this approach is that the level of ground rent is often arbitrary – a flat in Skegness might have a ground rent which is significantly higher than that of a flat in Mayfair – and the landlord would receive no compensation for the loss of the reversion. 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% – of the freehold value of the flat. This, though, would 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.

The Law Commission has suggested that it might not be appropriate to have a “one size fits all” method of valuation. Perhaps there could be a different method for valuing flats which are homes rather than investments or there could be a different scheme for low value claims. It has invited views on its proposals and it will be interesting to see what emerges from this process in due course.

Nicola Muir is a barrister at Tanfield Chambers

The Law Commission report, Leasehold home ownership: buying your freehold or extending your lease, and details of how to respond to the consultation by the 20 November are at: www.lawcom.gov.uk/project/leasehold-enfranchisement/#leasehold-enfranchisement

 

Published in Estates Gazette 16th October 2018