Residential long leasehold new properties have been in the spotlight recently, so what of commercial long leaseholds both existing and new, and is there another way of transacting?
Here we set out some of the aspects of long leaseholds, what they mean and how they could be altered in the future to encourage investment and play a better part in place-making in towns and cities across the UK.
1 Control of Use
The ‘user clause’ in the long leasehold is probably the most crucial clause as there is often no test of reasonableness when it comes tothe leaseholder wishing to change the use of the property.
It is, however, set at the start of a long lease and so the long leaseholder must anticipate any changes in use over a very long period of time possibly upwards of 100 years. This is almost impossible to do and the clause should allow for scope for modernisation as far as the long lessee is concerned or they risk being potentially held to ransom during the course of the lease.
Many town centre leaseholds prevent “upwards” development. Such clauses should allow for the property to be developed incrementally both horizontally and vertically over a period of time (probably 150 years) as many long leases currently discourage regeneration. Control of an area to enable place-making is a real consideration both for the landlord and the long leaseholder.
2 Site Management
This relates to the fact that the third-party rights are not easily enforced one against another and therefore a landlord enforcement basis enables service charge payments to be made.
Rent charges in the past have been used, but many solicitors will say these can be much more penal than the actual long leasehold system. In European countries and, indeed, in Australia strata title is much more common, but how easily the repairing obligations are enforced remains to be seen.
The alternative here may be a share in a freehold owning company in conjunction with long leases. This is often the way that sales of ground rents back to the occupying lessees are affected on blocks of apartments. Perhaps we can learn from the current debate on commonholds on residential property so that unit owners no longer have a wasting asset and share in decisions on how service charge budgets are set and enable a statutory charge to ensure payment. There are doubts, however, as to how such payments would be enforced.
It is not only local authorities that find income valuable rather than perhaps a capital receipt in whole or part. Trusts, of which there are many in Birmingham, notably King Edward School Foundation and Calthorpe Estates find the income extremely valuable to receive from a development where they do not wish to take full equity involvement. Indeed, historically, Governments have restricted the capital receipts that local authorities were able to receive so that land value was converted to income and subsequently reduce rents and take premiums in lieu.
It does, however, bring about the nightmares of trying to assess a ground rent when the only reference is to the value of the land, as there is very little evidence for actual rentals for the land. This is generally overcome by gearing the ground rent payable to the freeholder to the occupational rentals and excessive gearing above 10 per cent is to the detriment of the long leaseholder’s investment value as is the basis of gearing. The Landlord invariably wishes to share in the uplift in rental value but the long lessee only wishes to part with a share of the actually received income.
There are mechanisms to accommodate the various interests but they all have an impact on the investment value of the long leaseholder’s interest which should be borne in mind at the outset.
Perhaps fixed increases or RPI/CPI increases will start to be seen in commercial ground leases as well as residential with or without caps and collars.
One alternative may be to offer full equity in part of the development equivalent to the capital value of the site. This may appeal to certain organisations but, equally, may be more difficult for Trusts who are looking for certainty of income. Perhaps a more equity-based vehicle might have to be the solution.
4 What should the length of term be?
It may well be that certain properties need lease lengths to allow for redevelopment as they have to be viewed in conjunction with adjoining sites. This is back to the overall control of certain areas which estates, trusts and local authorities have to bear in mind.
The difficult balance of having leases expire at similar times to facilitate renewal and redevelopment without seeing areas of decline is one of skilful management. So what size of redevelopment should be envisaged? Large enough to allow repositioning eg Edgbaston Village but of a manageable size to allow for incremental development.
Is a comprehensive plan always the answer or should town centres especially be allowed to develop incrementally? An element of fortune is also needed as to when the leases expire against where we are in the property cycle.
The original terms granted were invariably 99 years, with some extended to 99 years plus an option to extend by 26 years to mitigate stamp duty at the time. It certainly is our belief that below 75 years the valuation tables do not fully reflect the impact or the shortening of the term. The lease is a diminishing asset and below this length financing can be a problem and becomes a diminishing asset on the balance sheet whilst still being operationally useful.
Obviously to the freeholder this becomes increasingly valuable and we would suggest that a minimum of 150 years with perhaps redevelopment clauses and preferably longer if a long leasehold is required within an overall development to allow for sensible collection of service charges. On a multi-phase scheme the last phase may well be ten years after the first so lease lengths need to accommodate this.
If this long leasehold however is the ground floor of a building perhaps where there are other uses above invariably residential or offices, the longer-term requirements for the redevelopment of a building are required to be thought through.
Very few long leaseholds ever reach expiry and it is certainly the case that very few practitioners are aware that provided the long lessee is a commercial tenant that they would be entitled to an occupational ‘rack rented’ lease at the expiry of their long lease, so the freeholder in effect carries out a 1954 Act renewal.
These are both the assessment of capital values and the rents at review.
Review rents, where not linked to income or values on the building, were often based on a 25 to 33 year review pattern based on land values. There is evidence for low yields being paid for ground rent investments but against high freehold land values but all of which vary significantly and therefore all cases will need to be assessed individually.
The valuation of long leaseholds interest can be a problem and different answers arise from the various methods used. Traditionally valuers have used “dual rate“ with a sinking fund of perhaps three or four per cent but where can such interest rates be obtained? Is the income received quarterly in advance or annually in arrears (as the tables assume)? Should that sinking fund assume tax and, if so, at what rate. Where are the comparables as a lot of purchases are from gross fund buyers? Hence the same sets of facts produce very different results.
So do long leaseholds deter investment, redevelopment and regeneration? This is a ‘disputed yes’ where leases have fallen to 75 years or less. Even those with under 100 years can cause reluctance to regenerate or redevelop.
But, like most answers to a complex debate, it depends. Certain institutions will not buy anything other than freehold as a matter of policy, excepting capital allowance situations with the option to purchase the freehold once all claims have been made.
Others may be prepared to deal with well-known long-term estate owners where the value of control is reflected eg Regent Street or it may be reflected in the price. Could a joint venture company with share ownerships to the respective parties be the answer? Can the differing decision-making processes (and criteria) be accommodated or are we back to splitting up ownerships with full ownership of part in lieu of a premium and ground rent model.
Whatever your view, it’s certainly time for a proper debate.