Leasehold reform?

There are more than four million leasehold homes in England alone, according to government estimates, and while flats have almost always been owned on a leasehold basis, in recent years it has also increasingly been the model used for newly built houses.

This was viewed as a worrying trend by the government and in December 2017 it announced plans to tackle the “growing problem” of newly built houses sold as leasehold rather than freehold, and to limit ground rents on new lease agreements. 

It also pledged to address other problems commonly associated with the leasehold model including “disproportionate costs to extend leases; poor value property management; and a slow and costly sales process”.

To this end, leasehold reform was included in the Law Commission’s 13th Programme of Law Reform, with the aim of finding ways to make buying a freehold or extending a lease “easier, faster, fairer and cheaper”. This culminated in the Law Commission publishing three reports in July 2020, recommending reforms to: 

1. Leasehold enfranchisement – the right for people who own property on a long lease (leaseholders) to buy the freehold or extend their lease.
2. The right to manage – the right for leaseholders to take over the management of their building without buying the freehold.
3. Commonhold – a currently rarely used model in the UK which allows for the freehold ownership of flats, offering an alternative way of owning property which avoids the shortcomings of leasehold ownership. 

Ground rent ban

Off the back of these recommendations, the government this year introduced the Leasehold Reform (Ground Rent) Act 2022 (the Act), which will see ground rent charges on most new residential leases in England and Wales banned from 30 June 2022. The Act – which will also apply to new retirement homes from 1 April 2023 – was viewed by government as a key milestone in its work to fix the leasehold system and to level up home ownership. 

The ground rent regime has long drawn criticism, given that leaseholders receive no return or value for the ground rent, and because ground rents with short review periods have risen dramatically in recent years, which allow landlords to double the ground rent every few years, depending on the review period stipulated in the lease.

The legislation has drawn some criticism for not being retrospective – when an amendment was tabled to remove ground rents from all existing leasehold properties, it was defeated by 306 votes to 162 – and does not therefore help existing leaseholders struggling with crippling ground rent bills. 

The impact on leaseholders, freeholders and developers 

Indeed arguably, the new Act will add to the woes of existing leaseholders because if they are looking to sell their leasehold, prospective buyer would be deterred by the idea of paying even a reasonable existing ground rent, as this charge has now essentially been outlawed. 

A second bill to address issues with existing ground rents has been promised, but there is still no indication on timings. At this stage then, existing leaseholders can take only small solace from the fact the Act provides that for existing leaseholders who choose to extend their leases through the non-statutory route, the ground rent will now be restricted to zero on that newly extended term. 

 

Changing the law so that the ground rent ban applied retrospectively would be the ‘nuclear option’ which would cause major disruption to investors, says Robert Haigh, a partner and lease enfranchisement lead at property advisers Matthews & Goodman. “If it is not applied retrospectively, however, it may actually have the unintended consequence of creating further woes for owners of leasehold houses – making them even more unattractive a proposition for some buyers.” 

On the face of it, the ground rent ban appears to be beneficial for tenants of new leases, says Joanne Cummings, residential and commercial property partner at Spencer West; however, this will have a significant effect on all freeholders who intend to grant new leases as their ability to charge ground rent will cease. 

“This will create a two-tier leasehold system: for those freeholders and leaseholders who entered into a lease prior to the commencement of the Act and those new freeholders and leaseholders who entered into leases after the Act has come into force. This two-tier system may also exist within the same development. This will ultimately have an effect on the leasehold property market going forward,” she comments.

Developers will need to consider if the loss of ground rent means that the development of apartment blocks is no longer profitable, she suggests. “Insurance and legitimate administration charges are still ways for developers to make a profit. They need to be careful not to charge an administration charge in connection with or in respect of a peppercorn rent. This will be in breach of the Act and may render a fine.”

Cummings warns that leaseholders may find that freeholders and developers are required to increase the premiums to compensate for the loss of income that this Act will bring about. “Many developers have already adapted their leases in readiness and many have already reduced their ground rents to a peppercorn and may have adjusted their premiums already. However, those developers who planned to grant leases in phases will find that some leases will generate ground rent and others will not. If ground rent income was taken into account when financing was obtained, this could result in a cashflow issue once ground rent from the new leases ceases.”

It may be more difficult for developers to sell their reversions on to investors as the income from ground rent on new developments will be lost, she says. “This does make those old developments with ground rent income more valuable. You may find that some freeholders / developers are able to cash in.”

Her advice to leaseholders is to be prepared to pay higher premiums for new developments to compensate developers for loss of ground rent, and the requirement to contribute to the Building Safety Levy. “Alternatively, leaseholders should look for properties which fall under the old ground rent regime. This may ultimately be a commercial decision.”

As commercial leases are exempt from the Act, there may be an appetite for investors to develop more commercial premises where ground rent receipts are certain for the foreseeable future – particularly as businesses and workers are returning to the office post lockdown. Cummings adds that “this may result in more applications for change of use from residential to be made. However, whether this is an attractive trend for the local government is debateable in light of the housing shortage in the UK”.

The biggest losers from the incoming changes are the developers and pension funds who bought into leaseholds for the residual income, says Stuart Collar-Brown, co-founder and director of My Auction. “Individuals whose pensions are invested in long-term, low-risk portfolios such as ground rents, will also lose out when the government’s changes hit the market.”

For leaseholders, this change could make it more expensive to get a lease extension on existing leases, says Danny Stern, head of property litigation at Slater Heelis. “Developers will need to find another source of revenue to replace ground rents, and may start selling more freeholds as a result. Estate agents may be more conscious of ground rent and of advertising leaseholds for sale, including the particulars of what, if any, ground rent clause there is.”

Freeholders, leaseholders and property professionals will be affected in different ways by the incoming reforms, says Cummings. “Freeholders may be in a rush to sell leaseholds before the Act comes into force so they can continue to charge ground rents, while tenants of new leases may find themselves increasingly asked to be directors of management companies that may own the freehold. This means that unless they outsource management of the building and the filing requirements of the company, this could put their freehold ownership of the lease in jeopardy.”

Property lawyers, she says, will see increased enquiries from leaseholders relating to surrenders and regrants; while lawyers acting for purchasers of new leases that have not yet completed which contain ground rent provisions will need to ask their clients to consider if they progress with the purchase or hold off without knowing how much the premium may be affected.

“Surveyors will need to consider how new lease premiums are to be valued; with the two-tier leasehold system, how estate agents market properties that are still subject to ground rents will have to be carefully considered together with surveyors and lenders. Although most major developers have already started to implement the changes into their leases, those smaller developers that have not do not have much time to make changes. They will need to carefully check and ensure they are not requesting or accepting ground rents unlawfully.”

Right to manage

Having seen the ground rent reforms successfully through, the government has now consulted on another package of leasehold reforms. The consultation, which ended on 22 February 2022, sought views on proposals to give more leaseholders the ability to manage or own their properties in buildings where there is a mixture of homes and other non-residential facilities.

Currently, if non-residential properties take up more than 25% of the total floorspace, leaseholders cannot collectively bid to buy their building outright through enfranchisement or take over the management of their building, in what is known as a ‘right to manage’. The new proposals would give these leaseholders the right to manage or buy their building outright, by increasing this limit to 50%.

The proposed increase in the non-residential element from 25% up to 50% will allow for the enfranchisement of more mixed-use buildings, says Sarah Barnes, a partner and head of residential property at Napthens; but that being said, a cap will still exist, and many buildings will still not be included within these parameters.

“The primary benefit for leaseholders, is that they will have more control of the management of their building,” Barnes believes, “while the main drawback is that many leaseholders will fail to appreciate the complexity of what is required when managing a mixed-use building. Landlords will have far more experience in this area and will therefore have a better understanding of which agents to instruct.”

Though this proposed change would enable a greater number of tenants to enfranchise, says David Lester, a partner at Blythe Liggins, one drawback might be that the management of a mixed-use building where a large proportion is non-residential may require greater management time and expertise than a purely residential block. “This means the resident-owned landlord may have more need to outsource the management to a professional managing agent, thereby negating some of the potential cost savings by being self-administered.”

The current consultation concerning the amendment to the current thresholds for residential versus non-residential use in a building is encouraging, says Katie Cohen, a property partner and leasehold enfranchisement specialist at Keystone Law. 

“It will enable leaseholders in otherwise non-qualifying buildings comprising in excess of 25% commercial use to enfranchise, which in my experience, has been a barrier to acquiring the freehold, throughout my 15 years of practice. Many buildings in London especially fall within this category and this will invariably extend, yet again, the heavily debated ‘what is a house?’.”

This proposal is probably the most contentious of the changes mooted in the consultation, remarks Tim Jordan, director of conveyancing in the property group at SAS Daniels LLP. “This will be welcomed by residential leaseholders who wish to acquire freeholds with a more significant commercial element, but may be met with dismay by freeholders threatened with losing control of their investments, notwithstanding some of the safeguards being proposed.”

Changes to freehold

Other proposals in the consultation aim to make it cheaper for leaseholders to collectively buy their freehold. A ‘mandatory leaseback’ would require landlords to keep a lease on some properties in the building. This means reducing the cost of a collective buyout of their building.

This proposal, says Lester, is probably the most contentious of those mooted in the consultation. “It has the potential effect of reducing the cost of acquiring the freehold and leaving the landlord with part-ownership of the building.” 

What the government needs to factor in and consider is a choice element for leaseholders, says Collar-Brown. “They may not want to, or may not be in the financial position to, purchase the share of freehold for their property and they should not be penalised for this. The whole idea behind the proposed changes is to make the leaseholders’ lives easier, so the government must not lose focus of this aim.”

Leaseholders may also see the cost of enfranchisement reduce further with future government proposals announced last year, such as allowing leaseholders to extend their lease by 990 years at a peppercorn rent, abolishing marriage value and capping the treatment of ground rent in the valuation calculation at 0.1% of the property value.

The leasehold reforms will be welcomed in general by property lawyers, leaseholders, surveyors and estate agents, as anything which clarifies and simplifies the system is good for these parties, says Zoe Longman, head of Burges Salmon’s residential real estate team.

Freeholders and developers will be less welcoming of the changes however, she warns. “The reduction in ground rent for new leases will remove a potential investment source and owners of large leasehold and freehold reversionary interests will fear changes proposed to determination of valuation rates and removal of marriage value as a single biggest threat to their receipts and values.”

There are many pitfalls that are exploited by freeholders to deny the rights of leaseholders to acquire their freeholds and extend their leases, which can be ironed out and, in most cases, exhausted if a standardised process was implemented, says Cohen. 

“Ensuring that the leaseholder knew from the outset whether a claim would be accepted is, of course, beneficial. Knowing the likely cost for their freehold or lease extension is also advantageous but freeholders will no doubt be on tenterhooks to understand whether the proposed extinguishment of, for example, marriage value will be implemented and if so, at what cost for short leasehold reversionary investments.”

What the industry needs more than anything at present is clarity, declares Collar-Brown. “We need definitive answers from the government on what is going to be implemented and when. The market has been in a state of limbo since the changes were originally proposed back in 2016 and uncertainty is never good for any market.” 

The proposed leaseholder calculator will, however, be a change welcomed by many across the industry, particularly surveyors, he says. “The calculator would provide the clarity required by many and help eliminate the back and forth of offers between leaseholders and freeholders.”

Commonhold

The government is also calling for views on changes to support greater use of commonhold, as an alternative form of homeownership to leasehold – including for those in shared ownership schemes in England. The commonhold model is used in countries across the world and provides a structure for homeowners to collectively own the building their flat is in from the outset – with a greater say on their building’s management, shared facilities and related costs.

This proposed reform appears to be a small step towards making commonhold a more common option for flats and abolishing leaseholds altogether – much to the glee of anti-leasehold campaigners, says Cummings.

“The main benefit of commonhold is there are no terms which makes a leasehold interest an ever-decreasing asset. It also disposes with the need for freehold interests to be involved with the management of block or the estate. By making freehold reversions less valuable, it will lead to more developments being managed by leaseholders who own a share of the freehold. This will make the transition to commonhold much more natural. Since the introduction to commonhold in 2002, there are only a handful of registered commonhold which suggests that this may be the catalyst.”

Levelling up?

For property lawyers, implementing these new proposals will be a complicated time as they navigate the legalities of the changes, says Collar-Brown. “At present, so many protections are in place around leases and if it all changes, there is currently no clarity for property lawyers to know what to do. With everything around leases being so black and white, it will be a case of trial and error as property lawyers seek clarity on the situation. This could have a knock-on effect on the industry with property lawyers needing to therefore charge higher fees due to the higher level of work involved,” he adds. 

Ultimately, says Jordan, the market will take time to settle as the proposed changes will be quite far reaching if they are all introduced. “In my view, proposed buyers or developers should try to be patient before jumping into a purchase or investment too quickly, although of course personal circumstances may dictate otherwise.”

In the short term of one to five years, we are likely to see a smaller leasehold market as fewer leaseholds will be created, says Stern. “If the legislation is extended to abolish ground rents in existing leases too, then developers may want to consider selling those leaseholds altogether (if they haven’t already done so).” 

Cohen hopes that within the next five years we will have a working Act which has revolutionised the ‘mishmash’ of Acts and regulations governing the enfranchisement arena. “The amalgamation of an Act covering not only houses but flats also would be welcomed and would represent the biggest overhaul of the leasehold system since the enactment of the 1967 Act, which in practice is difficult to navigate due to many provisions being unworkable and irrelevant.”  

She predicts, however, that it is unlikely that many changes will happen in the next one to three years due to the complexities of the proposed changes and the need, in her view, to get the balance between the freeholders and leaseholders’ interest aligned. 

“I would anticipate significant challenges from the prime central London estates, particularly if proposed changes were significantly disadvantageous to their valuable short leasehold reversionary investments. Changes and reforms are of course very much welcomed, but the devil is very much in the detail,” she adds.