From the vantage point of the rostrum, in unprecedented economic times with historically low interest rates and persistently low inflation, the reversionary ground rent market (freehold ground rents sold subject to shorter residential leases) has been quietly picking up momentum in recent years. And why not? For those in the know, reversionary ground rents can provide investors with a secure, albeit modest, income return coupled with inherent growth potential not solely linked to the performance of the housing market.
It is widely recognised that non-reversionary ground rent investment has become a vehicle of choice for large-scale institutional funds in the last few years, which has seen pricing escalate rapidly for larger ground rent assets with periodic index linked reviews. Any historic rule of thumb of value equalling 10 times the ground rent as an indicator of value for ground rents has gone out of the window and has been replaced by a much more sophisticated bid level process factoring in review pattern, length of time to review, size of ground rent and an assessment of any potential bolt-ons such as management rights, insurance rights etc. Non-reversionary ground rents have certainly enjoyed being front and centre as the new kid on the investment block.
Yet, ground rent assets with shorter unexpired leases have largely been out of the spotlight. As lot sizes are typically relatively small – out of nearly 700 lots offered by UK auctioneers with leases subject to unexpired terms of less than 99 years between 2013 and 2016, the average lot size was c.£40,000 – reversionary ground rents are not particularly attractive to large scale investors and don’t particularly suit private treaty sales. Auction remains the most obvious marketplace for these assets and we can report that this market is performing well – and, crucially, is going through a period of reinvention.
Reinventing itself? Just how do you go about re-inventing a ground rent? Well, in reversionary ground rents, it can be said that ‘90 is the new 80’. The definition of what is and what isn’t considered ‘reversionary’ by the market has shifted towards pricing leases up to 90 years primarily on their lease extension premium potential rather than the value of their ground rent income stream. The income multipliers on assets with unexpired leases between 80 and 90 years have less and less relevance to the sale price – and are certainly not predictable. The much closer link for these assets is now with the potential lease extension premium a lease would attract for the freeholder. The resultant pricing implications for investors and vendors are significant when considering investment strategies and are unlikely to change in the foreseeable future.
Market forces are a strange beast but, we would argue that the shift in perception on reversionary ground rents is entirely logical. This is because:
- Newly created apartment leases with initial terms of 99 years are very rare in today’s market. Most housebuilders and developers offer 125 years plus, preferring to extract value from review provisions and market ground rents of £250 plus rather than creating inherent value from ever shortening leases and lease extension potential. This inevitably creates scarcity in the market. It will be a number of years until the more modern 125 plus year leases tick down to become reversionary.
- Under the 1993 Leasehold Reform and Urban Development Act, while ‘marriage value’ only kicks in for lease extensions on leases with unexpired terms of under 80 years, for any lease extended, the tenant must compensate the landlord for the right to receive the property back at the end of the lease. The statutory calculation is with relation to the deferment rate – typically between 5% (Central London) and 6%. Ignoring the maths, this means that in practice the inherent reversionary value of the asset (assuming static house prices) increases between 5% and 6% year in, year out. With any house price growth, this effect is amplified.
- Within a low return environment, the price point for reversionary ground rents is relatively small compared to other forms of property investment. Equally, for freehold residential assets under £40,000 there are no Stamp Duty obligations, making this quite a tax efficient investment for a wide range of buyers.
- The sophistication in pricing we have witnessed in non-reversionary ground rents has begun to filter in to the reversionary market as traditional ground rent buyers have been priced out of non-reversionary assets by large scale purchasers with very different pricing models. Reversionary ground rents have been perceived to offer better value for money to smaller investors.
- The underlying pressure on lessees needing lease extensions at higher unexpired terms is apparent. With increasingly tightened mortgage lending rules and many borrowers taking on longer term loans, the marketability of shorter leases in the housing market has been diminished, particularly since the late noughties recession. This is unlikely to relax any time soon.
Given the current economic climate and the likely pressure on short lease holders to extend leases to either maximise their asset, facilitate a house move or secure a mortgage, we envisage that the spotlight will brighten on the opportunity offered by the reversionary ground rent market over the next few years. This is particularly the case for assets with 80 to 90 years unexpired.
We would strongly encourage any owners of such assets who are considering their investment strategy to make sure to seek a professional appraisal of pricing to ensure they can be confident they are maximising the potential of their increasingly valuable, and increasingly rare, asset.
Richard Watson is a partner at Allsop, one of the UK’s leading property auction firms.