Many landlords are attracted to investing in property because they feel their money is always safe in ‘bricks and mortar’.
However, in these riskier times Property Hawk looks at an alternative investment. One based around a strategy which suggests that actually investing on the land on which these bricks and mortar sit may be the better option. What we are talking about is investing in ground rents.
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In very simple terms ground rent is the rent paid by owners of the land on which a building sits. In most domestic property there is a single owner of a property the freeholder. However, where property has been developed for apartments for instance the ownership is often split into freehold and leasehold interests. The leaseholder will generally own the bricks and mortar i.e. the apartments. The freeholder retains the ownership of the land. In return for the use of the land on which the building is located the leaseholder is required to pay the freeholder a small annual rent. This is the ground rent. This system has developed historically through the system of Common Law. The Conservative Government of Teresa May has proposed to stop ground rent abuse.
Many buyers of new build homes and this includes both houses and flats purchase their property as a leasehold interest. This means that they have to pay a rent, frequently annual for the benefit of the land on which the property sits. The freehold interest is either retained by the developer or frequently sold off by them to specialist ground rent owning property businesses. Traditionally these ground rents generated what was known as a peppercorn rent which referred to the negligible value of the rent in relation to the property or leaseholds capital value. However, there has been increasing instances of developers imposing unreasonable escalations into the ground rents they charge which when coupled with static capital values experienced in the value of property in some parts of the UK has resulted in potentially disproportionately high grounds rents being charged (certainly not the intended peppercorn) making these properties virtually unsaleable.
An example reported in the media was that of Clair Scott whose claimed that her new build £200k terrace property was made unsaleable because the ground rent was projected to soar to £9,440 by 2060. This rapid escalation in ground rent ground rent double every 10 year has the impact of putting off potential buyers and also clauses and also can be seen as unacceptably onerous by some mortgage companies thereby limiting the choice of mortgage companies to potential purchasers. When escalating grounds rents are added to inflated service charges and management fees charged by management companies then the costs to an owners and potential residential landlord can significantly squeeze a landlords net rental yield.
The Conservative Government of Teresa May have promised to respond to a campaign by the Guardian newspaper and to stamp out abuses of the system. One of the house builders Taylor Wimpy accused of abusing the ground rent system has stated that it will carry out an internal review.
New builds are not the only area where unscrupulous landlord seek to exploit the situation of re-gearing the leaseholders lease. Some opportunistic and some would argue unscrupulous landlords acquire vast numbers of ground rents which pay a peppercorn rent and then look at pouncing when a landlord or leaseholder is most vulnerable; when they look to sell their property.
Companies such as Hamilton King and Southern Land Securities act together to generate value from what to most investors would see as low yielding investments. How do they do this? These companies which receive a peppercorn rent from most of their leaseholders. However, when it comes to selling a property many unsuspecting owners (landlords such as myself amongst them) will be tripped up by the fact they had carried out such innocuous works such as replacing their rotting wooden windows with nice shiny UPVC windows believing that this was an improvement. Only to find out when completing the sellers pack that they should have obtained consent from the freeholder first. The result is that the landlord holds the owner over a barrel whilst they are trying to obtain a sale of their property by forcing the leaseholder to sign a deed of variation which in normal circumstances an owner would throw out as ridiculous. Instead they are ‘forced’ to sign a deed of variation agreeing to a massive increase in the ground rent sometimes in the order of a 1000% and then as is the case of the new build developments above they also have to agree to heavily geared escalator clauses in the lease requiring the ground rent to double every 10 years. On top of these changes to the lease the owner also has to pay hundreds of pounds in legal fees to bring about this detrimental change in the lease. All of this is carried out under the guises of a legitimate business practices.
Failure to pay the ground rent is a very serious matter. It would normally result in the freeholder ultimately taking action to reclaim the leasehold interest so should be avoided by the leaseholder at all costs. However, there are routes available under certain circumstances for the leaseholder to buy their own freehold. The result is if the leaseholder owns an apartment then they will buy a share of the freehold with the other apartment owners. In the couse of an owner of a house then there are slightly different mechanisms for the leaseholder to buy the freehold of the land on which their house sits. Freeholders who look to sell the freehold interests for a block of apartments are required to offer it first to the leaseholders in the block of apartments first under legislation within the ammended Housing Act 1996. The Right of First Refusal (RFR) is provided by Part 1 of the Landlord and Tenant Act 1987 (the 1987 Act) as amended by the Housing Act 1996.
If you do have specific legal questions about ground rent abuse, leasehold enfranchisement you can sign up and post your question to the dedicated part of our landlord forum.
Investors are increasingly seeking out low risk investments paying high levels of income. This is an investment profile that fits ground rents where the owner and landlord ultimately has the sanction to take back the freehold of the land if the leaseholder fails to pay their rent. This is a big incentive for the leaseholder to keep paying the very small ground rents and not to default on the lease. It also gives the landlord a great deal of security as failure of the tenant to make payments could ultimately result in the landlord taking the land back and then making a big capital gain on the reversion of the freehold interest to them. A no lose scenario.
Many landlords are put off by the slightly unusual nature of these investments. But James Cannon, Savills head of commercial auctions explains ground rents are the ‘closest proxy to investing in bonds that the property industry offers’.
“Too many investors overlook the huge returns on offer”, says Sinead Cruise a journalist for Property Week recently commented.
The market in ground rent investments is now a mature market with a number of businesses operating in the sector. Low returns on investments have made investing in ground rents attractive for income seekng investors.
Income returns from these investments are not stellar however compared to the 0.5% available to many investors with cash they look very attractive. Ground rent investments produce an annual income of around 6% although this varies considerably depending on the time period to reversion. Where a landlord is prepared to sweat the assets these could be several percent higher taking the annual income to around 10%. This is because landlords are often responsible for ensuring that the buildings have appropriate landlord building insurance.
In these cases a landlord will often have the opportunity to gain an introducers fee from the landlord insurance broker.
Gary Murphy a partner with Allsop and a residential auctioneer who sells many ground rents explains the potential upside of ground rent investments: ‘Ground rents can be both dry and active investments, depending on the type of ground rent you buy and your appetite to sweat the asset.’
Murphy points to three main angles of opportunity that investors have exploited: lease extensions, development and management potential, and the chance to drive income from commissions paid to landlords by the insurers of the property. I have also indicated above how some landlords can sweat their assets to attract the maximum value out of their ground rent investments. In summary the main opportunities that exist are:
Landlords can potentially make money from their ground rents by granting them an extension to the length of their leasehold. These extensions are particularly lucrative when the length of the leasehold drops below 60 or 70 years because many lenders will then refuse to lend against a leasehold property making them un-mortgageable.
Development and management
The second angle is development and management. Murphy claims that investors have made fortunes from ground rents that cost them a fraction of their initial outlays.
‘Some agreements state that the leaseholder must obtain consent of the freeholder if he wants to conduct any refurbishment of the property,’ he says. ‘If the occupier wants to, say, knock a wall or extend a kitchen, the freeholder is within his rights to ask for some incentive.’
Other ground rent investors have taken full advantage of flat roof space or redundant garages to build penthouse flats or develop entire new properties.
There are a number of specialist ground rent companies that are interested in buying portfolios of ground rents to add to their portfolios. The companies are often backed by institutional money giving them large budgets to acquire portfolios of ground rents.
In October last year, Savills sold the biggest portfolio of industrial property ground rents in more than five years. It attracted a range of institutional bidders, including Prupim, which landed the portfolio for £59m, reflecting an initial yield of 3.65%.
Disposal of these portfolios can often provide a landlord with a large capital return after many years of carefully putting together a portfolio.
There are a number of ways for a landlord to buy ground rents. Many landlords will have come across the sale of ground rents in the auction rooms which specialise in selling these kinds of niche property investments.
The other alternative is to buy a ground rent through a specialist ground rent broker. One such specialist broker is the Ground Rent Business based in Essex. The brokerage, run by Richard Irving has tens of ground rents available starting at a few thousand pounds up to many hundreds of thousands for leases paying higher rents and with greater reversion potential.
For those landlords who do not want to get involved in the direct management of their ground rents it is possible to invest in a number of specialist funds.
One such fund launched recently by Braemar Securities is a £20m ground rents fund for private investors.
The fund will be structured as an OEIC (open-ended investment company) listed on the Channel Islands Stock Exchange and based in Guernsey. It expects to attract £20m investment in a period of between one and three years.
Braemar predicts ‘close to double-digit returns’, derived from a forecast 6%-7% yield from the ground rents, and a further 3% from introduction premiums from insurance companies.
It will be 60%-70% geared with debt ‘sourced from a big-name UK bank’ and will buy up ground rents from its own £250m residential portfolio, as well as from house builders.
Things to consider when looking to buy a ground rent: