Reforms to leasehold home ownership announced: lease extension

In summer 2020 the Law Commission published a series of reports following consultation into perceived shortcomings of current leasehold law with the aim of producing a number of recommendations for reform. One of those reports, "Leasehold home ownership: buying your freehold or extending your lease" focused on leaseholders' ability to extend their leases and enfranchisement rights.

The full report runs to almost 900 pages with proposed changes to the law governing leasehold extension set out primarily in chapter three. There is also a summary report which is shorter in length and therefore more accessible.

The government announced, on 7 January 2021, that a number of the recommendations made by the Law Commission will be implemented.

The reforms seek to address certain unfair effects within current leasehold law such as:

• prohibitive administration costs which can disincentivise or prove unaffordable to leaseholders wishing to achieve greater security (or be able to sell or re mortgage their homes) through lease extension;
• limits on term extensions (for leasehold houses this has been limited to a 50-year extension and for leasehold flats the term extension was limited to 90 years but with multiple opportunities to extend); and
• escalating ground rents, equating to significant ground rent liabilities for long leaseholders and resulting in properties being un-mortgageable or unsaleable.

Housing Secretary Robert Jenrick has stated that the reforms are intended to "reinforce the security that home ownership brings" and have been described by Sajid Javid MP as "sweeping away medieval leasehold laws." They also aim to make it easier for leaseholders to sell or re-mortgage their homes and may largely bring an end to ground rents as a source of financing in the residential sector.

The Government has announced that it will legislate to bring into effect the following.

1. Leaseholders of both houses and flats will now be able to extend their lease to?a new standard 990 years (maximum) with a zero ground rent.
2. A cap will also be introduced on the ground rent payable when a leaseholder chooses to either extend their lease or become the freeholder.
3. An?online calculator will be introduced so that leaseholders can more easily determine how much it will cost them to extend their lease (or purchase their freehold).
4. Abolition of marriage value.
5. Leaseholders will have the right to agree to a restriction on future development of their property to avoid paying development value.
6. Ground rents will be reduced to zero for all new retirement properties to 'protect the elderly'.

The announcement also states that "legislation will be brought forward...to set future ground rents to zero" which will form "the first part of seminal two-part reforming legislation in this Parliament."

The valuation reforms, referred to at points 2.c) to 2.e) above relate to recommendations set out in the Law Commission's Valuation Report published on 8 January 2020.

The Mayor of London has also issued a press release in which he has set out his expectation that all shared ownership homes built as part of the new Affordable Homes Programme (running from 2021-26) are sold with a 999-year lease as standard. Where possible, developers are also encouraged to offer private leasehold homes on similar basis.

The government's announcement sets out the headline principles that will be revised/introduced however it is light on detail. For a more in-depth idea of what the legislation might contain one has to turn to the chapter and verse of the Law Commission's report.

However, the details of the Law Commission's report may of course not translate in full into legislation. For example, the government's announcement does not mention certain details and recommendations set out in the Law Commission's report such as landlords' entitlement to obtain possession of the property for redevelopment purposes (recommendation 2 at paragraph 3.62 of the report) and the additional rights for leaseholders (recommendation 3 at paragraph 3.112 of the report) set out below ('what other reforms to lease extension might be expected?').

The government's headline announcements do not make it entirely clear what the outcome of the reform will be and again we must turn to the Law Commission's report for clues. For example:

• does the right to extend a lease for "990 years with a ground rent at zero" mean that any current ground rent for the current term still runs or does it get 'bought out'? The Law Commission report suggests that the current requirement for leaseholders simultaneously to extend their lease and to extinguish their ground rent would apply but also sets out a number of possibilities for retention or buy-out of ground rent depending on circumstances.
• how does the "cap...on ground rent payable when a leaseholder chooses to either extend their lease or become the freeholder" apply? The Law Commission report suggests this relates to the capping of ground rent in calculating the premium payable on extension.

How this turns out will determine the impact on existing ground rent portfolios.

The Law Commission report recommended that, in addition to the right to extend for 990 years at peppercorn rent there should be some additional rights. However, these do not expressly form part of the current government announcement:

• a new right for leaseholders with a very long remaining term (i.e. 250 years) to extinguish the ground rent under their lease (on payment of a premium) without extending the term of their lease; and
• a right for leaseholders with "onerous" ground rents to extend the term of their lease without buying out their ground rent (applicable in the event that the Government does not cap the treatment of ground rent in calculating enfranchisement premiums). It seems to have become generally accepted in the market (reflecting a view that has been held by valuers for many years) that a ground rent above 0.1% of the property's freehold value is onerous.

Notably, the Law Commission did not recommend a general additional right for leaseholders to extend their lease without changing the ground rent such despite such rents being "vitally important to landlords' interests and the interests of those behind them (such as pension funds and insurers)" and despite the fact that "continuation of ground rent can significantly reduce the premium payable for a lease extension." The report did acknowledge that retention of ground rents for the unexpired term of an existing lease can still occur under "voluntary" lease extensions agreed outside of the statutory scheme.

The Law Commission's report contained recommendations relating to both individual and collective enfranchisement, and so reforms in both areas may also be forthcoming.

The government has also announced that it will create a Commonhold Council to reinvigorate commonhold, and although this is not a reform to lease extension it indicates the direction of travel away from leasehold as a form of property ownership and the processes of extension and enfranchisement associated with it.

In October 2020, following the publication of the Law Commission reports, some property agents had begun reporting that residential ground rents were starting to be considered to be a more 'risky' asset class as the potential impact of the proposed reforms generated uncertainty around the traditionally low-risk investment status of residential ground rents.

Landlords and investors in ground rent portfolios will be wary of the uncertainty that could arise from the proposed reforms in terms of expected income, pricing and overall investment value:

• landlords may expect to receive a twofold reduction in income, firstly as a result of new methods of valuation/calculation of premium payable on lease extension and secondly due to the fact that a leaseholder need only seek an extension on one occasion;
• as a result of the abolition of marriage value, the uplift effect on premiums payable by leaseholders whose term falls below 80 years will no longer be realised by landlords and it is therefore expected that the overall result will be a lower premium (although it is expected that the 'abolition' of marriage value will be challenged and some valuers have suggested that consequential amendments to the valuation formula could result in an increase to premiums);
• some commentators have considered whether premiums may rise due to the fact that the element of the extension premium relating to the extended term will now be calculated on 990 years rather than 90 years however the differential in value between 90/990 years might not be as pronounced as anticipated (valuers will no doubt be considering this);
• the calculation of the costs of lease extension / freehold purchase should provide greater certainty by providing a standardised payment matrix rather than relying on protracted 'haggling' between parties which have resulted in certain cases in increased costs and discrepancies between valuations of flats within the same building (although as to how valuers and government will agree on a standardised matrix remains to be seen);
• investors who purchased freehold interests with the intention of selling those interests to leaseholders in the future could suffer lower returns and loss in value to their portfolio;
• restricting ground rents (particularly 'zeroing' of ground rents) will mean that developers will not receive or be able to sell a steady ground rent income;
• impacts may be most keenly felt by pension funds, local authorities and housing associations who have what might be considered to be socially 'legitimate' freehold ownership of residential blocks. It is expected that there will be fairly strong opposition to these proposals from some quarters so it is possible that the position could be softened for those groups which can be said to have a social responsibility. However, no specific carve-outs have been mentioned and MHCLG's previous statements about restricting ground rents to zero in leases on future sales of leasehold homes have suggested the adoption of a universal approach;
• the extinguishment of ground rents (depending on how these are legislated for) and the expected reduction in renewal premiums could have the combined effect of increasing initial lease premiums (this may well be marginal in cases where pricing has already been fairly set and is not 'upset' by ground rent changes) although this may well be tempered by the market;
• loss of ground rent may cause landlords to have a less active interest in a building, this is likely to be felt most acutely where more socially motivated ground rent investors have taken a proactive approach to their investments, however the change may be imperceptible in cases where investors have sought primarily to collect their income.
• loss of ground rent may leave a 'gap' in landlord's funds in terms of any costs which it is not possible to recover from leaseholders;
• restriction of ground rents could result in unviable projects if freehold investors are no longer able to make figures stack up to justify the price required by developers; as ever this will be most felt on schemes already started as generally developers who previously did place reliance on ground rent sale proceeds will factor the changed world into their acquisition land pricing.

The impact of these measures on investors/developers overall will depend on how various portfolios have been priced, development viability calculated, income streams calculated etc. For example, those who have traditionally excluded ground rent sales from their acquisition stacks may be better shielded against at least the immediate effects of the proposed changes.

It remains the case though that some ground rent investors who have built ground rent portfolios from assets without the worst excesses of ground rent, may find that legislative change retrospectively alters the value of their investment.

Prior to the government's announcement it was possible for investors to seek to mitigate the potential impact of reforms by appropriate pricing off the back of an agreed and satisfactory 'risk premium'. However, since the government's announcement on 7 January 2021, there are concerns that the market has been effectively 'sterilised' as the detail of the reforms are awaited.

One of the aims of the proposed legislation is to restrict future ground rents. However, the precise effect on existing leases with ground rents and whether there will be any retrospective application is unclear (although the ability to buy out the ground rent outlined above applies to existing leases).

The government has announced that it will be establishing a Commonhold Council to 'reinvigorate' the use of commonhold as a form of property ownership. There may, therefore, be future obligations that developments be commonhold thereby defeating any reason for ground rents as the building is owned collectively by the tenants. Rather than incentivise developers to adopt Commonhold, however, it seems that the approach is to disincentivise the use of leasehold by ending ground rents and reducing the financial benefits to freehold owners.

The government intends to restrict ground rents in some form, and in its recent announcement the government stated that it "has previously committed to restricting ground rents to zero for new leases to make the process fairer for leaseholders" and that "legislation will be brought forward...to set future ground rents to zero." As such it is expected that future legislation will prohibit ground rents, at least to some extent, in any new leases but at this stage it is unclear (except in the case of new retirement leases in respect of which the government has announced ground rents will be reduced to zero).

Bad practices have been recognised within the industry by lawyers, politicians, industry lobby groups and developers alike and although there is support for reform there are concerns around the possible broad-brush effects of such reforms:

• there has been criticism of the removal of ground rents with concerns around leaseholders being exposed to potentially higher or variable costs of building management in the absence of a 'professional freeholder';
• market-leading retirement developers have criticised the proposal to reduce ground rents to zero for all new retirement properties stating that "retirement has been caught in the crossfire of leasehold reform to address bad practices elsewhere"; and

• it is felt that certain of the reforms assume the existence of an unscrupulous investor/developer however this ignores those involved in responsible long-term investment who seek to take on the responsibility of protecting assets and reassuring homeowners that their homes will be maintained on the basis of fair and reasonable ground rents, and indeed others who bought a financial asset based on ground rents which were conservatively set.

   

It is difficult to gauge the full and real impact of the reforms without a draft bill to consider since we do not yet know how prescriptive or otherwise the drafting and the resulting criteria will be. However, the sector has already started to react. For example, it has been reported that in autumn/winter last year, a number of major housebuilders had already begun the process of removing ground rents on new flats or offering peppercorn ground rents with 999-year lease terms. This may be evidence of how resilient the market can be as it shifts to absorb and take control over the risks that might arise from leasehold reform.

It has not been an easy 12 months for anyone and it is likely that the sector will need to be flexible enough to weather further changes this year, in light not only of the reforms flowing form the Law Commission reports but also with wider-reaching reform and review of the Landlord and Tenant Act 1954 being widely discussed.

The commentary on timing remains imprecise:

• the statement in the government announcement on 7 January 2021 that legislation will be brought forward in the upcoming session of Parliament, to set future ground rents to zero;
• on 15 October 2020 a House of Commons publication stated that "The aim is to legislate "as soon as Parliamentary time allows".?The legislation, when published, will be informed by the outcome of the Law Commission's work and other, related consultation exercises."; and

• on 13 January 2020, Housing Secretary Robert Jenrick, referred to the publication of a draft Bill "shortly" (see Hansard for detail).