Ground rent reform: consultation and comment
In the low yield environment that dominated following the global financial crisis, until recent interest rate increases, the long term and predefined cash flows of ground rent investments enabled financial institutions such as pension funds to match long duration liabilities with a return which, at that time, represented an attractive return relative to fixed income investments.
In an inflationary environment, ground leases can also provide a degree of inflation protection, often featuring inflation-linked payment obligations (such as RPI or CPI linked increases). These attributes resulted in a number of long income and ground lease investment funds being launched in the UK targeting institutional investors, such as pension funds, many of which include residential ground lease investments.
A criticism of ground rent is the apparent lack of benefit to the tenant. In contrast to service charges, for which payment is made for services rendered, ground rents are paid by tenants simply as a standing cost. From the landlord’s perspective, the benefit is realised by the tenant at the acquisition of the lease for which the tenant has paid a reduced premium. Therein lies a balancing of commercial opportunity.
However, it is more difficult to rationalise ground rent provisions within leases that create an exponential increase in the amount due, for example, doubling every five years. This has resulted in leases bearing those characteristics becoming less attractive to buyers and lenders, with the latter being primarily concerned that future escalation of ground rent may become unaffordable for borrowers, with a knock-on effect on the ability for mortgages to be serviced.
The Leasehold Reform (Ground Rent) Act 2022 (LR(GR)A 2022) came into force on 30 June 20221 with the effect of restricting ground rent under all newly granted long residential leases2 in England and Wales to a peppercorn. The Government has since announced a consultation into ground rents payable under existing leases to deliver on its "aim of giving leaseholders a fairer deal." The consultation poses five options to address "existing anachronistic leases which are not suitable for a modern housing market."
The consultation is not consistent in its reference to the type of lease to which the new proposals will apply – namely because part of the consultation is to identify what sorts of leases should properly be excluded from the reach of any subsequent legislation. However, one might expect that, to level the playing field, the provisions must be intended to apply to long residential leases that would satisfy the criteria for a "regulated lease" under the LR(GR)A 2022.
This would have the same effect as the LR(GR)A 2022. Tenants would effectively not be required to pay any ground rent – the landlord could still demand a peppercorn but this would in practice mean a zero payment by tenants. This is the most onerous of the options from an investor perspective as it will immediately erode value in any ground rent portfolio. The Government acknowledges "that there are potential risks that some freeholders may leave the market if a peppercorn cap was introduced" and have invited feedback from relevant stakeholders to provide feedback as to the probability of this occurring.
This would mean that in leases where ground rent is lower than the capped amount, the ground rent would never be able to exceed the cap and in leases where ground rent already exceeds the cap, the current ground rent income stream would be reduced to the capped level. This is the most straightforward of the proposals, and will be capable of achieving broad understanding amongst landlords and tenants. A cap fixed for the lifetime of the lease would protect tenants from unmanageable charges whilst retaining a certain, and therefore costed, income for investors and landlords. Depending on the level of the cap (ground rent in London is normally somewhere between £500 – £1,000 per residential unit, therefore any cap above £1,500 would likely be regarded as unusual and onerous) investors may be impacted differently, particularly in the shorter term. Some may not be able to realise the future full potential growth of their portfolios over time, whereas others may experience an immediate downturn in income. Option 2, like option 1, has the benefit of being unequivocal and therefore the chance of enforcement action being taken against landlords who may inadvertently charge an incorrect ground rent is lower than for the alternative options.
This proposal necessitates what might ultimately be a complex calculation (for example, index linked and 0.1% of property value). It is possible that this would generate grounds for dispute – there would need to be agreement as to the value at a point in time and that point in time itself would need to be carefully selected so as not to artificially inflate or depress the figure upon which the ground rent percentage is calculated. The consultation proposes that none of the administrative costs of obtaining valuation and exercising the calculation should be recoverable from leaseholders, so this cost ultimately would be an additional deduction from the income to investor landlords.
This option in some ways reflects the outcome of the Competition and Markets Authority’s investigation into the charging of ground rents on leasehold homes. Following that investigation, a number of housebuilders agreed to remove doubling ground rent clauses and to ensure that ground rent paid by tenants would remain at the amount it was when the property was first sold. The potential challenges are similar to those posed by option 2 with the additional challenge of establishing and agreeing what the initial ground rent was under certain leases.
This option may cause disparity between leaseholders. Those who have already experienced ground rent increases that they find untenable would be "stuck" with their difficult position, whereas those whose ground rent has not increased to such levels may be protected. The consultation contemplates transitional arrangements to allow time for stakeholders to adapt, albeit a short period is favoured in order to trigger leaseholder protections as soon as possible.
Possible concerns / effects
The legislative position will interfere with the commercial bargain that has been struck between landlord and tenant by "overriding lease terms through primary legislation."3 This is unusual but not novel – there are existing statutes under which unilateral steps can be taken by one party to deprive the other of an existing benefit (for example compulsory purchase). However, in those cases the party against whom the statutory right is exercised is compensated.
In the present proposals for ground rent reform, the Government has made it clear that ground rent investors will not be compensated. Ground rent investors therefore are unlikely to receive any compensation for the fact their investment case has been undermined by a change in law, with a transfer of value effectively flowing from freeholder to leaseholder. This may prove particularly problematic for pension fund investors who have paid out on expected incomes and lenders who have security over portfolios with significant ground rents, causing loan-to-value issues.
It is possible that in some circumstances developers will be less impacted if they are not heavily reliant on ground rent revenues and do not make ground rent a significant part of their forecasts.
Unlike under the LR(GR)A 2022, there will not be an opportunity to developers/landlords to adjust premiums prior to grant to reflect the inability to charge ground rent. There is no ability to retroactively "rebalance" the commercial arrangement.
The proposals do not distinguish between "normal" ground rent (a relatively small annual amount) and ratcheting ground rents (resulting in multiple times the original agreed payment). Pension and other institutional investment funds holding "normal" ground rent portfolios fear that value will be impacted as a result of the proposals and in seeking to protect leaseholders, it is possible that pension savers will be prejudiced. There is no differentiation between legitimate investment interests and those of entities who have benefitted from what have been described as "unscrupulous" ground rent terms. To date, however, the Government does not seem to have given consideration to this argument.
The proposals may, however, help to address the "two-tier" system caused by LR(GR)A 2022 whereby newer leases are more attractive due to the absence of any ground rent provision. This would only work where there is consistency across old and new leases (i.e. implementation of option 1).
There are concerns that, if introduced, these proposals (under any of the five options) may have the effect of making the UK a less attractive place to invest. Government "undoing" of legitimate bargains struck between landlords and tenants may be viewed as precedent for an increasing disregard for commercial arrangements. In turn, this could cause concern amongst potential investors as to future change of law risk in the UK (usually the stuff of hypothetical, worst case scenarios outlined in the risk factors of investment funds).
The consultation closes today (17 January 2024), and it is anticipated that the Government will receive robust responses from both trade bodies and those representing institutional investors. Indeed, at the second reading of the Leasehold and Freehold Reform Bill on 11 December, the strength of feeling of that the topic was arousing was extremely evident.
It remains to be seen as to whether or not these reforms will be accelerated, due to the prospects of a General Election later this year but we have previously experienced long delays between consultation launches and government responses (MEES reform, for example). If any of the proposed options make it as far as draft legislation it is possible that a legal challenge might be brought and with it, a hampering of progress and therefore, we can expect to hear a lot more on this topic in 2024 as the legislative process progresses.
2 A long residential lease has a term in excess of 21 years. The full set of conditions that a lease must satisfy to engage this legislation is set out in section 21 Leasehold Reform (Ground Rent) Act 2022.