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Enfranchisement claims: price is what you pay, value is what you get

Posted: 26/03/2020


In January the Law Commission (LC) published its report on how enfranchisement claims should be valued to calculate the premium payable by leaseholders when they enfranchise. Whilst superficially this may be of little interest to those who don't own a flat, in fact any changes to the valuation process are likely to have a profound effect on anyone who relies on income from a charity or pension as we explain below.

Background

In England and Wales there are only three types of tenure relating to property namely (a) freehold, (b) leasehold and (c) commonhold. Only leasehold and commonhold can be used for multi-tenanted buildings. This is because the law does not recognise that successors in title of a freehold can enforce positive obligations. Commonhold is a separate topic by itself and outside the scope of this article.

Leasehold tenure has a number of perceived defects, such as declining lease lengths or, more recently, escalating onerous ground rents which result in leaseholders not being able to sell.

As a result, a right was introduced in 1967 to allow leaseholders of houses to acquire their freehold or extend their lease. Similar rights were given in 1993 to leaseholders living in flats to acquire their freehold (known as collective enfranchisement) or to extend their leases by 90 years (individual lease extension). Each type of claim has a different process and method of valuation. The process is perceived to be complicated, expensive and prone to disputes. As a result the LC has been tasked with making the enfranchisement process easier and cheaper.

The Law Commission’s remit

The report follows on from a lengthy consultation published by the LC in September 2018. After that consultation the Government asked the LC to examine the options to reduce the premium (price) payable by existing and future leaseholders to enfranchise, whilst ensuring that "sufficient compensation" is payable to landlords.

In addition, there are two general policy obligations first to promote transparency and fairness in the residential leasehold sector and second to pursue a better deal for leaseholders as consumers.

So, the LC is looking at any options to produce a simpler, clearer and consistent valuation methodology, to simplify legislation and to make the whole enfranchisement process easier, quicker and more cost effective (and thereby reducing the costs paid by the parties of the claim). A separate report detailing recommendations to the legal process will be published later this year.

What is market value?

The premium for the freehold interest or lease extension under enfranchisement is intended to reflect the market value of the landlord's asset but when it comes to calculating the premium the interest of the leaseholders and landlords are diametrically opposed. Leaseholders want lower premiums; landlords want high. In addition to the premium are the professional costs and due to the complexity of the existing regime, claims often end up in expensive litigation.

How are premiums calculated?

There are currently two methods used to calculate the premium payable. First, what is known as the "mainstream valuation basis" and this applies to all flats and many houses. This is based on an assessment of the market value of the landlord's interest. Second, the "original valuation basis" – this is based on the market value of the land on which the house is built, but not the house itself. It results in lower premiums for leaseholders (typically two thirds of the first method) and only applies to houses which fall below certain financial limits under S9(1) of the Leasehold Reform Act 1967.

Sufficient compensation and human rights

Before looking at the options proposed by the LC, it is worth mentioning that any proposal which has the effect of reducing what landlords currently receive by way of compensation will be open to challenge under Article 1 of the First Protocol to the European Convention on Human Rights. This states:

"Every natural or legal person is entitled to the peaceful enjoyment of his possessions. No one shall be deprived of his possessions except in the public interest.”

Any reform to the enfranchisement regime needs to be compliant with the Convention which has been incorporated into our system by virtue of the Human Rights Act 1998. Although following Brexit the Government has said it will repeal the Human Rights Act, it is unclear if this means Article 1. We assume it doesn't.

Suggested proposals

It is fair to say that the LC by this Report has succeeded in alienating both sides of the landlord/leaseholder relationship. Leaseholders feel that the LC hasn’t gone far enough and landlords feel they will see an unreasonable reduction in the value of their assets.

Save proposals put forward by leaseholders such as the premium being based on a simple formula:- say, 10 x the annual ground rent have been dismissed by the LC as they will not stand up to scrutiny under the Human Rights Act.

The LC has therefore put forward three schemes with seven further sub-variations which they have called sub-options. In order to understand these, we must explain some of the terminology and concepts used by valuers to work out the premium payable.

Landlord’s compensation

Landlord's compensation consists of a combination of compensation for the loss of their rental income and compensation for the loss of their capital asset.

Terminology

"The Term"

The value of the landlord's income stream from the ground rent is assessed to determine what capital sum the landlord needs to receive at the valuation date to replace the income being paid over the term of the lease. This valuation is achieved by applying what is known as a "capitalisation" or "yield rate". Once the capitalisation rate has been selected then it is converted into a "multiplier", which is also known as a "years purchase multiplier".

When there are future rent reviews, which leases often contain then the landlords' right to any increase is deferred as the increased income will not be recovered until a future date. Valuers use a "deferment rate" to calculate this. There are currently generic deferment rates of 4.75% for houses and 5% for flats, following the Sportelli decision.

"The Reversion" Under a lease extension, the landlord loses the right to have the property back when the lease expires and must wait an additional 90 years. For a freehold purchase the landlord loses the right to have the lease back altogether. The landlord has to be compensated for this.
"Marriage Value" This works on the principle that by combining the freehold and leasehold interests, their value is greater than the sum of their parts. Or to take an analogy of a pair of Ming vases, each vase has its own value but a pair will fetch far more. The difference between the two values is said to be marriage value. At present the legislation says there is no marriage value if the length of the lease is more than 80 years.
"Hope Value" This is explained by saying that there is a value in the hope that one day the Leaseholder will be able to release marriage value in the future. This is always less than marriage value.

The three schemes

The LC suggests that there are three schemes and it is up to the Government as to which one it chooses.

Scheme 1 Only the Term and Reversion are to be compensated (plus where it exists additional value and/or other loss). This assumes the leaseholder is not in the market to buy out the landlord. This will result in the lowest premium to the landlord. This reflects the basis of valuation currently used under the original valuation basis referred to above and is also analogous to the current compulsory purchase regime.
Scheme 2 Only the Term, the Reversion or Hope Value are compensated. This assumes that the leaseholder is not currently in the market but may be in the future. This should give a valuation 10-20% higher than Scheme 1. This is what the landlord would get in the open market if the landlord's interest were sold to an Investor as opposed to the leaseholder.
Scheme 3 This is the current mainstream valuation basis for valuation and produces the highest premium. This measures the Term, Reversion and Marriage Value. It assumes the leaseholder is always in the market. Only if this scheme is used with some of the sub-options mentioned below will it result in a reduced premium from what a leaseholder pays now.

Scheme 1 has the highest risk of being successfully challenged by landlords under the Human Rights legislation, whereas Scheme 3 simply retains the status quo, so won't be challenged.

Various sub-options

In addition to these schemes the LC suggests other options which could be considered:

  • Should the rates used to calculate compensation be prescribed? By prescribing rates this would remove the main arguments often fought between valuers. It will also allow the creation of on-line calculators so leaseholders would have a far better idea of what the compensation would be at the outset, unlike now.

  • Should those rates be prescribed at current market values or below market values?

  • Should a cap on the level of ground rents to be taken into account? At present there appear to be many recently granted leases with escalating ground rents which are onerous (that is with rents higher than 0.1% of the market value of the property) and therefore subject to very high premiums if they enfranchise.

  • Should leaseholders be able to elect to restrict development by entering into some form of statutory restriction? Often in collective claims there are disputes over the landlord's loss of development potential, for example to build on top of the roof. By removing the ability to carry out development, leaseholders will reduce the premium.

  • Should owner-occupiers be treated differently from absent buy-to-let investors? Originally the enfranchisement legislation was just intended to benefit the former not the latter group.

  • The current 80 year cut off when taking into account marriage and hope value is an artificial construct; should it be removed or reduced to 70 years or lower? If it's removed then leaseholders will end up paying more.

  • At present, leaseholders' improvements are discounted. Should this continue, as it can be difficult to ascertain what works constitute improvements, especially if they were done years ago. If removed, then this will increase premiums.

  • On expiry of a long lease, leaseholders can hold over and become assured tenants. As a lease term declines, so the risk of holding over increases, thereby preventing the landlord from recovering possession. Should this go? Again, if it is removed, premiums will increase.

To be effective, whatever scheme and sub-schemes are adopted by the Government, the conventional valuation methodology must also be prescribed and no other methodology. Otherwise valuers will find a way to circumvent the charges.

Consequences of these suggested reforms

Prescribing rates would most certainly reduce the scope of the parties to argue and reduce the threat of a tribunal hearing. It will also result in significant cost savings in respect of professional fees and reduce the time it takes to complete an enfranchisement claim. Some valuers acting for leaseholders charge by way of the perceived savings made between the landlord's asking price and the final price agreed. The use of prescribed rates and an online calculator will put a stop to that practice as there should not be any difference between the two parties' figures.

Although the use of an online calculator seems attractive it will be difficult to create one which can deal with some of the unusual properties encountered in practice or where a building has several layers of leasehold interests and intermediate landlord's interests which need to be brought out.

More worryingly, as highlighted at the beginning of this article, some of the large London estates and charities are dependent on the income they receive from enfranchisement claims to fund their activities. It seems an odd outcome that by reducing premiums for the rich in prime central London, charities will no longer be able to help low paid and disadvantaged people, but this is a consequence of any reform.

It also seems odd that pension funds stand to lose a significant proportion of their asset base if any of these options are taken up, particularly with sub-option 2 (capping the treatment of onerous ground rents).

The Government has six months in which to give its interim response to the report and to give its final response within a year. With an 80 seat majority this Government can get through pretty much any legislation it wants. Is it going to be bold or mild? Only time will tell, but nothing is likely to happen overnight any legislation is months away. In the meantime do you as a leaseholder bring a claim now or await until the law is changed since it could be cheaper? Given that currently, marriage value becomes payable if the term of your lease falls below 80 years then it would be unwise to wait if your lease is near to this point but every claim is unique so you should always take advice before deciding whether to wait or not.


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Penningtons Manches Cooper LLP

Penningtons Manches Cooper LLP is a limited liability partnership registered in England and Wales with registered number OC311575 and is authorised and regulated by the Solicitors Regulation Authority.

Penningtons Manches Cooper LLP