The economics of extending a lease

GreatApe

Having looked into extending one of my leases I am surprised as to how it is calculated. It seems quite a rip off with the freeholder getting a lot in the event a leaseholder extends.

This is how it seems to work.

You need to compensate the freeholder for the lost ground rent and you do this by paying them a sum upfront which will return the same amount as the lost ground rent. This seems fair.

The bit that surprised me is, you also need to compensate the freeholder for the value of the flat. What you need to do is give the freeholder a sum of money so that they can put that sum of money into a bank or other investment such that in (# of years left on lease) years time the sum of money is worth the same as the flat is. This seems silly as the freeholder effectively gets 2 flats worth at the end of the lease if a person extends

Here is an example, we will take a discount rate of 5% and a flat valued at £500,000 with a 90 year lease and £100 annual ground rent.

The cost of extending the lease would be roughly

£2,000 for the lost ground rent
~£6,100 for the extension itself

Now ~£6,100 probably sounds reasonable to most people but the time value of money means this is a huge sum. If the landlord put that sum into an investment that returned 5% annually the landlord would have in 90 years the sum of ~£500,000 (in todays money).

What is worse is that the total cost to the leaseholder involves hefty fees likely to be in the region of >£5k

GreatApe

The crazy thing is, could it be worthwhile not to extend a lease and let it lapse?

Using the above example of £6,100 for the lease extension. If a person puts £6,100 into an investment that returns 5% annually (above inflation) that investment will be worth £492,500 in todays money by year 90. More or less the same as the value of the flat (which is how the £6,100 to the free holder was calculated)

However the leaseholder also needs to pay valuation and solicitors etc etc so the actual cost to the leaseholder is not £6,100 but closer to £11,000

If the leaseholder puts this £11,000 into an investment returning 5% annually (above inflation) they will have £888,000 by year 90 (in todays money) and could buy the flat back for £500,000 (in todays money)

System

The shorter a lease gets the sooner the freeholder gains an entire property, this has a value, especially if it's in their lifetime or that of the heirs to their estate, so the loss of that needs to be compensated

You could invest more aggressively than 5% a year yourself, but you'd have trouble selling if it's unmortgageable

You could take it to tribunal if it gets too expensive
Fees will be a few thousand. Watch out for bad non statutory deals where your years are topped up to 99 rather than extended by 90

System

Watch out for "doubles every X number of years" ground rent deals too

Thrugelmir

A return of 5% above inflation for 90 years compounded. Dream on....

GreatApe

MatthewAinsworth wrote: »

The shorter a lease gets the sooner the freeholder gains an entire property, this has a value, especially if it's in their lifetime or that of the heirs to their estate, so the loss of that needs to be compensated

yes I understand that and if the lease extensions were for 999 years (or indefinitely) or for the purchase of the freehold by the leaseholders it makes reasonable sense to pay the net present value of the property to the freeholder. However to pay the net present value of the flat to the freeholder but to only get a 90 year extension seems a huge rip off.

Apparently it costs almost the same to buy the freehold or to extend the lease. Something is wrong there. The act that allows a lease to be extended should be amended so it is not a 90 year extension but maybe a 990 year extension.

GreatApe

Thrugelmir wrote: »

A return of 5% above inflation for 90 years compounded. Dream on....

Why do you think that unsustainable?

PS I have said on other threads I see the world moving to zero real returns so I agree with you that someone trying to get 5% real return for a long period is going to find it hard. However I think I am in a minority when I say rates will be zero indefinitely.

Right now you can get 5% in the same sector, for instance with British land shares which yield 5% and the value of their properties should go up with inflation

System

If you do a statutory extension it'll be peppercorn ground rent, so whoever extends in future can do so before marriage value comes in, I agree it probably ought to be more than 90 years, I did a statutory extension and then later sold on

The freeholder might privately accept £10 a year fixed ground rent for 990 years because then at least the ground rent contract has a value
I had to apply to the tribunal to force my freeholder to give me serious offers on statutory terms

You could privately invest for more than 5% and do the extension later

Ground rent/freehold investments aren't that hot without leverage - about 5% a year, I wouldn't want to be a freeholder of flats with that responsibility - there are investment funds in ground rents but they're pretty naff

System

The historical average for small cap is either 12% or large cap+2% depending on who you speak to, I agree the 5% real returns is modest if you're passive & aggressive with investing

GreatApe

Before anyone thinks me crazy, I'm not suggesting the following is a good idea just thinking out aloud

Assuming a person decides not to extend a lease, using a £500,000 flat with a 90 year lease with the option to extend the lease a further 90 years for a cost of £13,000 inc fees (solicitors/valuers etc)


The possible advantages

No capital gains tax, in fact a capital gains credit (to offset other gains) as the value of the lease goes towards zero.

£1.05 million in the ISA by year 90 (in todays money)

The known disadvantage:

Loss of property as freeholder gets it back.


Assuming over a 90 year period the property just tracks inflation. The loss is £500,000 but the gain is £1,050,000 in the ISA and a ~£150,000 tax credit for negative capital gains.

Better off by £700,000??

GreatApe

MatthewAinsworth wrote: »

If you do a statutory extension it'll be peppercorn ground rent, so whoever extends in future can do so before marriage value comes in, I agree it probably ought to be more than 90 years, I did a statutory extension and then later sold on

The freeholder might privately accept £10 a year fixed ground rent for 990 years because then at least the ground rent contract has a value
I had to apply to the tribunal to force my freeholder to give me serious offers on statutory terms

You could privately invest for more than 5% and do the extension later

Ground rent/freehold investments aren't that hot without leverage - about 5% a year, I wouldn't want to be a freeholder of flats with that responsibility - there are investment funds in ground rents but they're pretty naff

It seems !!!! value for the lease holders, imagine you do 5 extensions or 5 subsequent owners do 5 extensions

You effectively pay 5 x the NPV of the flat to the freeholder. It is imo a huge rip off. The long time frames seem to be masking this huge rip off. Statutory lease extension should be a indefinite extension not 90 years or at least a 999 year extension.


Anyway if we used your 10% for large caps (rather than my assumed 5%) then surely its much better to not extend a lease and just put the same sum into the stock market?