Extending leases of flats under the
Leasehold Reform, Housing and Urban
Development Act 1993 where there is
a head lease of the building
Anyone who lives in a flat, and holds the long lease, can usually apply for
an extension of 90 years. If, say, the lease has only 30 years remaining,
it can be turned into a lease with 120 years remaining. Once this is done,
the ground rent ceases to be payable but a premium has to be paid to
reflect this and also to reflect the fact that the landlord’s interest is put
back by a further 90 years.
If there is a head lease, in between the flat lease and the freehold, the
head lease will also be affected by the lease extension. The head lessee
will cease to receive the ground rent from the flat but will have to continue
to pay rent to the freeholder under the head lease. As a result, particularly
if there are rent reviews, the head lease could turn into a substantial
negative asset, a liability to continue paying annual sums by way of rent to
the freeholder without any income to cover the liability.
In a recent case, heard in June 2008, the Lands Tribunal considered
the problems which affect the head lease when the lease of the flat
is extended and dealt with the following arguments and issues;
- Commutation of Head Rent under the Act
- Commutation of Head Rent under Human Rights Legislation
- Formulaic Valuation of the Head Lease as a Minor intermediate
Leasehold Interest
- Application of the Formula after the New Leases take effect
- Market valuation of the Negative Income of the Head Lease
- Fund basis
- Inclusion of Hope Value in the Landlord’s/Tenant’s interest
- Compensation payable to the Freeholder
- Relativity
In broad terms, the existence of a head lease creates valuation problems
where there is to be a new lease granted to the individual lessees in a house
or block of flats. Once the new leases are in place, the ground rents
payable under the original leases cease to be payable (they are commuted
to a peppercorn) but the head lessee has to continue paying the head rent
to the freeholder. Thus the head lease becomes a liability.
How much of a liability depends on the length of term remaining
and whether there are rent reviews. Usually, the head lease rent equals the
sum of the ground rents and any rent review provisions are mirrored
in the sub- leases.
The result is that the head lease is revenue neutral at all times. But this
tranquillity is lost when the new leases of the individual flats are granted.
To remedy the imbalance, the Act gives the head lessee the right to receive
a premium from the tenants sufficient to put it in the position it would have
been in had the new leases not been granted. A sum of money representing
the present value of its future loss. How this was to be measured could not
be agreed. The Tribunal was asked to decide the basis on which the loss
should be assessed.
In the first place, it was argued (by the freeholder) that the head rent
should be abated or commuted after the new leases took effect, so that
the head lessee also ceased to pay rent to the freeholder thus retaining
revenue neutrality. No loss would then be suffered and no premium
necessary. This argument was rejected.
If this was not accepted, the head lease should be valued under the formula
contained in the Act. This formula was intended to apply where the head
lease was a “minor interest” of no great value, positive or negative,
having an expectancy of possession of less than one month and a profit rent
of less than £5 pa. If the formula was used, the premium payable to the
head lessee would be much reduced from any market valuation of future
loss. This argument was rejected.
The Tribunal accepted the lessees’ argument that the head lease liability
was to be valued by a market valuation of the negative income flow after
the lease extensions took effect. At this point, the ground rents, and indeed
the reviewed ground rents, would cease to be payable, leaving the head
lessee to pay out an annual sum of £ 45,500 (the reviewed head rent) to the
freeholder without recompense. By capitalising this negative income flow
at a single rate, (the Tribunal adopted 3.5 %) the amount of reverse
premium necessary to reflect the loss would be established. The Tribunal
rejected the argument that it should be established by reference
to a sinking fund.
Why did the freeholder seek to argue these points and to reduce the
premium payable to the head lessee to nil or as little as possible?
Because if the head lease was shown to have a negative value,
the amount payable to the head lessee would fall to be deducted under
the Act from the amount payable to the freeholder on any subsequent
claim for the freehold by way of collective enfranchisement.
The Tribunal decided these points in favour of the head lessee.
Having done so, it then took away the benefit it had conferred, by ruling
that the freeholder should be paid compensation for its future loss at the
collective enfranchisement stage by receiving an additional payment from
the individual tenants at the lease renewal stage. Thus the tenant has to
pay a substantial sum to the head lessee to compensate it for its future loss and, as a result of the loss this would cause the freeholder at a collective
enfranchisement, a further substantial sum to the freeholder.
Whether compensation is in fact payable in this way will depend on how
likely it is that the lease renewals will be followed by a collective
enfranchisement.
The questions of hope value and relativity arise in the context of marriage
value.
Where the existing lease has less than 80 years remaining, marriage value
is payable on the renewal of the lease. Marriage value is defined by the Act
as the difference between the aggregate value of the interests
of the freeholder, the head landlord and the lessee before and after lease
renewal.
The freeholders argued that their interest should be enhanced by the
inclusion of hope value, meaning a value attributable to the hope
of obtaining marriage value. In a recent decision (Sportelli), the House
of Lords rejected this argument and held that hope value was to be
excluded from the landlord’s interest in all cases involving enfranchisement
except in the case of non-participating tenants in a collective
enfranchisement. The Tribunal will be bound by this decision.
The question of relativity is slightly more complex. If marriage value
includes the amount by which the new lease is worth more than the old
lease then it is clear that the freeholder will want this increase to be as
great as possible so that his share of marriage value, 50%, will be enhanced.
Because of the statutory assumptions and disregards, the valuation of the
existing lease is conducted by reference to a hypothetical lease which does
not itself have the ability to be enfranchised. It is a wasting asset. As there
are very few, if any, comparable leases in the real world (they will all have
the benefit of the Act) there are no direct comparisons which can be used
to establish the value of the lease. To get round this, valuers express the
value of the existing lease as a percentage of the freehold value.
It follows that the lower the percentage (relativity) the higher will be the
gain on lease renewal. When the new lease takes effect, for an extra 90
years, it assumes a value which is approximate to the freehold value.
If the lease is valued at say, 60% of freehold value before extension it will
give rise to a higher gain than if it is valued at 80%.
The Tribunal reached its relativity percentages by reference to analysis
of comparable transactions adjusted to reflect the statutory assumptions
and disregards. It reached figures which lay between the (low) landlord
and (high) tenant figures.
The decision is an interim decision and will become final when further
submissions have been made.
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