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Compounding the felony

View profile for Paul McAndrews
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The hidden, devastating, effects of compound interest have been considered in a previous GD Online article (Extreme Service Charge; June 2015) concerning service charge payments in residential leases of holiday chalets on the Gower peninsula. Some of the leases, granted in the early 1970s for terms of 99 years, reserved a fixed annual service charge,  beginning with £90 for the first year but increasing  annually by 10% of the amount paid in the previous year. The result was that in 2012, the service charge was £3,366 and in 2072, the final year of the lease, it will be £1,025,004. The annual increase at 10% compound, a remorseless process of compounded yearly increases, rendered the lease an onerous contract.

A similar fate has been experienced by the unfortunate leaseholders of those flats where the ground rent reserved in the lease has been compounded at ten yearly intervals.  Ground rent is supposed to be a nominal sum, originally introduced in building leases common in the 19th century, where the lease  (usually for 99 years) is granted of a plot of land on which the leaseholder builds the house at his own expense. The annual rent is for the plot, the ground on which the house is built, but not the house itself. In modern leases it is often in the region of £100 to £250 per year and if it is reviewed, or stepped, it is usually by a fixed increase once every 21 or 33 years or to double the previous amount. Three or four such increases, during a 99 year term, is not onerous, ending up at between £800 to £ 2000 for each of the final years of the lease.

Recent press reports have disclosed the alarming practice of some landlords and house builders introducing compound increases of ground rent at regular, ten yearly intervals, in long leases. Where it is doubled every ten years, a ground rent of £250 for the first ten years will increase to £ 4,000 after four such increases. During the last ten years of a 99 year lease it will have increased to £128,000 payable each year. If the lease is longer, say for a term of 125 years, the compounded increases will produce a ground rent of £1,024,000 for each of the last years of the lease. Shades of the Gower service charge.

Unusually for houses, which are normally sold as freehold, such compounding of ground rent has been introduced on newly built estates by certain developers who sell the houses on 999 year leases. Purchasers, especially first time purchasers, often do not appreciate the difference between leasehold and freehold and that the escalation of ground rent on a compound basis can destroy their investment making their lease unsellable and their house unmortgageable. If a 999 year lease of a house doubles its ground rent every ten years starting at £250 for the first ten years, the ground rent payable after 150 years will be £8,000,000 per year.

Is help at hand?

Leasehold enfranchisement legislation enables owners of long leases of flats, exceeding 21 years, to obtain a new lease by adding 90 years to their existing lease. Long leaseholders of houses can acquire the freehold. In both cases, once the new lease or freehold has been acquired, ground rent ceases to be payable. That would seem to be a solution to the problem were it not for the fact that the ground rent payable during the remainder of the lease has to be paid over to the landlord as part of the premium for the new lease or freehold. It is paid as a lump sum arrived at by capitalising the remaining ground rent, including the future increases, at an appropriate rate (in the region of 6%) by discounting it annually on a compound basis. Typically, a leaseholder with 50 years of the lease remaining at a yearly ground rent of £100 will pay approximately £1,300 to buy out the ground rent. Most of the premium payable will be in respect of the present value of freehold vacant possession value deferred to the end of the lease.

But the position is reversed where the freehold reversion is so remote as to make the present value of it negligible. Where the lease has 950 years or more remaining the ground rent capitalisation will be by far the biggest element of the premium. If the increase in rent is compounded at ten yearly intervals the capitalisation of it will produce a much higher premium: in one reported case the leaseholder seeking to buy the freehold of a house let on a 999 year lease with compound increases of ground rent was asked to pay up to £40,000, most if not all of which would be in respect of buying out the ground rent. Whilst the discounting is also done on a compound basis it is of little help to the leaseholder if the sums being discounted are huge to begin with.

The introduction of regular compounded increases, of service charge or ground rent, can only be achieved between willing parties as a matter of agreement. Legal advisers of would be buyers, where a lease of a flat or a house is being bought, have a duty, as ever, to read the small print and advise of the consequences.

This guide is for general information and interest only and should not be relied upon as providing specific legal advice.  If you require any further information about the issues raised in this article please contact the author or call 0207 404 0606 and ask to speak to your usual Goodman Derrick contact.