The Government is currently consulting on Leasehold enfranchisement valuation rates to determine what deferment and capitalisation rates should be prescribed under the Leasehold and Freehold Reform Act (LAFRA).
To many investors this may sound like specialist valuation assumptions, but in practice, they are among the most important numbers still to be settled in the reform programme.
I support the objective of making enfranchisement simpler and more predictable. But simplification does not make the underlying economics disappear, as how the rates are set will redistribute value between leaseholders and freeholders, sometimes significantly.
THE IMPACT OF THE DEFERMENT RATE
The deferment rate is used to value the freeholder’s right to recover possession of a property when the lease expires.
A freeholder due to receive a flat back in 80 years is not receiving that asset today, so its future value must be discounted to a present value.
The higher the deferment rate, the more heavily that future value is discounted and the lower the reversionary value today. A lower rate does the opposite and can increase the premium payable by the leaseholder.
The current benchmark is 5% for flats and 4.75% for houses, following the 2007 Sportelli decision. The Government is considering whether to retain those rates, update the Sportelli methodology or adopt a different approach.
I regard the deferment rate as the bigger unknown. LAFRA is intended to abolish marriage value and restrict the ground rent that is taken into account in the statutory calculation, which leaves the reversionary interest carrying greater weight in many valuations, particularly for shorter leases.
Government modelling shows how sensitive the calculation can be. For a typical £250,000 flat with 80 years remaining, reducing the deferment rate from 5% to 4% raises the reversion value from £5,044 to £10,846; increasing it to 6% reduces the reversion to £2,363. Those figures are not the total enfranchisement premium, but they show why a movement of one percentage point is not a technical footnote but can be very significant.
THE IMPACT OF THE CAPITALISATION RATE
The capitalisation rate performs a different job, by valuing the freeholder’s future ground rent income. If a leaseholder pays £250 a year, the freeholder owns the right to receive that income over time and the capitalisation rate converts that stream into a present value.
Again, a higher rate means a lower present value. But the evidence is less uniform than for deferment.
Part of the modelling referred to above, the Government’s analysis of First-tier Tribunal decisions found capitalisation rates ranging from 4.5% to 9%, although 88% of the sample sat between 6% and 7%. The mean was 6.6% and the median 6.5%.
That variation demonstrates the point that ground rent investments are not all the same. The amount of rent, review pattern, lease structure and perceived risk are all significant and a single prescribed rate therefore buys certainty at the cost of some individualisation.
There is a further complication: LAFRA limits the ground rent used in the statutory valuation, while the Government has separately proposed a £250 annual cap on existing ground rents for 40 years before they fall to a peppercorn.
If that wider reform (as described in the House of Commons research briefing Leasehold reform in England and Wales: What’s happening and when?) proceeds, the economic significance of the capitalisation rate may change again. Therefore, it is difficult to view the rate in isolation from the income stream to which it will eventually be applied.
Just as there has been considerable evidence to suggest that the value of flat is falling, I am already seeing the investment market assess portfolios in anticipation of reform.
That is a reminder that policy does not need to have commenced before it affects pricing: expectations about future ground rent income and reversionary value can influence what an investor is prepared to pay today.
THERE IS A NO NEUTRAL RATE
For this reason, I think the debate should move beyond whether a particular percentage looks high or low. There is no neutral rate. Government modelling estimates that, against the existing 5% baseline for flats, a 3% deferment rate could transfer around £6.3 billion more from leaseholders to freeholders over ten years, all else being equal. At 6%, leaseholders would pay around £1.1 billion less.
Those are modelled transfers rather than net economic gains or losses, but the scale is important, because rather than simply choosing a tidier valuation formula, the Government is making a decision with consequences for existing property owners.
Like all ALEP members, I want reform to make enfranchisement more comprehensible and workable. Commonhold will also have an important role in the future of property ownership. But neither objective is helped if one part of the transition is set without sufficient regard to the others.
The rates need to be evidence-based, legally robust and considered alongside the abolition of marriage value, ground rent reform and the practical route towards commonhold. The percentages may be small, but the future consequences are not.
