England's distinction between freehold and leasehold property is a mystery to foreigners - and indeed to many Englishmen. The notion that you can 'own' a property while renting it on a long-term lease from a 'freeholder' seems contradictory. And it is contradictory - a clash between ancient feudal land rights and modern capitalism that has never been quite resolved in two centuries of reform acts.
Yet the irony of this contradiction is that the feudal land rights or freeholds can be bought and sold like any other goods in the capitalist system. With just a few thousand pounds, investors can buy the title deeds to their very own manorial estate. They shouldn’t expect access to grand houses: the title confers ownership of the land and not of the homes or gardens that sit on it, which are owned by the lessees. But, with sufficient patience, they can expect returns that are both unusually safe and - with a bit of time - very generous.
Consider the experience of an investor we shall call George (he preferred to remain anonymous). In 1984, he paid £10,000 for the freehold to a large house in the London suburb of Clapham that had been split into six flats, each with 100 years left on the lease. The deeds gave him the right to collect a ground rent of £50 per year from each of the lease-holders – so £300 in total, giving a rental yield of 3 per cent.
That's pretty meagre in itself. But - confusingly for an asset class typically called 'ground rents' - the ground rent is only the most visible part of a much larger return. George receives ancillary income every year that boosts the rental yield, mainly fees for management of the communal areas and commission from the insurance broker. And he has also realised some chunky capital gains, without selling the asset.
First, the deeds conferred ownership of a landlocked site behind the property, which he got permission to build on and sell off. Second, he received £23,500 from one leaseholder and £21,000 from another for lease extensions last year, and expects similar sums from each of the remaining four flat owners. These lease extensions alone mean George's original investment will have grown at least 12 times over - albeit with a quarter-century lag.
What is notable about the returns George has experienced - which are typical of ground rent investments - is that house-price inflation is only a small part of the mix. Leaseholders will be prepared to pay more to extend the lease on a more valuable property. But relative to the price of the freehold title, he or she will still pay a large sum even if house prices fall by a quarter over the next decade. So lease extensions are a far more certain source of returns than house prices, which also require a good deal of maintenance to support.
There are broadly two types of ground rent investment - long leases for income and short leases for capital gains. Long leases, which typically have between 80 and 125 years to expiry, entitle investors to a bond-like income from ground rents, topped up with ancillary income. These trade at between 15 and 20 times the annual ground rent, depending on the ancillary revenue streams, says Gary Murphy, partner and auctioneer at Allsop. Most leases come with the right to manage and insure the building, but freeholders can also earn fees from renting out car parking spaces or even roof space for aerials. The price will also be higher if it's possible to build a flat on the roof or a house on a vacant part of the site, as George did in Clapham.
Short leases have less than 80 years to expiry. These are valued at a discount to the price of the property itself rather than as a function of the ground rent. That's because the freeholder theoretically owns the property when the lease expires, so the value of the freehold gradually reverts to the value of the leasehold, which is normally much higher. This is theoretical because the freeholder no longer has the right to refuse the lessee an extension. But the closer to expiry the lease is, the more the extension will cost and so the more valuable the ground rent. The return therefore depends only on the passage of time - which is more certain than any other driver of financial returns.
Of course, there are some drawbacks to this asset class. The legal conventions of leases date back to an era when money was linked to gold, so the safeguards against inflation we now take for granted are wanting. Some leases contain no provision for ground rents to rise at all, while others stipulate that they double once every 25 or 33 years - equating to an annualised compound gain of 2.8 and 2.1 per cent respectively. Some modern leases tie ground rents to inflation or earnings.
The market value of those ground rents associated with long leases is susceptible to inflation worries, like the gilt market. If inflation expectations increase, it follows that investors will apply a discount to the bond-like income stream they offer.
Politics is another risk. The freehold-leasehold distinction is anachronistic. The economic basis of freeholds is also dubious: unlike returns from stocks and bonds, returns from ground rents do not reward and stimulate investment and growth; they merely act as a land tax that investors buy the right to collect. The Campaign for the Abolition of Residential Leasehold is a vociferous lobbying organisation, and leasehold property-owners are a much larger part of the electorate than ground-rent investors. It is not surprising that legislation in recent years has favoured the lessee. However, the worst that is likely to happen to freeholders is that their tenants gain the right to buy them out at the market price.
How and what to buy
The auction room is the place to buy ground rents. One major advantage they have over buy-to-let properties is their relative cheapness - you don't have to splash your entire portfolio on a single asset. Prices at a recent Allsop auction ranged from £7,000 for a two-flat Victorian conversion to £148,000 for a block of sixteen flats with impending lease extensions.
Despite the low entry price, ground rents typically attract specialist investors, says Mr Murphy at Allsop. We can venture various explanations. First, they require some management - arranging insurance, keeping communal areas in decent shape, and so on (though similar management duties haven't stopped non-specialists taking over the buy-to-let market). Second, the legislation governing the sector can be a barrier - investors need a decent lawyer. Third, the extremely lumpy return profile makes more sense if you own a portfolio of titles rather than just one.
Some investors may therefore prefer to gain exposure indirectly, through a fund. The advantage is a smooth increase in value, ready access to your cash if you need it, and none of the hassle of ownership. The drawbacks are the usual ones - none of the fun of direct investing, and fees, which can be quite hefty for niche asset classes. There is also little choice, with only three retail funds to choose from.
The Freehold Income Trust (FIT), managed by Alpha Real Capital, is the oldest fund, with £159m under management in 64,300 leases. It focuses on long leases and generates a bond-like income stream - indeed, the assets are valued on a discounted cash flow basis like bonds. The yield target is 4.25 per cent, but the trust paid out 4.6 per cent last year. Capital gains are modest by comparison – 0.9 per cent last year. FIT’s unbroken track record of positive returns testifies to the resilience of the asset class in general (see graph), though inflation-protection has been eroded in recent years by rising inflation and falling yields.
Brandeaux Ground Rent Income is the largest fund on the market, with £454m under management. It differs from the Freehold Income Trust because it invests in short leases that gradually revert to the value of the leasehold property. This means it is more correlated with the housing market than FIT, which worked wonders in the housing boom but led to asset write-downs in the bust. Faced with heavy redemptions in late 2008, it suspended trading. So liquidity - one of the supposed advantages of investing in funds - proved elusive when it was needed most.
Finally, the Braemar Group PCC Limited Ground Rents fund only buys bond-like long leases, but unlike FIT it invests in commercial ground rents as well as housing. The fund expects to distribute about 4.5 per cent. One drawback of this fund is its diminutive size, which will inflate expenses.
