Ideas Farm: Freeheld to ransom

There may be no such thing as a free lunch in investing. But in the UK’s arcane property system, I have found something close.

Three months ago, the landlords in my 12-flat building received a letter informing us that the freeholder was about to sell up. By law, they were obliged to give us right of refusal, at the same price.

Common to many freehold investment structures, the identity of our freehold’s ultimate owner is cloaked by a NatWest-managed shell company. But Land Registry records show the title was last bought in 2003, along with 26 other flats in three nearby blocks, for £52,000. That valued each freehold at about 1 per cent of the properties’ leasehold market value.

Each year, the freeholder collected £100 in annual ground rent per flat until 2019, when it jumped above the rate of leasehold value growth, to £430. That equates to a 5.8 per cent average annual yield since 2003, or a two-fold cash return on the freehold investor’s initial outlay.

But it gets much better – for the freeholder, that is. The price quoted in the letter was £153,760. Add that to accumulated income, and the freeholder has a paper profit of £14,207 per flat, or a more than 10-fold return.

Keen to avoid paying ground rent, dump our dreadful property management company and boost our flats’ market values, we decided to explore our buying options.

We were also determined to get a better price. Not only did the freeholder’s valuation represent a return far above those for property, credit and equities since 2003, but reforms mean risks are mounting for the asset class. Since 2019, all new build homes must be sold as freeholds, and ground rents on new multi-lease developments were effectively banned in June. The prospect of a ban on ground rents on existing leases, while not on the books, is growing. Alert to the shift, some institutional investor-owners including Persimmon and Aviva have offered leaseholders the chance to buy freeholds at cost or amend ground rent terms.

Confident of our strong hand, and poised to instruct a solicitor to start negotiations, we paid a surveyor to arm ourselves with a fair market price. What they reported stunned us: in their estimate, the freehold was worth between £197,000 and £216,000. If we contested the £153,760 offer, we were told, a tribunal might set the price much higher.

Online calculators suggest it could be much lower, too. But in all valuation models I have used, the number of flats and their average market value are less of a determinant than the amount of time left on the lease. In our case, that stands at 101 years, meaning the ‘marriage value’ principle – whereby the leasehold value starts to drop as the cost of a new extension rises – is far off. But it also means more time for ground rents to rise.

Like all valuation models, calculating the freehold price is highly subjective. But tribunal judgements show a lot rests on the capitalisation rate used in calculating the term and reversion values. The lower the rate, the higher the hypothetical cash flow multiple, the lower the discount rate and the greater the premium.

At the current offer value, our building’s ground rent equates to a cash yield of 3.4 per cent until its next review in 2040. But arbitrarily assume a cap rate of 5 per cent, which implies both low-risk and perpetual high growth, and you get an inflated investment value gain thrown in for free.

Efforts to raise the cash to pay for our own inflated freehold offer collapsed this week, at the eleventh hour. Although frustrating, I wonder if we may have dodged a bullet.

In theory, freeholders are responsible for the exterior and common parts of a building. In practice, these costs are often passed on to leaseholders via service charges. Despite this, maddeningly, the capital gains freeholders hypothetically forgo are legally guaranteed.

Given leaseholds make up a fifth of UK housing stock, it’s not always possible for property buyers to avoid the freehold gravy train. Still, further reform might allow several million hard-pressed landlords, tenants and homeowners to breathe a little easier.