The Leasehold Problem

by George Hatjoullis

Buying a flat normally involves buying a leasehold. You are not actually buying the flat but the right to live there subject to the terms of a contract known as the lease. The contract is negotiable (you can sell it on) but under law it seems to be a tenancy agreement. You do not need to leave the property when the lease expires and the tenancy continues along the terms previously agreed. Of course, the freeholder has the right to terminate the tenancy.

The problem with buying a leasehold is that you are buying a depreciating asset. Every year knocks off some value from the lease. You may under law be able to extend the lease but It’ll cost you! You will have to pay a premium to the freeholder plus reasonable professional costs. Unless the lease is of such a long-term, e.g. 999 years, as to be irrelevant, it is best to think of a leasehold flat as a long term rent agreement which can be traded in the secondary market. So if you buy a leasehold flat with a 125 year lease for, say, £585k you are effectively paying £4680 p.a. in rent for 125 years. Let us call this your basic purchase cost ‘rent’. The good news is that your rent is fixed for 125 years and if rents for your locality rise then the resell value rises minus any lost years. Let us assume rents in this locality for an equivalent property are £24k p.a. The price does not look too bad.

Unfortunately the lease premium is not the only cost. A property such as this might have an initial service charge of £2500 p.a. If you want to get some feel for how significant this is, think of how big a mortgage you could fund at, say, 2%. A potential lender will certainly think in these terms. The mortgage you could fund is of course £250k on an interest only basis. This service charge should be added to your ‘rent’ calculation so you are looking at £7180 p.a. now. The service charge is not however fixed for 125 years. It will rise and often in an opaque manner. If it rises too fast or is subject to controversy it might depress the resale value of your lease further as well as create stress and cashflow problems. It is a contingent liability and one that it is difficult to hedge or value up front.

The service charge covers such things as buildings insurance and maintenance and these are costs you would need to cover as a freeholder. In a share-of-freehold context you get some say in the implementation but you cannot avoid the costs. Being a freeholder is not any less stressful (in my experience) or even less prone to maladministration. Service charges are costs that all householders bear in some form or other. In the case of leasehold flats they are explicit and under the control of someone else, though you have some rights to transparency, and protest.

Finally we come to the ground rent. This tends to be ignored by leasehold buyers because it is initially quite low. The escalation built into the lease needs some careful thought. Recent press reports have some escalation clauses doubling the ground rent every ten years. May I refer you to the wheat and the chessboard problem. If you place one grain of wheat on the first square and the double the amount of wheat on each subsequent square how much wheat do you end up with? A lot more than you might imagine! If your ground rent starts at £10 how much do you think it will be in 100 years if it doubles every 10 years?  At the start of the 101st year you will be paying £10,024 per annum!

A more reasonable ground rent and escalation might be £350 per annum doubling every 25 years. For a finite lease and given that we know the ground rent schedule for certain, it is best to think of this as an additional initial cost when buying the lease. Assuming it is possible to invest tax-free for 125 years at 2% this would come to no more than £67k. In fact a precise calculation would be somewhat less but given the arbitrariness of the assumptions this would give a false sense of precision. The initial price is thus £652k and this translates as an average total purchase cost ‘rent’ of £7716 p. a. over 125 years, increasing in line with the service charge. The actual cash flow will also increase with the ground rent of course but we have accounted for this in the initial price.

Our initial comparison thus gives us an average total purchase cost ‘rent’ of £7,716 per annum versus a commercial rent of £24k per annum. Much depends on what is included in the commercial rent figure, notably council tax, and what is excluded from the purchase cost ‘rent’, notably financing costs. If you borrow £585k at 3% (ignoring the deposit) your mortgage interest payments will be £17,550 per annum (the loan is repaid by your basic purchase cost ‘rent’ and of course the outstanding amount is reducing so this part of the ‘rent’ is biased to fall). Your total purchase cost ‘rent’ is thus of the order of £25,266 per annum initially, which is a little more than the commercial rent assumed.

This is a very crude comparison, full of assumptions. It is however interesting that using an actual flat (looked at this weekend), rental data from Zoopla, long dated gilt yields, and indicative mortgage rates, that the two numbers come out so close. Varying the assumptions will vary the calculations but it is quite likely that these two rent numbers are kept quite close by market forces. The net advantage of leasehold is a degree of security of tenure for which it is worth paying some premium.

Buying a leasehold flat might seem a relatively low-cost way of getting onto the ‘property ladder’. Unless the lease is 999 year or there is a share-of-freehold involved, it may not be such a good idea. The second-hand value of the lease has a downward bias so in a rising market the spread to freehold property is almost certainly rising (which is partly why it seems a low cost first step). This means the absolute amount you need to step up is constantly moving away from your means. It is best to view leasehold flats with 125 years on the lease as an alternative method of renting. Looked at this way the attraction is less compelling. You might do better to rent and invest any spare cash in residential and commercial property investment trusts via a lifetime ISA.