Government wakes up to abuse of the leasehold system – but this is just a symptom of a bigger problem

Published: by Catharine Banks

The recent Housing White Paper included a welcome promise that the Government will consult on measures to tackle unfair and unreasonable abuses of the leasehold system. There has been a steady stream of media coverage in recent months of new build homebuyers finding themselves trapped by spiralling increases of the ground rents they are required to pay on top of their mortgage. It’s good to see Government taking steps to help those homeowners directly affected by this – but worth also understanding what this practice is and the drivers behind it, which we believe to be more than just simple greed on the part of housebuilders.

Rather than selling new build homes freehold (meaning the home buyer buys the home and the land it stands on), some housebuilders have instead decided to sell them leasehold (meaning the home buyer only buys the home itself – and only for a specified amount of time). The housebuilder then retains the freehold, which entitles them to claim ground rent from the leaseholder. There’s nothing inherently wrong with this: leasehold is a well-established form of tenure (almost 10% of homeowners are leaseholders[1]), that can give homeowners a very high degree of security in their ownership: 999 year leases are common. Leasehold can particularly suit apartment blocks with shared areas that need to be maintained.

But housebuilders are just that – housebuilders, not management companies. So in many cases, these freeholds are then bundled up and sold on to estate management and investment companies. Again, this is not necessarily a problem. However, the issue attracting attention recently is that many of these leasehold contracts contain clauses which double the amount of ground rents payable with each rent review period that passes – which can be as frequently as every ten years. Although the annual rent may seem reasonable to begin with, these increases mean that by the end of the lease, the sums payable each year will have spiralled to incredibly high levels. In one example, a flat in Islington with a 999-year lease starting off with a ground rent of £250 per year, doubling every 25 years, would in the latter years of the lease have an annual ground rent of £69 trillion.

These clauses can make properties virtually unsaleable – with homes that are only a few years old given a value of zero. Unable to sell the property, and facing the prospect of enormous rents on the home they thought they owned, leaseholders are left trapped.

Today’s announcement by the Government will be welcome news for those leaseholders trapped in this situation. It’s good too to see that some housebuilders have promised not to sell new homes on this basis in future, and will review their use of the practice. But why has this been happening in the first place? It’s easy to put it down to greed on the part of housebuilders and the estate management companies that end up buying these freeholds. That may be true to an extent: 7% yield for doing very little in the way of property management is certainly attractive in an era of historically low investment yields. But we suspect there is actually a systemic failure underpinning this kind of value extraction.

It won’t come as any news to regular readers of this blog that the land market in this country is broken (see here, here, here and here). We know that competition between developers is focused in the land market. Developers compete to buy land based on their calculations of its residual value. And we know that this residual value can be distorted to maximise land values – by making ever more generous assumptions about the eventual price homes could be sold at, cutting corners on the quality of new homes, and negotiating away obligations to provide affordable housing or infrastructure. However, there is an argument to be made that developers are reaching the limits of their ability to do this – even in our over-heated property market there are limits to how much homes can be sold for, and to how much you can cut corners on quality and developer contributions. So developers are looking for innovative ways to get an edge in the land market – and future income from ground rents (in effect, diluting ownership), is one way to achieve this.

Essentially, factoring in future income from ground rents enables the developer to offer higher prices for land, and so secure sites ahead of rival bidders. And as long as high prices continue to be paid for land, high returns need to be made too, creating a self-perpetuating cycle in which land prices need to be kept artificially high in order to ensure investors of all stripes are making a return on their asset.

It’s extremely encouraging to see Government promising to tackle abuses in this particular method of land value extraction. But on its own it won’t tackle the underlying issue. In the long run, more needs to be done to ensure that more of the value created by development is channelled towards providing affordable, good quality homes of all kinds, as well as the services and infrastructure needed to support them – not just lining the pockets of landowners and investors.

[1] DCLG/English Housing Survey, Table FT2231 (S322): whether accommodation is owned freehold or leasehold