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Underlying value

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The low-risk, low-volatility ground rent market is holding steady, despite the rapid decline in values and transactions in the broader residential market. Jeremy Davies explains how ground rent sales can provide vital cash flow

Ground rents are something of an anomaly in the residential
property sector. Created when long leasehold interests are sold,
typically on new-build apartment schemes, they provide both a
means of ensuring communal maintenance provisions are administered
(albeit funded by service charges), and a valuable source of income for
developers and investors.

In new-build blocks, the sale of ground rents to investors can generate
a capital sum equal to around 3% of the scheme’s gross development
value, or as little as 0.5% if the leases are poorly structured.
The financial stress many residential developers are under has
contributed to an increase in the supply of ground rents coming to
market. The main vendors of ground rents are builders of new apartment
blocks, who are currently faced with low sales volumes in a declining
market. In such conditions, the sale of a historic ground rent portfolio
can provide a vital lifeline to cash-strapped developers and much needed
turnover for agents.

Recent reductions in the Bank of England base rate have reduced
funding costs for ground rent portfolios, but debt is more difficult to
obtain and loan-to-value ratios have fallen. Most buyers are paying cash,
and intending to ‘gear up’ at a later date. This against the background
of growing scarcity of residential development finance, which provides
developers with a strong incentive to monetise any assets through a
willing market of potential purchasers. There is a visible disconnect
between the availability of finance for development and long-term
investment, with the former being shunned as risky at a time of falling
capital values and few buyers for the end product.
The recession has caused inflation to decline rapidly from its height
of close to 5%. This has meant ground rents with rent increases linked
to inflation figures such as the Retail Price Index have become less
attractive, with regular fixed increases providing more certain growth
for the long-term investor.

The current climate has meant that prices have fallen year on year,
because the scarcity of cash has driven up the target returns of those
in a position to buy. With a large amount of ground rents being actively
marketed, run-of-the-mill stock that would have been attractive a year
ago is being overlooked in favour of ground rents with potential for
outperformance in the medium term.

Motives and drivers                   

A purchaser of ground rents has a very different risk profile from a
vendor. The apartment scheme is likely to have been speculatively built,
with the developer relying on capital receipts from apartment sales to
repay development finance and yield an immediate development profit.

A ground rent purchaser is likely to have a different approach. On newbuild
stock, the variables that make the apartments saleable – location,
aesthetics, square footage and rental yield – make very little difference to
the ground rent purchaser. He/she would normally look first for rent
review provisions, with a strong preference for regular fixed uplifts.
Historically, management and insurance could be lucrative for the ground
rent owner, but this is changing with increasing use by long leaseholders
of their Right to Manage.

Without debt funding, the return on ground rents is of little interest
to investors; it is only by ‘gearing them up’ with bank funding that they
become worth holding. Such funding is far less accessible than it is for
land or residential property purchases, and is usually available only in
tranches valued at more than £2m. Developers who retain ground
rents are often unable to borrow against them, and therefore cannot
use the funds for land purchases or dividend payment.

1. Large ground rent portfolios allow for economies of scale in the
administration of ground rent invoices and the appointment of
managing agents

2. The two parties have very different target returns, reflecting their
respective risk profiles. Developers taking substantial risks by
purchasing land and investing in materials might rightly expect an
annual return on equity of around 30% for the duration of a project.
Ground rent investors usually have an aversion to risk, so their target
returns might be closer to 15%. Developers with knowledge of local
markets and future land transactions in the pipeline often prefer to
employ their capital in more lucrative activities. The credit crunch
has accentuated this, as ‘cash in the bank’, available for spending on
distressed land sales, is valued more highly than a steady but
unspectacular income stream.

Cautionary note

To avoid conflicts of interest in the selection of managing agents, it is
important that vendors insist on a separation of the management and
ownership entities, which can be provided for in the contract of sale.
When a developer is pre-selling ground rents on a new development,
it’s worth considering setting up a residents’ management company to
be run by the long leaseholders, which would take responsibility for the
annual ground rent payment. This can be a reasonable solution for all
the parties involved, as the landlord’s administrative costs are reduced,
the leaseholders take responsibility for their own environment and the
developer gets both a reputation as a reasonable vendor and a capital
sum for the ground rents.

The extreme on the developer’s part is to include a ‘share of freehold’
with each long leasehold purchase. This is an expensive tactic however,
as the ground rent investment sale can generate in excess of £2,000 per
unit as a capital sum, while it will add little of that to the initial sale price
of the apartment.

Steady demand

Transactions in the market as a whole have almost ceased, yet there
still seems to be a demand for ground rents. Why?

1. Relative lack of volatility in valuation compared to the rest of the
market. As the value of new-build ground rents largely reflects
multiples of passing income and not capital values of the underlying
property, the decline in residential land values caused by falling
property prices has not yet been reflected in ground rent sales prices.
Having said that, the scarcity of debt finance has affected the pricing
of tertiary new-build ground rents, largely those with poor rent review
provisions or very long leases.

2. Shortage of good-quality stock. Just because a ground rent is
payable does not make it an attractive investment. It is rare to find
truly ‘triple A’ stock even in a market swamped with vendors, and
attractive lease structures will always have a scarcity value.

3. Fear of defaults in other property types, prompting a ‘flock to
safety’. Ground rents carry no risk of void periods, very little risk of
tenant default and require minimal direct maintenance. As such, they
are attractive to those who fear rental voids on tertiary commercial
property in the wake of recession, or falling capital values on rented
residential property. While there is little scope for rapid capital
uplifts, the downside is limited. In a market dominated by fear,
this is attractive.

Increasing the value of ground rents

1. On schemes that are yet to be built. It is worth discussing the annual
ground rents and rent-review provisions with a ground rent investment
company prior to instructing solicitors to draw up leases. Often
investors will be able to provide standard leases that contain attractive
provisions and assist with finding reputable local managing agents.
It is becoming increasingly attractive for developers to ‘pre-package’
their sales in bulk to ground rent investment companies, who then
release monies post-exchange to the developer, which helps fund
the development. In some instances this can replace the developer’s
expensive mezzanine finance, while providing an attractive forward
purchasing schedule for the ground rent purchaser.

Ground rent sales can yield 4% of GDV, but a more normal figure is
2-3%. By pre-selling ground rents, the developer also avoids having to
offer the right of first refusal to long leaseholders, as transactions can
be structured to effect an exchange prior to 50% of apartments being
sold and completion of the sale of the last apartment. This avoids the
statutory two-month expiry period connected with Section V notices
(the rights of pre-emptive purchase a landlord has to serve on the long
leaseholders when he is selling the freehold interest), and provides
certainty for both parties.

2. On completed schemes. It is too late to do much to improve the
value of retained ground rents. It is worth collating all the relevant
information – sample leases, office copies of title, management
provisions, etc – prior to approaching a ground rent investment
company. This will allow the company to quote rapidly, and avoid
confusion over the particulars of the subject property. Additionally,
paperwork showing the contact details of the long leaseholders
will allow the ground rent purchaser to serve the Section V notices
rapidly, which speeds up the transactions and reduces the vendor’s
legal costs.