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Commercial ground rents combine both the benefits of a fixed income with an ability to add value.

Commercial ground rents involve the freeholder leasing land to
a developer who agrees to pay an annual ground rent for the
lease term. The building can then be leased to an occupational
tenant, with the developer as head leaseholder. As an investment,
ground rents combine secure income, reversionary growth and the
opportunities for exceptional returns through active asset management.
Income valuation depends on the mechanisms for growth – as set out
in forthcoming rent reviews – such as frequency, unexpired term and
the tenant’s covenant quality. There are also many opportunities
created by restrictive use clauses in the occupational leases.

The rent reviews come in a mix of different formats. They can reflect
hypothetical characteristics of a property, such as the site’s rental value
as open land, be geared to the open-market rental value, offer fixed
uplifts or reflect government statistics such as the Retail Price Index.
Security is provided by the income’s reversionary nature, rent received
is normally at a discount to open-market rent if the head leaseholder
defaults. As such, investors can speculate on a variety of indices when
buying ground rents, with inflation-linked reviews making them a proxy
for government bonds or rent reviews geared to the open market,
providing exposure to occupational sub-markets across the country.
The frequency and nature of the rent reviews also affects the value,
broadly, the more frequent, the better net present value (NPV) of the
future receivable income. Vagaries as to the mechanism for reviewing
the rent can also have a detrimental affect on values, as there is a
premium placed on the certainty of knowing how the income will change
in future. As such, a landlord owning a ground rent with 20 years to go
until a poorly defined rent review, can see a rapid uplift in value if the
leaseholder is prepared to accept a premium to ‘re-gear’ the lease to
reflect fixed five-early reviews to the changes in the Retail Price Index.

The unexpired lease term has a large bearing on the value of a
commercial ground rent. The shorter the term until reversion, the higher
the NPV of receiving vacant possession. An investor would normally
want to apply a ‘wholesale discount’ to reflect the delayed nature of
the receipt, somewhere close to 40%. This creates an opportunity for a
valuable uplift if the leasehold interest can be ‘married’ with the ground
rent by the landlord, as the value of the whole would be greater than
the sum of its parts.

The quality of the underlying tenant’s covenant is significant,
although this can be tempered by the quality of the underlying property.
On secondary property, a quality long leaseholder provides security and
eradicates the hassles of chasing errant tenants. On more attractive
properties, a defaulting long leaseholder offers an opportunity to obtain
vacant possession, and so can be a blessing in disguise. Shrewd investors
will look at their outlay on the ground rent as a percentage of
the value of the underlying property to ensure sufficient security is
afforded in the event of default.

Occupiers of leaseholds subject to ground rents can benefit from
the arrangement also. A leasehold with a 30-40 year term can be
purchased relatively cheaply, and provides the occupying business
with a secure base in the medium term. If their business is successful
or they want to develop the property further, they can then purchase
the freehold ground rent and marry the two interests together. Most
ground rent owners are delighted to sell to the long leaseholders, as
their ability to pay ‘special purchaser’ prices can provide profitable exit
routes. Unlike in residential ground rent ownership, however, there is
no enfranchisement mechanism where commercial tenants can force
a sale, apart from a few cases where the property was originally in
residential use.

Vendors are often councils or public bodies, who typically own
ground rents on tranches of land sold on long leases in the 1930s to
the 1960s. Commercial owners tend to be pension funds, family trusts
or private property companies, who value the combination of secure
income and opportunity for out-performance in the medium term. Sales
by public bodies normally occur through public auction, while private
vendors normally deal ‘off-market’ through surveyors. The security of
income has meant recent market conditions have had less of an
impact on valuations than for more secondary property where there
might be the need to re-let vacant units in the midst of a recession.
Commercial ground rents combine the characteristics of fixed
income with the ability to add value through entrepreneurial active
management. As such, they are sought-after investments for a wide
variety of buyers, and liquidity should remain for those looking to sell –
even in these troubled times.

 

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