Ground rent investment is one of those killer property strategies not many people know about. It is a strategy you don’t need a fortune to get involved in, but it is very much a slow burner in terms of investment benefits.
However when those benefits arrive they can be very impressive.
To say ground rent investment is simple would be a lie. To say it can result in excellent ROI (return on investment) is true. But it is also true to say that it can be a bad investment and not worth the time of many investors.
Ground rent investment is a sophisticated, knowledge-intensive property strategy and it would be unwise to jump in without first maxing on your education, training and reading.
Engaging a property coach or adviser would also make good sense.
With those words of warning, here are some of the key features of ground rent investment…
1. What is a ground rent?
When a freeholder grants a long lease to someone (“a leaseholder”), a relatively modest rent (called “a ground rent”) is normally imposed and the freeholder’s interest is known as “a freehold reversion”.
If the person granting the lease is a leaseholder the lease is referred to as “a sub-lease”, the recipient of the lease “a sub-leaseholder” and the leaseholder’s interest is known as “a leasehold reversion”.
In this blog the term “reversion” or “reversionary interest” will be used to refer to both reversions.
Possibly because the term “reversion” is not an everyday word, the term “ground rent” is often in practice used to mean a freehold or leasehold reversion. This blog will sometimes do the same.
To minimise confusion, the rent which a reversion gives rise to – the ground rent – will be referred to in this blog as “rent” or “rental income”.
The term “ground rent investment” is therefore investment in reversionary interests.
2. Nature of reversionary interests
Reversionary interests typically arise when buildings are converted to or built as several flats and each flat owner (“leaseholder”; also known as “lessee” or “tenant”) is granted a long lease by the owner of the building (“freeholder”; also known as “lessor” or “landlord”).
However, reversionary interests can also exist in relation to new houses, where the developer or builder instead of selling it outright as a freehold (the norm), grants a long lease instead for any number of reasons – some good, some questionable.
A lease is a limited right. The lessor retains ownership of the land and sometimes parts of the building – such as communal areas.
The lessee is entitled to occupy the leased property for the duration of the lease only (typically 99 or 125 years but sometimes as long as 999 years) after which it reverts to the lessor – hence the term “reversion”.
The (ground) rent arises in recognition that the lessor still owns the ground on which the building sits and is entitled to some recompense for the use of their land.
The relationship is similar to that which exists between a landlord and tenant with mainstream rented property.
3. Rental income
If you buy a reversionary interest, its primary investment benefit is the rent receivable.
The rent is usually payable annually – in one or two instalments.
The amount of rent can be anything from a peppercorn to several hundred pounds per year in the case of modern leases of expensive city centre apartments.
The rent is an income – the higher its total value, the greater the capital value of the reversionary interest.
Where the rent is a mere peppercorn the value of the reversionary interest is likely to be modest, all things being equal.
4. Non-rent income
As well as the rent, a reversion could give rise to regular income in the form of entitlement to an annual management fee and/or commission for managing or insuring the building. However such income is in return for work – and is not investment income.
Service charge payments made to the owners of reversionary interests for repairs and maintenance of the building do not belong to them and must be used for the purpose provided and accounted for in line with the leases and statutory provisions.
Owners of reversionary interests may also be entitled to modest fees payable on certain events including the mortgage or sale of a leasehold property. However such fees are not investment income.
5. Capital receipts
At some point in the life of a lease, the owner of the reversionary interest (the lessor) will have a chance to make a capital gain or premium when the lessee requires an extension of the lease term when it is considered too short for any number of reasons.
The lessor stands to gain most when the lease expires to 80 years or less since at that point they become entitled to one half of “the marriage value” – being the extra value a lease extension adds to the leasehold property.
The lessor and lessee can agree the extended term and premium as they wish and in appropriate cases the premium may be tens of thousands of pounds. However, if they cannot agree terms, the lessee has a right to a 90 year lease extension at a peppercorn rent for a price decided by a tribunal.
Depending on the leasehold property, there may be other occasions when capital receipts or premiums may arise – such as where the lessee seeks permission to:
- Use a roof space for living accommodation
- Use a basement or cellar as living space
- Build on outside land which still belongs to the lessor
- Use a flat roof as a terrace
- Build another storey
- Change the use of the leased property or a part of it
- Vary the lease for their own benefit.
The amount of premium sought by the lessor will depend on many circumstances and it would be sensible for both parties to consult their own expert on the matter of valuation.
6. The valuation of reversionary interests
How much will a reversion cost you?
The precise valuation of a freehold or leasehold reversion is a complex matter, both a science and an art.
With highly valuable or complex reversions it is best practice to obtain a formal valuation from an expert prior to agreeing a price.
The basic method of valuation is to calculate a price based on a rental return considered acceptable at the time of purchase. That rental return is very much linked to prevailing interest rates.
With interest rates being very low at present (the Bank of England base rate is 0.75%), the current accepted rental return of reversions is also low – with 2.5% to 5% typically the norm.
The total rent of a reversion is £500 per year.
If you pay £10,000 for it, that amounts to a gross return of 5% per annum. It would be 20 years before you get back the amount you have invested – assuming no increase in the ground rents receivable.
If you paid £20,000 for it, that amounts to a gross return of 2.5% per year and it would be 40 years before you get back the amount you have invested.
These figures indicate how poor a ground rent investment can be if all it offers for many years is a rental income.
If a return of 2.5% is accepted, it will take you 40 years to double your money. If you invested that money in a buy to let property, past performance suggests such a property could double in value every 10 years.
With a ground rent, a £20,000 investment could be worth £40,000 after 40 years. Invest £20,000 in a buy to let property and it could be worth £320,000 after 40 years – and that takes no account of the leverage available with buy to let.
In addition to the rent, other regular income is often taken into account in fine-tuning the price of a reversion.
However, such income – for instance an annual management fee – is not investment income; the fact that it can push up the asking price operates negatively to reduce the rental return in real terms.
The length of the leases is a key factor taken into account when working out the price; shorter leases, especially those within a few years of the pivotal 80 years mark will tend to push up the value and depress the rental return.
MUST KNOW PROPERTY STRATEGIES
Buy to let (buy and hold a property for income and/or capital growth)
Rent to buy (property is rented before it is bought)
Rent to rent (rent property to rent it on for a higher rent)
7. Investment grade reversionary interests
The fact that reversions are a relatively poor investment if they offer little more than a rental income means you need to find investment grade reversions – reversions with the probability of large premium payments after a reasonable period of time – taken to be no more than 15 years.
You will therefore be looking for reversions with leases likely to dip below the pivotal 80 years mark within a 10-15 year period max, at which point lease extension premiums climb sharply on account of benefiting from 50% of the marriage value.
Similarly you will be looking for other premium earners including outside space belonging to the reversion and features such as roof spaces, cellars, basements and flat roofs which could give rise to a premium in return for their use.
You may also see an opportunity if one or more of the leaseholders is in arrears with ground rent or service charges or there is some other basis for taking forfeiture proceedings, terminating the lease and gaining possession of a flat.
However, the reality is that it is extremely difficult to succeed with forfeiture proceedings – not to mention the time and cost.
8. Types of ground rents
There are many types of ground rents including:
With reversions containing a large number of units, for instance 100 flats each at £500 rent per annum, the total ground rent receivable can be very large (£50,000 per year in this instance).
With reversions containing a small number of units, for instance 2 flats each at £25 rent per annum, the total ground rent receivable can be very small (£50 per year).
There are some very old ground rents of less than a pound a year!
Sometimes you will find a “company sale” where the company is being sold and with it the number of reversions it owns, which could be hundreds if not thousands.
The cost of such reversionary interests can run into hundreds of thousands if not millions of pounds.
MUST KNOW PROPERTY STRATEGIES
Option to purchase (profit from your control of a property)
Lease option (renting and controlling someone else’s property)
Delayed completion (completion is delayed to make a profit)
9. Downsides of reversionary interests
There are several negatives to investing in reversions. A big drawback is that collecting the rents and other sums due may be time-consuming and relatively expensive.
Complying with management duties such as dealing with repairs and maintenance can be difficult in the event of uncooperative leaseholders.
Even if you are entitled to charge a management fee, which is not necessarily the case with older leases, you may find that the cost of your time actually exceeds the rent or other income you are receiving.
There are several other drawbacks including:
- When selling, the owner of a reversion usually needs to give first refusal to the leaseholder/s; the need to give first refusal, serving prescribed notices and following a rigid procedure, means that selling can be very slow – taking many months
- The investment benefit of leverage is not normally available as mainstream lenders will not usually lend for the purpose of buying reversions
- Where the remaining lease term is very long, taken as 100 years or more, it will be at least 2 decades before it runs down to the pivotal 80 years mark – spiking the value of the reversion; for many investors that is too long term an investment and is unacceptable accordingly
- Where rents have no or inadequate provision for increase in line with inflation, time will reduce their real value; if the reversion is not gaining significant capital value at the same time, the investment may be an extremely poor one
- If interest rates increase they make reversions less attractive in terms of comparable yields – especially if the rental income is fixed for the entire duration of the lease or is inadequate in terms of inflation proofing
- As reversions are fundamentally priced on the basis of the annual rental return, interest rate rises are a double whammy; they make reversions less attractive as an income earning investment at the same time as depressing their capital value attainable on a sale
- Due to bad practices by developers who sold off houses on leases and then sold the freehold reversions to unscrupulous profiteering investors, the government has leasehold practices in its sight and the opportunity to find profitable modern leases of houses is likely to decrease going forward.
Anyone buying reversionary interests of new houses created in the last 10-15 years should be extremely cautious and should seek expert advice before proceeding, as there is every chance that the government could grant leaseholders certain rights – such as the right to buy the freehold on favourable terms – reducing the asset value of freehold reversions at a stroke.
10. A simple ground rent investment strategy
It should be very clear by now that reversions are a form of property investment which needs to be handled with great caution.
Some reversions make little investment sense – for instance, reversions where the rents are a few pounds a year and the leases have hundreds of years to run.
Before embarking on a ground rent investment strategy it is highly desirable for you to seek expert advice and in particular to compare and contrast the ROI you are likely to get with your chosen ground rent investment compared to other property investments you could pursue.
With some ground rents that could be an eye-opening exercise.
Subject to these and other caveats, here is a broad ground rent investment strategy which may be attractive to many prudent investors at the present time:
- Look to buy reversions with a rental return of not less than 5% and individual ground rents worth the collection time (£50 or more per year)
- In calculating the price to pay, disregard all other income unless it is of a genuine investment nature, involving no real work on your part
- Focus only on reversions with leases with 10 years or less to go before they reach the key 80 years mark; such reversions however will typically attract a premium price
- Only proceed where there is realistic opportunity to gain additional premium sums – such as for the use of a roof space, cellar or flat roof
- Look for properties which offer development opportunities – such as the chance to add more buildings or more floors upon the grant of planning permission.
If you have the time and the inclination to carefully study and master the subject, reversions can be a great investment – especially if you are prepared to wait for possible gains to materialise with the passage of time.
However, buying reversions with little chance of capital gains and low annual rents is a form of investment stupidity.
Before investing in ground rents it is strongly recommended that you discuss things thoroughly with an expert knowledgeable on the subject.
A critical consideration is to assess your possible gains elsewhere were you to invest the same amount of money.
Chosen wisely, ground rents can make you a killing; chosen rashly without due advice, they could seriously kill your returns and make you look quite silly.
Do you have any experience of reversions or ground rents? Please share your experiences below.
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Rebel Property Coach
My website is: www.rebelpropertycoach.com
Categories: 06 Strategies