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Sunday 10 March 2019

The home front revisited

By Peter Sugarman

Peter Sugarman, a Tortoise member, read our recent article on homeowners trapped in crippling leasehold arrangements. His own professional experience tells him the ancient system offers distinct advantages but also needs reforms to protect against unscrupulous actors…

You live in a small block of flats in one of the pleasanter London suburbs; your fellow leaseholders include various professionals and a retired accountant, seemingly with limitless time on her hands. The freeholder appears to provide you little in the way of value, and yet you pay both a ground rent and a high service charge. When you contacted an insurance broker to research insurance coverage for the building, you received a quote that was 35 per cent less than you have been charged. Meanwhile your freeholder has just levied a £200 fee for you to have the right to install new windows.

You’re angry; as is your younger sister – actually, in her case, distraught would be the more appropriate adjective. Nine years ago, on her 25th birthday, she bought a house, sold to her leasehold, not freehold. Her solicitor, recommended by the developer, failed to point out that the ground rent doubled every ten years – next year it will jump to £630. On her 75th birthday the annual ground rent will exceed £10,000. The local estate agent tells her the house is unsellable.

The Government is currently studying the leasehold market, and there are abuses aplenty which deserve consideration. There is no justification for houses being sold other than freehold; ground rents on flats should not be onerous, either in terms of the initial charge, or any escalation clause; and service charge management should not be a profit centre for freeholders. Responsible freeholders endorse any and all changes which address these problems, as well as welcoming prosecutions of bad actor developers, managing agents and solicitors who have failed to act in the best interest of their clients.

So why are the proposals to abolish ground rents and to replace leasehold with commonhold ownership flawed, particularly when commonhold is widespread on the Continent, US and Australia? The answer is that the UK market is fundamentally different from that elsewhere: our private rented sector has low levels of institutional participation, and many larger blocks of flats have significant numbers of non-resident, and in many cases non-domiciled, leasehold owners. Ensuring the long-term “health” of a block of flats requires its fabric to be maintained appropriately. This is challenging if the interests of parties are not fully aligned, or if there are no parties suitably qualified to take on the responsibilities. Flat owners want to maximise returns over their period of ownership, which vary between owners in the same building. Achieving consensus about high-cost maintenance is always difficult, but the problem is exacerbated if half of the owners are living in Hong Kong and the other half have no free cash and no ability to hold a management company to account.

I help to manage a portfolio of 10,000 leasehold properties for a large UK pension fund. What is their motivation for this investment? The answer is that pension funds and life insurance companies have a problem. In order to protect pensioners from risk, regulators want the pension funds to hold credit-worthy assets which generate a known stream of cash flows which are also protected against inflation – ground rents on freehold property are the only asset which meets this criteria, other than government inflation-linked bonds, which currently pay a negative interest rate.

Institutional investors are therefore happy to take on the long-term responsibility for caring for buildings, in return for a modest annual ground rent (say 0.1 per cent of capital value), rising every ten years in line with inflation. That is very different from the attitude taken by the small-scale traditional freehold property buyer looking for a quick short-term profit by padding service charges and imposing a new fee every time a leaseholder wanted to sneeze.

In our portfolio, we currently have fire marshals at two of our buildings (24/7) as a result of fire insulation issues identified after the Grenfell Tower fire which killed 72 people in June 2017. On one of those buildings we have fronted well over £1 million, both for the marshals themselves and for the remedial works. Without this expenditure residents (mostly tenants) would have been required to vacate. We hope to reclaim that money from the developer, who is being investigated for fraud by the local council, or from his insurer; but we expect litigation, which will need to be separately funded and could take at least two years to resolve. Across our portfolio at any one time there are some 15 per cent ground rent arrears; in consequence we provide freeholder loans to around 5 per cent of buildings to ensure insurance premiums are paid on a timely basis and full insurance coverage is maintained. Perhaps 10 per cent of the insurance policies on buildings we acquire are flawed in some way and we need to negotiate changes. We hold our managing agents to the highest standards and require them to be regulated. Over 50 per cent fail to meet these norms and are replaced.

Aviva, Nationwide, M&G and the large pension funds all have their reputations to preserve, and these have been the major buyers of freeholds over the past few years. They have every incentive to embrace legislation that drives out property cowboys. This has already resulted in the market self-correcting for new builds – no leaseholds for houses and no abusive escalation clauses – but they will leave the market if there is no economic incentive to participate, and they will look for judicial review if the value of their existing investment is impaired by retroactively applied confiscatory legislation.

Investors such as these are not against enfranchisement by leaseholders wishing to buy out the freeholder, nor do they oppose existing legislation which allows leaseholders the right to self-manage. They endorse measures which make processes simpler, quicker and more transparent. But before embracing commonhold wholesale please consider the unintended consequences.

Over the past three years the author has been involved in the acquisition of over £300m residential property freeholds. The views expressed are his own.