In the Summer of 2017, the government signalled its intent to regulate residential ground rents due to what it perceived as unfair practices. Fast forward to December 2017 and the government’s consultation period has already ended. Should lawmakers choose to follow these developments, legislation may not be too far away.

The main proposals include prohibiting the sale of new build leasehold houses and limiting ground rents on the sale of new build leasehold flats.

So what is the likely effect on the ground rent market presently and for the future?

After the government announced its intentions in December 2017, shares in Persimmon Homes, Barratt Developments and even McCarthy & Stone did come under short term pressure. But what is the real impact on investors?

The ground rent market has traditionally offered investors a high yielding and low risk fixed income investment, dominated by privately funded investors, however, over the last ten years, the market has been cornered by several property groups, pension funds and other financial institutions and developers who are keen to invest when interest rates remain at historic low levels.

Consequently, the market is extremely competitive with ground rents being sold at auctions nationwide between 25 to 35 times their ground rent income. For example, a development consisting of 20 flats with each flat being sold on a lease of 125 years at a ground rent of £250.00, increasing every ten years in line with the Retail Price Index (RPI), would typically fetch between £125,000 and £175,000.

This is great news for existing freeholders with large portfolios who can ‘cash-in’ on the perceived value of ground rents but for new entrants to the market, it is becoming increasingly difficult. The majority of residential property developers are working alongside ground rent investors to structure their leases so that the value of the freehold can be maximised. This provides additional income for developers who will offload the freehold to investor landlords.

With the constant need for more and more housing, the ground rent market has been on an upward curve as both investors continue to bid up the price of ground rents due to the demand for housing. However, will this continue?

The government’s proposed intervention into the market, as outlined above, especially in relation to new residential leases being subject to a peppercorn ground rent, will have consequences for all parties involved.

Firstly, for investors, many will have to re-think their model of investment if ground rents are to be regulated at a peppercorn. Will investors now be solely focusing on the long term reversionary value of a lease, in terms of the premium they would be in receipt of when the leaseholder wishes to extend their lease? It is clear, this is the view of some investors presently, but this is not a predominant strategy for ground rent investors. Or will investors continue to invest on the premise that even though the ground rent may not be recoverable, the insurance premium and management fee will continue to be recovered under each lease? In other words, ground rent investors will look to recover the loss of their income from ground rents through the management fee and insurance premium, recoverable under each lease.

This second point raises an important question as to whether the government may begin to regulate the service charge provisions found within a lease, if indeed, investors look to recover the loss of their income from ground rents through the management fee and insurance premium, recoverable under each lease.

Thirdly, developers will no longer be able to receive the same income from the sale of freeholds to investors at the prices previously generated. Whilst investor landlords won’t be able to base their investment on the receivable ground rent income from a development, the perceived income received from the management fee and insurance premium will have to form a basis of the price payable by investors.

Finally, with regards to existing leases, it does leave developers and investors alike in an unclear position. With the government prepared to intervene and regulate new leases, will this extend to existing leases? Some market commentators think such a move to be extreme as ground rent investors have invested on the basis of the return from the annual receivable ground rent. Regulating this could impact on present investors’ portfolios and business models and income streams.

There is no doubt that developers are taking on board what the government is projecting. Developers, as we speak, are offering existing leaseholders, leasehold house owners and/or flat owners, with the opportunity to vary their leases so that the ground rent reviews contained within their leases are in line with the Retail Price Index (RPI) instead of doubling every ten years, as per the terms of the existing lease. Is this simply a public relations tool or is there more behind this?

There is a long way to go until the government acts but in the meantime, the ground rent market remains as competitive as it has been over the last few years and we do not see any decline in market confidence as it currently stands.