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Law Commission

Reforming the law

Leasehold home ownership: buying your freehold or extending your lease

Report on options to reduce the price payable

Law

W Commission

Reforming the law

(Law Com No 387)

Leasehold home ownership: buying your freehold or extending your lease

Report on options to reduce the price payable

Presented to Parliament pursuant to section 3(2) of the Law Commissions Act 1965

Ordered by the House of Commons to be printed on 8 January 2020.

HC 13

© Crown copyright 2020

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ISBN 978-1-5286-1706-2

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The Law Commission

The Law Commission was set up by the Law Commissions Act 1965 for the purpose of promoting the reform of the law.

The Law Commissioners are:

The Right Honourable Lord Justice Green, Chairman

Professor Sarah Green

Professor Nick Hopkins

Professor Penney Lewis

Nicholas Paines QC

The Chief Executive of the Law Commission is Phil Golding.

The Law Commission is located at 1st Floor, Tower, 52 Queen Anne's Gate, London SW1H 9AG.

Professor Sarah Green and Professor Penney Lewis were appointed Law Commissioners on 1 January 2020. The terms of this report were agreed on 12 November 2019 when Professor David Ormerod QC and Stephen Lewis were Law Commissioners.

The text of this report is available on the Law Commission's website at http://www.lawcom.gov.uk.

All websites footnoted in this report were last visited on 16 December 2019.

Table of Contents

Glossary

Summary                                                       1 - 31

CHAPTER 1: INTRODUCTION

This Report

What is leasehold ownership?

What are enfranchisement rights?

What are premiums?

The views and opposing interests of landlords and leaseholders

Views on the fairness of enfranchisement premiums

The difference between premiums and professional costs

Two broad methods of calculating premiums

Our project

Our Terms of Reference: options for reducing premiums, not recommendations

Sufficient compensation and human rights

Leaseholders’ human rights

Landlords’ human rights

The options for reducing premiums in this report

The Consultation Paper and consultation events

How we have dealt with consultation responses

Issues beyond our Terms of Reference

Welsh devolution

Structure of this Report

Summary of the options for reducing premiums in this Report

Publications accompanying this Report

Acknowledgements

The project team

• CHAPTER 2: CALCULATING PREMIUMS UNDER THE CURRENT LAW

Introduction

(A): The current valuation methodology

• (1) The “term”

• (2) The “reversion”

• (3) Marriage value

Summary

Development value, additional value and other loss

Potential alternative bases for assessing market value

(B): The current valuation process

Introduction

Stage 1: valuations for advice

Stage 2: valuations for negotiation

Stage 3: valuations for Tribunal determination

Conclusion

• CHAPTER 3: ARGUMENTS ABOUT REFORM

Introduction

• (1) Opposing views on whether leasehold ownership is inherently unfair 46

• (2) Problems with the law governing the calculation of premiums

Problems with the current law

Practical consequences of those problems

Problems for leaseholders with onerous ground rent obligations in

their leases

Summary

• (3) Arguments for and against reducing premiums

The competing interests of leaseholders and landlords

Different types of leaseholders and landlords

Landlords’ arguments against reducing premiums

Leaseholders’ arguments in favour of reducing premiums

• CHAPTER 4: LAW AND VALUATION: OUR ROLE AND GOVERNMENT’S

ROLE

Introduction

Setting the legal framework and process for valuation

The route to valuation reform

• (1) What should the overall valuation framework be?

• (2) What is the correct methodology for assessing “market value”?

• (3) If rates are prescribed, by what process should they be set?

• (4) If rates are prescribed, what should the rates be?

Consultation responses about valuation methodology

The correct method for assessing market value

The correct rate or relativity graph

Conclusion

• CHAPTER 5: POSSIBLE NEW VALUATION “SCHEMES” TO REDUCE

PREMIUMS

Introduction

Overview of the “schemes” set out in this chapter

Setting premiums by reference to a simple formula

A multiplier of ground rent: Option 1A in the Consultation Paper

Set percentage of freehold value: Option 1B in the Consultation Paper 93

Setting premiums by reference to market value

The Consultation Paper

Consultation responses

A revised approach: from “components” to “assumptions”

Who would benefit from Schemes 1, 2 and 3?

Scheme 1: assumption that the leaseholder is not in the market and will never be in the market

Scheme 2: assumption that the leaseholder is not in the market, but may be in the market in the future

Scheme 3: assumption that the leaseholder is always in the market 116 The potential role of a simple formula

• CHAPTER 6: “SUB-OPTIONS” FOR A NEW SCHEME TO REDUCE

PREMIUMS

Introduction

Overview of the sub-options set out in this chapter

Reform to elements that would (or could) reduce premiums

Sub-option (1): Prescribing rates

What do we mean by prescription of rates?

The benefits of prescribing rates (at, or below, market levels)

The benefits of prescribing rates below market levels

Consultation responses concerning prescription of rates

A culture change: moving from individual tailored valuations to general valuations

Prescription of capitalisation rates

Prescription of deferment rates

Prescription of relativity (or the no-Act deduction)

Compatibility with A1P1 of prescribing rates

Conclusion: options for Government relating to prescription of rates 148

Can FHVP values be prescribed?

Sub-option (2): Treatment of ground rent

The significance of ground rents for landlords and leaseholders

The Consultation Paper

Consultees’ views

Compatibility with A1P1 of a cap on ground rent in the enfranchisement valuation

Conclusion: options for Government

Sub-option (3): Development value

The Consultation Paper

Consultees’ views

Alternative mechanisms to provide an election restricting development 169 Compatibility with A1P1 of enabling leaseholders to elect to take a restriction on development

Conclusion: options for Government

Sub-option (4): Differential pricing for different types of leaseholder

The Consultation Paper

How can a distinction be drawn in practice?

Consultees’ views on differential pricing

Compatibility with A1P1 of differential pricing for different types of leaseholder

Conclusion: options for Government

Reform to elements that would, by themselves, increase premiums

Sub-option (5): 80-year cut-off in respect of marriage value

The Consultation Paper

Consultees’ views

Conclusion: options for Government

Sub-option (6): Discount for leaseholders’ improvements

The Consultation Paper

Consultees’ views

Conclusion: options for Government

Sub-option (7): Discount for the risk of holding over

Current position

Consultees’ views

Conclusion: options for Government

Conclusion

• CHAPTER 7: WORKING TOWARDS AN ONLINE CALCULATOR

Introduction

The benefits of an online calculator

Reducing the variables by prescribing rates

The remaining variable: FHVP value

How is the FHVP value relevant to the calculation of enfranchisement premiums?

Conclusion

The status of an online calculator

Consultation responses

Consultees in favour of an online calculator

Consultees opposed to an online calculator

Conclusion

How should an online calculator be established?

Conclusion

• CHAPTER 8: COMBINING THE NEW VALUATION “SCHEMES” WITH

THE DIFFERENT “SUB-OPTIONS” FOR REFORM

Introduction

Summary of the schemes and sub-options

Adopting one scheme with a combination of sub-options

• CHAPTER 9: SECTION 9(1) VALUATIONS

Introduction

The current law

Current qualification criteria: when does the original valuation basis apply?

Current valuation methodology: what is the original valuation basis? 213

Applying section 9(1) in practice

Problems with the current law

Ascertaining which houses qualify for valuation under section 9(1):

problems with the current qualification criteria

Calculating the premium under section 9(1): problems with the current valuation methodology

The Consultation Paper

Consultees’ views

Should the section 9(1)

Discussion and options for reform

Options not put forward for Government

• (1) Extending section 9(1): should the original valuation basis under

section 9(1) be extended across all enfranchisement claims?

• (2) Abolishing section 9(1): should section 9(1) be abolished entirely without any form of replacement?

• (3) Replacing section 9(1) with equivalent provision

Options put forward for Government

• (1) Retaining section 9(1)

• (2) Replacing section 9(1) with an entirely new scheme providing a favourable valuation basis for low value properties

• CHAPTER 10: SUMMARY OF OPTIONS TO REDUCE PREMIUMS

• APPENDIX 1: LIST OF CONSULTEES

• APPENDIX 2: TERMS OF REFERENCE

• APPENDIX 3: CALCULATION OF PREMIUMS FOR THE WORKED

EXAMPLES (HOUSES 1 TO 4)

• APPENDIX 4: SECTION 9(1) MODELLING

GLOSSARY

“1967 Act”: the Leasehold Reform Act 1967, which gives leaseholders of houses the right to buy their freehold or extend their lease.

“1993 Act”: the Leasehold Reform, Housing and Urban Development Act 1993, which gives leaseholders of flats (a) the right to extend their lease, or (b) the right, acting with the other leaseholders in their building, to purchase the freehold of their block.

“2002 Act”: the Commonhold and Leasehold Reform Act 2002, which made various changes to the enfranchisement regime.

“A1P1”: Article 1 of the First Protocol to the ECHR (see below), which provides for the peaceful enjoyment of property.

“Assumption”: when assessing the market value of an asset, it is necessary to make “assumptions” about the market in which the asset is being sold or about the nature of the asset. For example, it is assumed that the leaseholder has complied with any repairing obligation in the lease.

“Capitalisation/capitalisation rate”: “capitalisation” refers to the calculation of a capital sum which reflects the right to receive income (such as ground rent) in the future. The “capitalisation rate” is the rate of return applied to calculate a capital sum that reflects the value of such an income stream. It is derived from market evidence. See paragraph 2.19.

“Collective enfranchisement”: the statutory right for leaseholders of flats, acting with the other leaseholders in their building, to purchase the freehold of their block.

“Compensation”: see “premium”.

“Consultation Paper”: our consultation paper “Leasehold home ownership: buying your freehold or extending your lease”, published on 20 September 2018, and available at https://www.lawcom.gov.uk/project/leasehold-enfranchisement/.

“Decapitalisation”: the process of deriving an annual income which is equivalent to a given capital sum. See paragraph 9.17.

“Deferment rate”: the annual discount applied, on a compound basis, to reflect the fact that money due to be received in the future (assessed at current prices) will instead be received now. In this context, a deferment rate is used to ascertain the present value of an asset that consists of the right to have a property back at the end of the lease. See paragraph 2.34.

“ECHR”: European Convention on Human Rights.

“Enfranchisement rights”: leaseholders have a statutory right to extend their lease. In addition, leaseholders of houses have a statutory right to purchase their freehold, and leaseholders of flats have a statutory right, acting with the other leaseholders in their building, to purchase the freehold of their block (“collective enfranchisement”).

“Freehold ownership”: freehold ownership is property ownership that lasts forever, and which generally gives fairly extensive control of the property.

“Freehold vacant possession (FHVP) value”: the amount that a property is worth held on a freehold basis and not subject to any leasehold interests. See paragraph 2.32.

“Find R test”: the test relies on a formula set out in section 1(1)(a)(ii) of the Leasehold Reform Act 1967, the purpose of which is to calculate, if the premium payable upon the grant of a lease were instead paid as an annual rent, what that rent would be. The test is used in section 1(1)(a)(ii) to determine whether a lease granted on or after 1 April 1990 (and not pursuant to a contract made before that date) qualifies for a valuation under the “original valuation basis” (under section 9(1) of the Leasehold Reform Act 1967) and, in that section, the outcome (“R”) cannot exceed £25,000 on the date that the lease was entered into or contracted for. See paragraph 9.91 onwards.

“Ground rent”: a regular payment which a leaseholder is required by his or her lease to pay to the landlord. Ground rents can be “fixed” (for instance, £300 per annum), subject to a simple review (for example, increasing by £50 per annum every 25 years), or subject to a “dynamic” review (for instance, increasing in line with the Retail Prices Index).

“Hope value”: a deferred form of marriage value (see below). If a freehold interest is sold to someone other than the leaseholder, marriage value will not be realised as a result of that sale. However, the purchaser might “hope” that they will sell the freehold to the leaseholder in the future, which will realise marriage value. The purchaser may therefore pay an additional amount now (“hope value”) to reflect that future possibility. In the context of collective enfranchisements, hope value may be payable in respect of non-participating flats, to reflect the fact that the leases of those flats may be extended (at a premium) in the future. See paragraph 2.51.

“Landlord”: a person who owns an interest in property out of which a lease has been granted. A landlord may be either the freeholder of the property, or hold a leasehold interest in the property himself or herself.

“Lease”: the legal device (usually a written document) that grants a person a leasehold interest in a property and sets out the rights and responsibilities of the leaseholder and landlord. A leasehold interest is a form of property ownership (see “leasehold ownership”).

“Leasehold ownership”: leasehold ownership of property is time-limited ownership (for example, ownership of a 99-year lease), and control of the property is shared with, and limited by, the landlord.

“Leaseholder”: a person who owns property on a long lease.

“Mainstream valuation basis”: the basis for valuing the enfranchisement premium for all flats, and for those houses which do not fall within the “Original valuation basis” (see below). It is based on an assessment of the market value of the landlord’s interest. See paragraphs 1.30 and 2.8 onwards.

“Market value”: the amount that an asset is worth if sold in the open market. See paragraphs 2.10 and 5.80.

“Marriage value”: the additional value that is gained when the landlord’s and leaseholder’s separate interests are “married” into single ownership. It is the difference between:

• (1) the value of the freehold in single ownership; and

• (2) the value of both (a) the freehold interest and (b) the leasehold interest in separate ownership.

The value of (1) is often more than (2). Marriage value is “realised” or “released” by an enfranchisement claim because the freehold and leasehold interests, previously in separate ownership, are now in single ownership. See paragraph 2.40 onwards.

“Modern ground rent”: the rent determined under section 15 of the Leasehold Reform Act 1967, payable during the additional term of a 50-year lease extension of a house (under the current law). It is calculated by valuing the “site”, and then decapitalising that value. See paragraphs 2.5 and 9.15.

“No-Act deduction”: when calculating marriage value, it is necessary to establish the value of the existing lease, on the assumption that the leaseholder’s statutory enfranchisement right does not exist. Valuers commonly value the existing lease by finding the real-world value of a comparable short lease, and then deducting from this the estimated value of the benefit of enfranchisement rights. This approach is also referred to as a “deduction for Act rights”. See paragraph 2.44 onwards.

“Original valuation basis”: the basis for valuing the freehold of a house under section 9(1) of the Leasehold Reform Act 1967, based largely on an assessment of the market value of the land on which the house is situated, but not the value of the house itself. It applies to houses which fall below certain financial limits. It does not apply to any flats. See paragraph 1.30 onwards and Chapter 9.

“Peppercorn rent”: many long leases specify an annual ground rent of a peppercorn. Strictly, the landlord in these cases could require the leaseholder to provide him or her with a peppercorn annually, but invariably this is not demanded. A peppercorn rent is used in circumstances where it is intended that there should be no substantive rent payable. Under the current law, any lease extension of a lease of a flat under the 1993 Act must be granted at a peppercorn rent.

“Premium”: the premium is the sum a leaseholder or nominee purchaser must pay to the landlord(s) in order to exercise enfranchisement rights, namely in order to obtain a lease extension or to acquire the freehold of property. The premium is also referred to as the “price” or “compensation”. In other contexts, “premium” is used to describe the capital sum paid by a leaseholder when they purchase a lease of a property: it is the sale price for the property. See para 6.148.

“Price”: see “premium”.

“Prime Central London”: Savills Residential Research produce a Prime London Index which is designed to reflect the price movements of prime property in London. The Index is divided into five areas: Central, North West, North & East, South West and West. The “Prime Central London” Index includes Notting Hill, Kensington, Chelsea, Knightsbridge, Marylebone, Mayfair, Westminster and Pimlico. Whilst the term Prime Central London (“PCL”) is not necessarily used with precision, it generally refers to these areas.

“Rateable Value” or “Domestic rateable value”: a value attributed to a property, based on an assessment of the annual rental value of the property. Part of a system of local taxation that was used by local authorities for domestic (residential) properties between 1967 and 1990 (and which was a predecessor to council tax). Assessments of rateable values were carried out by the District Valuer’s Office. Rateable values for domestic properties were abolished on 1 April 1990 when a new scheme of local taxation was introduced.

“Relativity”: the relative value of (a) a leasehold interest in a property, and (b) the freehold interest of that same property with vacant possession (the FHVP value), expressed as a percentage. See paragraph 2.44 onwards.

“Reversion”: we use “the reversion” to refer to the value of the right to have the property back when the lease expires (sometimes referred as the right to have “vacant possession”). See paragraph 2.28 onwards.

“Schemes”: we present three overall “schemes” as options for a reformed valuation methodology in Chapter 5. In Chapter 8, we explain how the adoption of one of the schemes can be combined with the various “sub-options” for reform discussed in Chapter 6.

“Section 9(1) valuation basis”: see “Original valuation basis”.

“Sub-options”: we present various “sub-options” for reform in Chapter 6. They are individual component parts of calculating enfranchisement premiums, which could feature in one or more of the overall valuation “schemes”. In Chapter 8, we explain how the sub-options could be combined with one of the new valuation schemes discussed in Chapter 5.

“Sunset period”: a temporary period of time following the introduction of new legislation (where such new legislation is intended to replace existing legislation), during which the existing law remains in force before being abolished. A sunset period is generally intended to assist those whose rights would be negatively affected by the introduction of the new legislation by giving them a period of time to exercise their rights under the existing law before it is abolished.

“Site value”: under the Leasehold Reform Act 1967, the value of the land on which a house is situated, not including the value of that house. Site value is decapitalised to calculate the modern ground rent payable during the additional term of a lease extension. See paragraph 9.15.

“Term”: we use “the term” to refer to the value of the right of the landlord to receive the ground rent for the duration of the lease. See paragraph 2.12 onwards.

“Term and reversion”: we use “term and reversion” to refer to the value of the right of the landlord to receive the ground rent for the duration of the lease (“the term”) and the right of the landlord to have the property back when the lease expires (“the reversion”). See paragraphs 2.12 and 2.28 respectively.

“Tribunal”: the First-tier Tribunal (Property Chamber) in England and the Residential Property Tribunal in Wales.

“Unexpired term”: the remaining amount of time left until the end date specified in a lease. A lease granted for a period of 50 years will, after 10 years, have an unexpired term of 40 years.

“Valuation”: the process of calculating the premium by putting a financial value on the interest the landlord has that will be acquired by the leaseholder.

“White knight”: a third party who contributes to the premium payable on a collective enfranchisement in respect of the non-participating leaseholders’ share of that premium.

“Years’ purchase”: years’ purchase is tied to inflation, and the fact that, in general, money will buy less in the future than it does now. It is a multiplier which is calculated through the setting of a yield (or other variable) and a number of years (for instance, until the expiry of a lease). See paragraph 2.16.

“Yield rate”: yield rate has the same meaning as “capitalisation rate”.

Law Commission

Reforming the law

LEASEHOLD HOME OWNERSHIP: BUYING YOUR FREEHOLD OR EXTENDING YOUR LEASE

Report on options to reduce the price payable

Summary

Introduction

Depending on which options for reform are pursued, it would be possible to create an online calculator for the calculation of premiums. Whilst valuation is complex, it does not have to be complex for the user. An online calculator would be simple for leaseholders to use, and would provide them with certainty about what their enfranchisement premium will be.

Valuation is a technical subject, but we have tried to make this Summary, and the Report, as accessible as possible. We have included a glossary at the end of this Summary.

The purpose of a leasehold home

What are enfranchisement rights?

Legislation has been enacted that gives leaseholders “enfranchisement rights”.

An example: why must leaseholders pay a premium?

A leaseholder has 60 years remaining on his or her lease, and is required by the lease to pay the landlord a “ground rent” of £200 per year.

The landlord is entitled to have the property back in 60 years’ time, and to receive the ground rent each year.

Result of an enfranchisement claim under the current law

Requirement to pay a premium

The landlord is no longer entitled to the property in 60 years, and is no longer entitled to the ground rent each year. The leaseholder must make a payment to the landlord to reflect the fact that the landlord’s entitlements under the lease are reduced or removed.

In Appendix 3 to the Report, we explain in detail how each element (the term, the reversion, and the payable share of marriage value) is calculated under the current valuation methodology.

We refer back to House A when we discuss our options for reform below.

What is “marriage value” and “hope value”?

The combined value of the leaseholder’s interest and the landlord’s interest in a property is often less than the value of those interests if they were held by the same person.

House A

The difference between those two figures is the “marriage value”, here £14,595.

When the leaseholder acquires the freehold, that marriage value is “realised” or “released” because the leaseholder now owns a house worth £250,000.

Where the lease has 80 years or less to run, the legislation requires the leaseholder to pay half of the marriage value to the landlord. Where the lease has more than 80 years to run, the legislation states that the leaseholder does not have to pay any marriage value to the landlord.

“Hope value” is a deferred form of marriage value. If the freehold is sold to someone other than the leaseholder, marriage value will not be realised as a result of that sale. However, the purchaser might “hope” that they will sell the freehold to the leaseholder in the future, which will realise marriage value. The purchaser may therefore pay an additional amount now to reflect that future possibility. That additional amount is “hope value”.

Hope value is always less than marriage value. A purchaser would not pay the full marriage value because the marriage value may not in fact ever be realised (if the lease simply runs its course and expires) or the marriage value may not be realised for a long time.

An individual leaseholder never pays both marriage value and hope value; only one of these elements of the premium is ever relevant to calculating the premium in an enfranchisement claim.

PROBLEMS WITH THE

CURRENT LAW

We explore various problems with the current law in Chapter 2 of the Report.

Complexity

Uncertainty being used as a negotiating chip

REDUCING PREMIUMS

Views on the fairness of enfranchisement premiums

During our project, we have heard opposing views from landlords and leaseholders about the fairness of the requirement to pay a premium in order to enfranchise, and the level of that premium. We summarise those views in the Report. Our Terms of Reference require us to examine the options to reduce premiums, and we take that as our starting point.

Owner-occupiers would benefit from a lower enfranchisement premium.

The policy of reducing premiums for leaseholders may be easier to justify under A1P1.

Leaseholders who are owner-occupiers, regardless of the length of their lease.

How would leaseholders benefit from the options set out in the Report?

Sub-option 3: no payment for development value (if the claim is for the freehold of a block of flats)

Sub-option 4: favourable premiums for owner-occupiers (if they are owner-occupiers)

Sub-option 5:

removal of 80-year cut-off for marriage value

but only if the reform is combined with other measures to reduce premiums

Sub-option 7:

removal of discount for holding over

CONCLUSION

We have set out the options for wholescale reform of the valuation regime in order to reduce enfranchisement premiums for leaseholders whilst ensuring that landlords receive sufficient compensation. Landlords will oppose any reforms that would reduce premiums, and we expect that some leaseholders will say that the options that we set out do not go far enough. The options that we have set out are detailed and nuanced, and reflect the limitations of human rights law. It is now for Government to decide which of the options to pursue, and then for Parliament to pass an Act of Parliament to implement that reform.

Find out more at designl02.co.uk

Design that makes a difference

Leasehold home ownership: buying your freehold or extending your lease

Report on options to reduce the price payable

To the Right Honourable Robert Buckland QC MP, Lord Chancellor and Secretary of State for Justice

• Chapter 1: Introduction

THIS REPORT

• 1.1 Leasehold enfranchisement is the process by which people who own property on a long lease (“leaseholders”) may extend the lease, or buy the freehold. ¹ In order to exercise enfranchisement rights, leaseholders must pay a sum of money (“a premium”) to their landlord. ²

• 1.2 We have consulted on wide-ranging reforms to the enfranchisement regime, which

would require primary legislation to implement.

• 1.3 This first report concerns solely the issue of how premiums are calculated. Our Terms of Reference, agreed with Government, include a specific provision in respect of premiums.

Government has asked us “to examine the options to reduce the premium (price) payable by existing and future leaseholders to enfranchise whilst ensuring sufficient compensation is paid to landlords to reflect their legitimate property interests”.

• 1.4 In accordance with our Terms of Reference:

• (1) we set out options for reducing premiums and for simplifying the way in which

premiums are calculated; but

• (2) we do not make a recommendation as to how premiums should be calculated. That is a not just a legal question: it involves considerations of law, valuation, social policy, and political judgement, and is therefore for Government and ultimately Parliament to decide.

• 1.5 This report enables Government and Parliament to decide how premiums should be calculated, informed by the consultation responses that we have received and our own expertise and analysis.

• 1.6 Our second report, to be published later this year, will address all other aspects of a reformed enfranchisement regime. In that report, we will make recommendations as to how the regime should be reformed.

• 1.7 Alongside our second report on enfranchisement, we will also publish our final recommendations for reform in respect of our related projects on:

• (1) the right to manage, which is a right for leaseholders to take over the management of their building without buying the freehold. They can take control of services, repairs, maintenance, improvements, and insurance; and

• (2) commonhold, which allows for the freehold ownership of flats (and other interdependent properties), offering an alternative way of owning property which avoids the shortcomings of leasehold ownership.

WHAT IS LEASEHOLD OWNERSHIP?

• 1.8 Many people own, or aspire to own, a home.³ But what does “ownership” mean? When an estate agent markets a house or flat as being “for sale”, what is the asset on offer? In England and Wales, property is almost always owned on either a freehold or a leasehold basis.

• (1) Freehold is ownership that lasts forever, and generally gives fairly extensive control of the property.

• (2) Leasehold provides time-limited ownership (for example, a 99-year lease), and control of the property is shared with, and limited by, the freehold owner (that is, the landlord).

• 1.9 So we refer to “buying” or “owning” a house or a flat. But when we buy on a leasehold basis, we are in fact buying a house or flat for a certain number of years (after which the assumption is that the property reverts to the landlord). A leasehold interest is therefore often referred to as a wasting asset: whilst it may increase in value in line with property prices, its value also tends to reduce over time as its length (the “unexpired term”) reduces. There comes a point when the remaining length of the lease makes it unsaleable, because purchasers cannot obtain a mortgage (since lenders will not provide a mortgage for the purchase of a short lease).

• 1.10 In addition, leasehold owners often do not have the same control over their home as a freehold owner. For example, they may not be able to make alterations to their home, or choose which type of flooring to have, without obtaining the permission of their landlord. The balance of power between leasehold owners and their landlord is governed by the terms of the lease and by legislation.

• 1.11 As well as this division of control, a landlord may have different interests from the leaseholders. For instance, the landlord may see a leasehold property solely as an investment opportunity or a way of generating income, while for leaseholders the property may be their home, as well as a capital investment.

• 1.12 We explain the reasons why houses and flats are held on a leasehold basis in Figure 1 below.

• Figure 1: Why are houses and flats held on a leasehold basis?

Flats are almost universally owned on a leasehold, as opposed to freehold, basis. That is because, for historic reasons, certain obligations to pay money or perform an action in relation to a property (such as to repair a wall or a roof) cannot legally be passed to future owners of freehold property. These obligations are especially important for the effective management of blocks of flats. For instance, it is necessary that all flat owners can be required to pay towards the costs of maintaining the block, which is important since flats are structurally interdependent. There are therefore good reasons, under the current law, why flats are sold on a leasehold basis.

But leasehold ownership is not limited to flats. Sometimes houses are sold on a leasehold basis. That has been the case for some years. ⁴ The first piece of enfranchisement legislation enacted in 1967 - the Leasehold Reform Act 1967 (“the 1967 Act”) - granted enfranchisement rights to leaseholders of houses. More recently, new-build houses have been sold on a leasehold basis. That allows developers to sell the property subject to an ongoing obligation to pay a ground rent. The right to receive a ground rent (in respect of both houses and flats) is a valuable asset, which can then be sold to an investor. Concerns have been raised about the sale of houses on a leasehold basis, and the UK Government has announced its intention to ban the sale of leasehold houses. ⁵

The reasons for selling houses on a leasehold basis are less apparent than those for leasehold flats. One reason might be the need to impose positive obligations on house owners in relation to the upkeep (management) of an estate, but that does not apply in all cases.

The reasons why, for legal purposes, houses and flats may be sold on a long lease do not, however, require the lease to provide income streams to the landlord, beyond those needed to maintain the property, the block, or the estate.

In many countries, leasehold ownership does not exist. Instead, forms of strata or condominium title are used so that flats can be owned on a freehold basis. In England and Wales, commonhold was introduced as an alternative to leasehold in 2002 (by the Commonhold and Leasehold Reform Act 2002), to enable the freehold ownership of flats. Commonhold allows the residents of a building to own the freehold of their individual units and to manage the shared areas through a company. Commonhold has not, however, taken off - fewer than 20 commonholds have been created since the law came into force. ⁶

Alongside our work on enfranchisement, we are carrying out a separate project to consider the various legal issues within the current commonhold legislation which affect market confidence and workability. We will recommend reforms that would allow commonhold to be reinvigorated as a workable alternative to leasehold, for both existing and new homes. ⁷ We will publish our final report later this year.

WHAT ARE ENFRANCHISEMENT RIGHTS?

• 1.13 As a consequence of the features of leasehold ownership described above, legislation has been enacted that gives leaseholders “enfranchisement rights”.

• (1) Leaseholders have a right to extend their lease (“the right to a lease extension”), which provides them with longer-term security in their home and goes some way to overcoming the problem of owning a wasting asset. Leaseholders’ security in their home, and the value of their asset, is far better protected if they can extend, say, a 60-year lease to 150 years.

• (2) Leaseholders of houses have a right to purchase their freehold, and leaseholders of flats have a right, acting with the other leaseholders in their building, to purchase the freehold of their block. Freehold acquisition provides leaseholders with the same advantages as a lease extension (namely, security in their home and protecting the value of their asset), but also allows leaseholders to gain control of their property from a landlord.

• 1.14 We summarise the current law of enfranchisement, and its history, in Chapter 2 of our Consultation Paper. ⁸

• 1.15 In order to exercise enfranchisement rights, leaseholders must pay their landlord a “premium”. ⁹

WHAT ARE PREMIUMS?

• 1.16 The result of an enfranchisement claim is that the leaseholder acquires, from the landlord, an enhanced interest in their property. Put another way, an enfranchisement claim involves the transfer of a property right (a longer lease or the freehold) from the landlord to the leaseholder.

• 1.17 The landlord’s entitlement under the lease, which is lost on enfranchisement, is valuable to the landlord. Equally, the enhanced interest acquired by the leaseholder though the enfranchisement claim is valuable to the leaseholder.

• 1.18 Leaseholders must therefore make a payment to their landlord to reflect the value of the enhanced interest that they acquire from the landlord: see Figure 2. We use the term “premium” to describe this payment, but it is sometimes also referred to as a “price” or “compensation”.

• Figure 2: An example - why must leaseholders pay a premium?

A leaseholder has 60 years remaining on his or her lease, and is required by the lease to pay the landlord a ground rent of £200 per year.

The landlord is entitled to have the property back in 60 years’ time, and to receive the ground rent.

Result of an enfranchisement claim under the current law: flats

The lease is extended by 90 years, so the landlord will not now be entitled to have the flat back for 150 years.

The ground rent is reduced to a peppercorn (nil monetary value), so the landlord will no longer be entitled to the ground rent of £200 per year for the next 60 years.

Result of an enfranchisement claim under the current law: houses

The leaseholder purchases the freehold, so the landlord will not now be entitled to have the house back at all, and will no longer be entitled to the ground rent of £200 per year for the next 60 years.

Requirement to pay a premium

The landlord is no longer entitled to the property in 60 years, and is no longer entitled to ground rent. The leaseholder must make a payment to the landlord to reflect the fact that the landlord’s entitlements under the lease are reduced or removed.

• 1.19 Calculating the premium is known as “valuation” as it involves putting a financial value on the interest that the landlord is losing and that will be acquired by the leaseholder. Broadly speaking, enfranchisement premiums are intended to reflect the “market value” of the landlord’s asset. The market value is the amount that an asset is worth if sold in the open market.

The views and opposing interests of landlords and leaseholders

• 1.20 Throughout the responses to the Consultation Paper, and our Leaseholder Survey, ¹⁰ the strength of feeling of many consultees - particularly of leaseholders - was evident. A large number of leaseholders expressed their anger at finding themselves in the situation of having to pay an enfranchisement premium, and more generally at the perceived injustices with leasehold. There were also many leaseholders who found their ownership of a leasehold property, along with their attempts at enfranchisement or sale, to be emotionally distressing, or a source of significant stress or unhappiness. We appreciate the time that all consultees have taken in responding to the Consultation Paper and Leaseholder Survey, and in expressing their views to us. Although we have not been able to engage with each person individually, the responses we received have fed into the options for reform in this report (and our forthcoming recommendations for reform in our second report), providing real-world and useful examples of some of the issues arising in leasehold and enfranchisement law.

• 1.21 The strength of feeling evident from consultees, especially from leaseholders, was particularly obvious with respect to the requirement to pay a premium in order to make an enfranchisement claim, and the level of that premium. Leaseholders who have already paid a substantial sum to buy their home felt that, through enfranchisement, they were having to pay twice. When it comes to calculating premiums, the interests of leaseholders and landlords are diametrically opposed. Leaseholders want lower premiums; landlords want higher premiums. Any reform that reduces premiums will be beneficial to leaseholders, at the expense of landlords who will receive less money for the lease extension or the freehold. Any reform that increases premiums will be beneficial to landlords, at the expense of leaseholders who will have to pay more money for the lease extension or the freehold.

Views on the fairness of enfranchisement premiums

• 1.22 It is clear to us, from our consultation events and from consultation responses, that many leaseholders and landlords have fundamentally different and irreconcilable views about whether the requirement to pay premiums is fair, and about whether the basis of calculating those premiums is fair.

• 1.23 We explore the arguments further in Chapter 3, but summarise them below.

Leasehold ownership is inherently unfair for leaseholders.

It is unfair that a third-party landlord should make a profit from owning the freehold to my home.

The difference between premiums and professional costs

• 1.24 This report is concerned principally with premiums, and the way in which they are calculated - which is referred to as “valuation”.

• 1.25 In addition to the premium, enfranchisement also costs money as a result of the professional fees of lawyers and valuers relating to the enfranchisement procedure itself (“professional costs”). There are two categories of professional costs: (1) litigation costs, namely the costs incurred when there is a dispute between the parties which has to be resolved by the Tribunal¹¹ or courts, and (2) non-litigation costs, namely the costs incurred as a result of the enfranchisement transaction itself, such as advice, valuation costs or conveyancing costs.

• 1.26 Professional costs are incurred by both leaseholders and landlords, although leaseholders are currently required to make a contribution towards their landlords’ nonlitigation costs so the greater burden of professional costs falls on leaseholders. We considered whether and, if so, how leaseholders should contribute towards their landlords’ non-litigation costs in Chapter 13 of the Consultation Paper, and our second report will set out our recommendations for reform on that subject.

• 1.27 It is important to separate (i) the premium, from (ii) the non-litigation (and litigation) costs. They are two distinct components of the total cost to a leaseholder of exercising enfranchisement rights.

• 1.28 The premium is money paid to the landlord for the lease extension or freehold. The litigation and non-litigation costs will be paid to professionals such as lawyers and valuers. The two are, however, related, as changes to how the premium is calculated will have a direct effect on professional costs. That is because the simpler it is to calculate the premium, the lower the professional costs that are associated with valuation will be.

• 1.29 For the leaseholder, the cost of enfranchisement is the sum total of the premium and the professional costs (both their own professional costs and any contribution they are required to make towards their landlord’s non-litigation costs). Lowering the professional costs therefore lowers the total cost of enfranchisement. But that is not the same as lowering the premium. To lower the premium, it is necessary to consider the basis on which the premium is calculated: the only way to reduce the premium is to change the basis of the valuation.

Two broad methods of calculating premiums

• 1.30 Broadly speaking, under the current law there are two bases on which enfranchisement premiums are assessed.

• (1) The “mainstream valuation basis” is based on an assessment of the market value of the landlord’s interest. It applies to all flats and many houses.

• (2) The “original valuation basis” is based on an assessment of the market value of the land on which the house is situated, but not the value of the house itself, and results in lower premiums for leaseholders. It applies to houses (not flats) which fall below certain financial limits.

• 1.31 The original valuation basis applies to houses to which the enfranchisement legislation originally applied, and is set out in section 9(1) of the Leasehold Reform Act 1967 (“the 1967 Act”). It is therefore often also referred to as the “section 9(1) basis of valuation”.

• 1.32 In this Report, we first address the mainstream valuation basis (in Chapters 5 to 8), and then the original valuation basis (in Chapter 9).

OUR PROJECT

• 1.33 Our enfranchisement project is a wide-ranging examination of leaseholders’ enfranchisement rights. In September 2018, we published a Consultation Paper, setting out our provisional proposals for a new enfranchisement regime. Our consultation closed in January 2019, and since then we have been analysing the responses and developing our recommendations for reform.

• 1.34 This report sets out our conclusions on premiums, and sets out options for reform. We will publish our second report, setting out our final recommendations for reform to all other aspects of the enfranchisement regime, early next year.

OUR TERMS OF REFERENCE: OPTIONS FOR REDUCING PREMIUMS, NOT RECOMMENDATIONS

• 1.35 Our Terms of Reference include two general policy objectives identified by Government, which are:

• (1) to promote transparency and fairness in the residential leasehold sector; and

• (2) to provide a better deal for leaseholders as consumers.

• 1.36 Our Terms of Reference include a specific provision in respect of premiums. While we have quoted this provision above, we repeat it here for ease of reference.

Government has asked us “to examine the options to reduce the premium (price) payable by existing and future leaseholders to enfranchise whilst ensuring sufficient compensation is paid to landlords to reflect their legitimate property interests” (emphasis added).

• 1.37 This Report is focussed on identifying options for reform that reflect that term of reference.

• 1.38 Providing options to reduce the premium payable is not, however, the only part of our Terms of Reference that is relevant to valuation. We have also been asked:

• (1) to produce options for a simpler, clearer and consistent valuation methodology;

• (2) to simplify the legislation; and

• (3) to make enfranchisement easier, quicker and more cost effective (by reducing the professional costs), particularly for leaseholders, including by introducing a clear prescribed methodology for calculating the premium.

• 1.39 Whilst our Terms of Reference include ensuring “sufficient” compensation is paid to landlords, it is not possible to reduce premiums without reducing the compensation which the landlord receives. We discuss the meaning of sufficient compensation further below.

• 1.40 There is no suggestion that existing leaseholders should be able to obtain a freehold or lease extension without paying the landlord an appropriate price; our task is to propose reforms to improve the enfranchisement process, and to set out the options for reducing premiums that are payable by leaseholders while ensuring sufficient compensation is paid to landlords.

SUFFICIENT COMPENSATION AND HUMAN RIGHTS

• 1.41 Our Terms of Reference require us to consider valuation options that ensure “sufficient compensation is paid to landlords to reflect their legitimate property interests”.

• 1.42 Views will invariably differ on what constitutes sufficient compensation. In legal terms, a central issue in determining whether compensation is “sufficient” is whether it is compatible with Article 1 of the First Protocol (“A1P1”) to the European Convention on Human Rights (“ECHR”), which provides for the peaceful enjoyment of property.

A1P1 to the ECHR (quoted in part)

Every natural or legal person is entitled to the peaceful enjoyment of his possessions. No one shall be deprived of his possessions except in the public interest and subject to the conditions provided for by law and by the general principles of international law. ...

• 1.43 A1P1 and most other rights under the ECHR (“the Convention rights”) have been incorporated into English law by the Human Rights Act 1998 (“the 1998 Act”). The Convention rights therefore form part of English law, and any reforms to the enfranchisement regime that we set out, which Government seeks to implement, and which Parliament enacts, need to be compliant with the Convention rights.

• 1.44 The 1998 Act requires Government to make a statement either (a) that, in its view, a proposed law is compatible with the Convention rights, or (b) that, even though such a confirmation cannot be given, Government nevertheless wishes the proposed law to proceed. ¹²

• 1.45 The 1998 Act allows certain courts to grant a declaration that a provision of an Act of Parliament is incompatible with the Convention rights, and to award damages for any breach of Convention rights.¹³ In addition, a challenge can be brought in the European Court of Human Rights (“ECtHR”) which can decide that there has been a breach of the Convention rights and which can make an award of compensation.

• 1.46 Accordingly, if legislation that reduces premiums is not compatible with the Convention rights, a challenge could be made to the courts in England and Wales or to the ECtHR, and Government could be required to pay compensation to landlords whose rights have been infringed. The legislation is also likely to be amended in order to make it compatible with the Convention rights.

• 1.47 Our project, and the options for reform that we present, must therefore operate within human rights law.

• 1.48 During our project, some consultees have asserted that any reduction in enfranchisement premiums would be unlawful under A1P1. Of those consultees, some went further and supplied us with copies of opinions from barristers that they had instructed in order to support their arguments. It is clear that any reforms that reduce enfranchisement premiums are going to be carefully scrutinised. Given the necessity for a reformed valuation regime to be lawful under A1P1, we have obtained the opinion of Catherine Callaghan QC, which we refer to as “Counsel’s Opinion”, on the compliance with A1P1 of our options for reducing premiums in this Report. Ms Callaghan is a specialist human rights barrister, and we asked her to provide an independent opinion on whether the various options for reform would be lawful under A1P1. We have published Counsel’s Opinion, and our instructions to Counsel, alongside this Report.¹⁴ We quote Counsel’s Opinion throughout this Report.

Leaseholders’ human rights

• 1.49 During our consultation events, and in their consultation responses, leaseholders often asked us why we were focusing on landlords’ human rights, and what consideration was being given to their own human rights.

How are leaseholders’ human rights under the ECHR relevant? (Taken from Counsel’s Opinion)

It is important to bear in mind that leaseholders also enjoy rights that are protected under the ECHR. Leaseholders enjoy the right to the peaceful enjoyment of their possessions under A1P1. Residential leaseholders who are owner-occupiers also benefit from the right to respect for their home under Article 8. [Article 8 provides that “Everyone has the right to respect for his private and family life, his home and his correspondence.”] However, leasehold enfranchisement legislation does not interfere with leaseholders’ property rights under A1P1. Leaseholders’ interests are taken into account when determining the amount of compensation payable to landlords, as the exercise of assessing whether a fair balance has been struck necessarily entails balancing the interests of landlords against the interests of leaseholders, both in their own right and when considering the general interest of society.

Article 8 is not concerned with the right to own or occupy property as such.¹⁵ Article 8 is not engaged or violated either by the ordinary operation of a lease (which limits a leaseholder’s occupancy of the property to the term of the lease) or by requiring the leaseholder to pay for the extension of the lease or purchase the freehold to avoid that result.¹⁶

• 1.50 The law is clear that leaseholders cannot rely on their human rights under A1P1 or Article 8 to challenge the ordinary operation of their lease, including the fact that they must make an enfranchisement claim, and that they must pay a premium to do so.

Landlords’ human rights

• 1.51 Landlords’ human rights do not prevent leaseholders from buying their freeholds or extending their leases against the wishes of their landlord. But they do require leaseholders to pay a sufficient sum for the freehold or lease extension in order to justify the interference with the landlord’s property rights.

• 1.52 The premium that is paid by leaseholders to landlords is, therefore, relevant when assessing the compatibility of enfranchisement with A1P1. Any options for reform that would reduce the premium must be tested for their compatibility with A1P1. Further, that is the case whether the landlord is an individual or a company.

How are landlords’ human rights under A1P1 relevant? (Taken from Counsel’s Opinion)

A1P1 protects the right to the peaceful enjoyment of possessions, and in substance guarantees the right of property.¹⁷ "Possessions" include real and immovable property, and therefore A1P1 protects any proprietary interest in land.

A1P1 can be invoked by any "natural or legal person" who has suffered an interference with their possessions for which the state is responsible, and can therefore be invoked not only by an individual but also by a company or other legal entity (whether based in the UK or elsewhere).

A1P1 is a qualified right. An interference with a person's property rights can be justified where a legitimate aim is pursued by reasonably proportionate means. This involves an assessment of whether a fair balance has been struck between the demands of the general interest of the community and the requirements of the protection of the individual's rights. The payment of compensation is relevant to the fairness of the balance struck.

Legislation which permits a leaseholder to compulsorily acquire the freehold or extend the lease of a house or flat interferes with a landlord's property rights under A1P1 and will only be lawful if the level of compensation payable to the landlord is sufficient to justify the interference with those property rights.

• 1.53 It is not necessary for landlords to be provided with full market value for their interest; there is some discretion within which property rights can be interfered with to achieve a legitimate aim. But generally the further away from market value the compensation is, the more difficult it is likely to be to justify the interference.

• 1.54 In this Report, we only put forward options for reform that are likely to be compatible with landlords’ rights under A1P1. We have not, therefore, put forward options that are unlikely to be compatible with landlords’ rights under A1P1. Our assessment of the compatibility of the options for reform that we put forward in the Report is based on Counsel’s Opinion. We asked Counsel to provide advice in accordance with the Government Legal Department’s “Guidance Note on Legal Risk”.¹⁸ Counsel’s Opinion therefore includes an assessment of whether the risk of a successful challenge to the various options for reform is “low”, “medium low”, “medium high” or “high”. We put forward options for reform which Counsel has assessed as being “low” or “medium low” risk. We have not put forward options which Counsel has assessed as being “medium high” or “high” risk.

• 1.55 Counsel’s Opinion concerns the compatibility with A1P1 of the various options for reform that we discuss throughout this report. Each of these options is a means of calculating the premium that should be paid to the landlord to compensate him or her for the loss of his or her property right. Another aspect of the compensation that landlords currently receive during an enfranchisement claim is a contribution towards their costs: see paragraphs 1.24 to 1.29 above. This Report concerns valuation, and so our, and Counsel’s, human rights analysis at this stage is limited to the compliance with A1P1 of the various options for reducing premiums in this Report. Our final recommendations in our second report will address litigation and non-litigation costs, including the question of whether leaseholders should contribute towards their landlord’s non-litigation costs (as is currently required). Any assessment of whether the total amount of compensation that a landlord receives under a reformed enfranchisement regime complies with A1P1 will have to take into account whether a landlord is able to recover his or her non-litigation costs from the leaseholder. Our second report will therefore address the joint effect of the valuation options set out in this report and our recommendations concerning non-litigation costs on the compliance with A1P1 of a new enfranchisement regime.

THE OPTIONS FOR REDUCING PREMIUMS IN THIS REPORT

• 1.56 We set out the options for reform in Chapters 5 and 6 of this report, and summarise them in Chapter 8. As explained above, the options for reform set out in this Report reflect the requirement in our Terms of Reference to set out and examine options to reduce the premium payable by leaseholders whilst ensuring sufficient compensation is paid to landlords.

• 1.57 The options that we examine also seek to achieve the other aims set out in our Terms of Reference (see paragraph 1.38 above), for example, by increasing certainty or by reducing delays.

• 1.58 Throughout this Report, we highlight in boxes some of the key benefits of particular options for reform.

• (1) We distinguish between two types of benefit. First, options for reform that would reduce premiums for leaseholders. Second, options for reform that would have other benefits, such as increasing certainty or reducing delays. Some options for reform would deliver both types of benefit; others (depending on how they are implemented) would deliver one or the other. Where an option does not, on its own, reduce the premium, we put it forward only on the basis that it could be used as part of a package of reforms which would have the overall effect of reducing the premiums.

• (2) We set out who would benefit from those options for reform, and generally distinguish between leaseholders who currently have more, and those who have less, than 80 years left to run on their leases. That is because, under the current law, those with 80 years or less left to run pay marriage value whilst those with more than 80 years left to run do not.

• 1.59 Some of the options for reform that we set out in this Report could, if implemented, allow enfranchisement premiums to be ascertained by leaseholders through an online calculator. We discuss the way in which an online calculator could work in Chapter 7.

• 1.60 The Consultation Paper included questions in Chapter 16 about the valuation of intermediate leases. ¹⁹ We will set out our final conclusions and recommendations on those valuation points when we publish our second report later this year. This Report focusses on the options for reducing premiums, which were the subject of Chapters 14 and 15 of the Consultation Paper.

• 1.61 As we explained in the Consultation Paper, the different options for reform that we present in this report, and the recommendations that we will make in our second report, will have financial and non-financial implications for landlords and leaseholders, and for the wider property market and economy. Government will undertake impact assessments in relation to any reforms that it pursues. Throughout the Consultation Paper, we therefore asked various questions about the impact of problems under the current law, and the potential impact of reform, for the purposes of gathering evidence and data to be used in the preparation of those impact assessments.

THE CONSULTATION PAPER AND CONSULTATION EVENTS

• 1.62 Following publication of the Consultation Paper, we held various public consultation events around England and Wales in order to explain our proposals for reform, encourage discussion and debate about our proposals, gather attendees’ views and encourage people to provide written responses to the Consultation Paper. We also met with different groups of stakeholders to hear their views about reform. As well as inviting consultation responses, we invited leaseholders to respond to a survey to share with us their experiences of the enfranchisement process. We received over 1,100 responses to the Consultation Paper (consultees are listed in Appendix 1), and over 1,500 responses to the Leaseholder Survey.

• 1.63 As explained above, there were many strongly held views about leasehold reform, from leaseholders, landlords, professionals, and others. We have taken those views -expressed to us at consultation events and in written consultation responses - into account as we have developed the options for reform that we set out in this report.

How we have dealt with consultation responses

• 1.64 All of the responses we received to the Consultation Paper have been analysed as we have developed the options for reform that are set out in this Report.

Different categories of consultee and different interests

• 1.65 In carrying out our analysis of the consultation responses, we have categorised consultees as best we could, in order to assist with understanding the distribution of the views of different groups in respect of different topics. ²⁰ In doing so, however, we do not wish to suggest that everyone within a given category would have a single opinion that is necessarily different from those in other categories, but our categorisation sets out those consultees who broadly have the same or similar interests. To take a simple example, landlords as a group were opposed to any reduction in premiums since their income from enfranchisement premiums would reduce, whereas leaseholders as a group were in favour of reduced premiums.

• 1.66 In addition, we have weighed the opinions of different stakeholders within these broad categories differently; for example, the opinion of a representative body will often carry greater weight than a response from one individual whom they represent.

Our approach to analysing consultation responses

• 1.67 It is inevitable that each consultee will have responded to our questions based on their own knowledge and experience, and we have borne this in mind when considering consultation responses. For example:

• (1) the specialist lawyer or valuer may only deal with enfranchisement claims in one area of the country, or may see a disproportionate number of disputes relating to relatively technical parts of the existing legislation, yet have little experience of the large number of relatively low value, straightforward claims;

• (2) the ground rent investor, who invests in relatively long leases, will be concerned about capitalisation rates being prescribed at below-market value, but will have little concern as to whether any reversionary value or marriage value is payable (we explain those concepts in Chapter 2 and in the Glossary);

• (3) other landlords whose estates comprise relatively short leases with low ground rents will be concerned about reversionary value and marriage value, but might have less concern about whether and how capitalisation rates are set;

• (4) leaseholders with short leases (with an unexpired term of up to 80 years) and relatively low ground rents will be concerned about whether and how marriage value is payable, but less concerned about capitalisation rates; and

• (5) leaseholders with long leases (particularly those with high or onerous ground rent obligations) will have little interest in whether marriage value is payable, but will be concerned about whether and how capitalisation rates are set.

• 1.68 We emphasise that we have not made decisions, and do not present options for reform in this report, simply on the basis of the numbers of consultees who were in favour of, or against, a particular option. Further, we have necessarily had regard to whether options or suggested alternatives are, in fact, workable and practical. For example, they may not work because they are not compatible with A1P1 or because they will only work for a certain sector of the market.

Responses concerning valuation

• 1.69 We received a wide range of consultation responses concerning valuation. We are publishing those responses on our website alongside this report. A large number of responses from individuals, many of whom identified themselves as leaseholders, were in favour of a simple formula to calculate enfranchisement premiums, the most popular option being the ground rent multiplied by ten. Other responses, generally from professionals and also from landlords, expressed general views but also addressed some of the technical detail of reform.

• 1.70 There were some very technical questions in the Consultation Paper, and quite understandably many consultees did not fully understand them. Some consultees explicitly said they did not understand the question; with others it was apparent from their response that they had not understood; and with some it was difficult to tell. Nevertheless, the overall views of the different categories of stakeholder were clear to us, notwithstanding any misunderstanding, and we have taken them into account in formulating the options set out in this report.

Inequality of arms

• 1.71 In paragraph 3.45 onwards below, we discuss the inequality of arms that exists, broadly speaking, between leaseholders and landlords in the current enfranchisement process. It is a systemic inequality between leaseholders (as a whole) and landlords (as a whole), as opposed to an individual inequality as between particular people within those groups. That inequality of arms exhibited itself in the responses that we received to the Consultation Paper. Some of the responses that we received from landlords were very detailed and technical, some were prepared with professional assistance from lawyers or valuers, and some were accompanied by opinions prepared by barristers. For these landlords, it made commercial sense to incur costs in order to put forward the best arguments that they could and to try to protect their financial interests. Even where landlords did not incur additional costs, they were often providing their responses in reliance on their own expertise acquired from detailed knowledge of their business operations. (The notable exception is landlords which are leaseholder-owned.)

• 1.72 We are very conscious, though, that leaseholders who are not lawyers were not necessarily able to provide equivalent responses setting out their best arguments. Individual leaseholders do not, in general, have the same in-house expertise as many landlords and they do not have the funds to pay professionals for assistance in preparing a consultation response. Their knowledge of the law is often drawn only from their individual, personal experience. Nor did leaseholders, as a group, pool their resources in order to pay for such assistance. Various organisations exist to try to coordinate and campaign for the interests of leaseholders but they are unable to match the resources that some landlords are able and willing to spend.

• 1.73 We have carefully weighed all the information that has been provided to us. In doing so, we have been mindful that those best placed to respond to technical questions are professionals and that many of the professionals who responded to the Consultation Paper were either explicitly instructed on behalf of freeholders or are generally instructed on behalf of freeholders more than they are by leaseholders. That reflects the inequality of arms and incentive structures that currently exist, in particular outside Prime Central London, and which we explore further in Chapter 3.

ISSUES BEYOND OUR TERMS OF REFERENCE

• 1.74 Our project concerns enfranchisement reform, and this Report concerns only valuation of enfranchisement premiums. The options for reform that we set out in this report, and our forthcoming recommendations to reform the enfranchisement regime, would play a significant role in improving the position of leaseholders. But our project does not solve all the problems that leaseholders can currently face.

• 1.75 Some consultees wanted the proposals in the Consultation Paper to go further. For example, some leaseholders would like enfranchisement to provide an opportunity to re-write the terms of their existing lease, or to obtain a freehold that is as free of obligations owed to others as possible.

• 1.76 Enfranchisement is, however, concerned primarily with the financial terms on which an existing lease is to be extended or a freehold is to be obtained: for example, allowing leaseholders to “buy out” their obligation to pay a ground rent following a lease extension. We also think that enfranchisement is not the best means of dealing with other problems with the terms of leaseholders’ existing leases. It would provide no solution for leaseholders who are unable to enfranchise (perhaps because, for instance, they cannot afford to). And while we believe that the options to reform valuation in this report, and our forthcoming recommendations for reform, will increase the number of leaseholders who are able to enfranchise, there will remain leaseholders who are not able to do so.

• 1.77 Existing leaseholders may benefit from some of our other forthcoming work. Our project on commonhold seeks to bring new life to this alternative form of ownership that would allow flats to be owned freehold, and managed collectively. And our project on the right to manage aims to make it easier for leaseholders to take over the management of their building from their landlord - without having to pay the cost of acquiring the freehold.

• 1.78 The UK Government and Welsh Government are also carrying out related work. For example, the UK Government has set out its intention to ban the sale of houses on a leasehold basis, and to prohibit the reservation of ground rents with any financial value.²¹ It is considering proposals about the regulation of managing agents.²² The Welsh Government is currently considering proposals put forward by a cross-industry working group. ²³

• 1.79 But some other problems identified by leaseholders remain outside the scope of these proposed reform projects. Other concerns may be addressed in the future as part of a comprehensive programme of leasehold reform. But it is necessary to prioritise. For now, the three projects that we are working on are each significant in themselves but also contribute to a wider programme of reform by Government. There may be scope for further reform work in the months and years ahead.

WELSH DEVOLUTION

• 1.80 The extent to which leasehold enfranchisement is devolved to the Welsh Assembly is unclear. Aspects of enfranchisement have, in the past, been treated as a devolved issue. ²⁴ “Housing” was expressly devolved to Wales in the Government of Wales Act

2006. ²⁵ Following the Wales Act 2017, rather than expressly devolving competence in certain areas, competence is devolved unless expressly reserved. The Welsh Assembly cannot modify “the private law”, which includes the law of property. But that does not apply if the modification “has a purpose (other than modification of the private law) which does not relate to a reserved matter”. ²⁶

• 1.81 Under our Protocol with the Welsh Ministers, the Commission will only undertake a project concerning a matter that is devolved to Wales if it has the support of the Welsh Ministers. ²⁷ To the extent that any of the matters in our Terms of Reference are devolved to Wales, the Welsh Ministers have indicated their support for the Commission undertaking this project.

• 1.82 Our project, therefore, is intended to cover both England and Wales, and to result, where reasonably possible, in a uniform set of recommendations that are suitable for both England and Wales. We asked consultees whether any specific considerations call for particular issues to be treated differently in England and in Wales. Some consultees commented that property values are different in Wales when compared to parts of England (in particular London) and that valuations under the “original valuation basis” are perhaps more common in Wales than in parts of England (in particular London). But no suggestions from consultees led us to conclude that a reformed enfranchisement regime should adopt a different approach in England and in Wales.

STRUCTURE OF THIS REPORT

• 1.83 In Chapter 2, we explain how enfranchisement premiums are calculated under the current law by reference to four worked examples, which we use throughout this report. First, we explain the valuation methodology, introducing the various concepts that are involved. Second, we explain the process by which enfranchisement premiums are agreed by the parties or determined by the Tribunal. We explained above (at paragraph 1.30) that there are two bases of valuation, and our focus in this chapter (and Chapters 5 to 8) is on the “mainstream valuation basis”. We discuss the “original valuation basis” in Chapter 9.

• 1.84 In Chapter 3, we consider the arguments for and against reforming the regime governing the calculation of enfranchisement premiums. We explain the arguments that we have heard about whether leasehold ownership is inherently unfair, the problems with the current law, and the arguments for and against reducing premiums (as required by our Terms of Reference).

• 1.85 In Chapter 4, we comment on our role in reforming the valuation regime - both what we are doing, and what we are not doing.

• 1.86 In Chapters 5 and 6, we set out the options for reducing premiums and for improving the enfranchisement valuation process. We split our explanation of the options into two parts: (1) “schemes”, and (2) “sub-options” for reform. There are three alternative options for an overall “scheme” which could be adopted. They would set the general framework for the reformed enfranchisement valuation regime. We explain those three alternative schemes in Chapter 5. Then in Chapter 6, we discuss various “sub-options” which could be incorporated within one of those three overall valuation schemes. Whichever “scheme” is adopted, one, some, or all of the “sub-options” could be adopted within it.

• 1.87 After setting out the schemes, and the sub-options, we then pause to consider - in Chapter 7 - the potential role of an online calculator in ascertaining enfranchisement premiums. Depending on which sub-options are adopted from Chapter 6, it would be possible for an online calculator to be made available which would tell leaseholders and landlords - in certain circumstances - what the enfranchisement premium will be.

• 1.88 In Chapter 8, we draw together the schemes (from Chapter 5) and the sub-options (from Chapter 6) to summarise how they relate to each other and which could work together.

• 1.89 Finally, in Chapter 9, we discuss the original valuation basis in section 9(1) of the 1967 Act (see paragraph 1.30 above) and set out the options for how that basis of valuation could be reformed. We explain the difficulties we have encountered in replacing section 9(1) with a simplified, updated equivalent provision in that we have not been able to identify a way to simplify section 9(1) which ensures that all - and only - those leaseholders who currently benefit from section 9(1) would continue to do so, or which ensures that qualifying leaseholders would pay exactly the same premiums as they currently do. We put forward two possible options for Government: first, retaining section 9(1) largely in its current form, and secondly, introducing an entirely new scheme to replace 9(1) and to provide a more favourable valuation basis to assist leaseholders of low value properties to enfranchise.

• 1.90 In Chapter 10, we gather together all of the options for reform set out in this report.

• 1.91 We list those who responded to the Consultation Paper in Appendix 1, and we set out our Terms of Reference in Appendix 2. Throughout this report, we use four worked examples to demonstrate the effect that the various options for reform would have on the enfranchisement premium payable. In Appendix 3, we set out the detailed calculations for those worked examples. Appendix 4 sets out some modelling that is relevant to our discussion of the original valuation basis in Chapter 9.

SUMMARY OF THE OPTIONS FOR REDUCING PREMIUMS IN THIS REPORT

• 1.92 We set out three alternative options for a new regime to calculate premiums. Within each of those three regimes, there is a series of further sub-options for reform. Depending on which options for reform are pursued, it would be possible to create an online calculator for the calculation of premiums. A diagram representing the options and sub-options, and the relationship between them, is provided at page 22.

PUBLICATIONS ACCOMPANYING THIS REPORT

• 1.93 Alongside this Report, we have published on our website: ²⁸

• (1) Counsel’s Opinion, concerning the compatibility with A1P1 of the options for reform set out in this report, together with our instructions to Counsel; and

• (2) In so far as the consultation responses we received responded to our questions about valuation:

• (a) a statistical summary of how consultees responded to the questions; and

• (b) the consultation responses themselves.

• 1.94 A statistical summary of consultees’ responses to the remaining questions in the Consultation Paper, and the consultation responses themselves, will be published alongside our second report, to be published later this year.

ACKNOWLEDGEMENTS

• 1.95 Our thanks go to all those who responded to our Consultation Paper (listed in Appendix 1) or who have supported our project in other ways. We are grateful for the work, time and careful thought they have given to the detailed issues covered in this report. We are also grateful to those who have organised and hosted consultation events which enabled us to engage with a wide range of stakeholders.

THE PROJECT TEAM

• 1.96 The Commissioners would like to record their thanks to the following members of staff who worked on this report: Matthew Jolley (team manager); Daniel Robinson (lead lawyer); Ellodie Gibbons (team lawyer); Charlotte Black (team lawyer); Frances Joyce (consultant valuer); Caoimhe McKearney (team lawyer); Kevin Pain (team lawyer); Emily Fitzpatrick (team lawyer); Thomas Nicholls (legal assistant); Jonathan Mellor (legal assistant); Liam Davis (research assistant) and Harley Ronan (research assistant).

• Chapter 2: Calculating premiums under the current law

INTRODUCTION

• 2.1 In this chapter, we explain how premiums are calculated under the current law.

• (1) First, we consider the valuation methodology: what is the method by which premiums are assessed? We focus on the mainstream valuation basis which applies to all flats and many houses: see paragraph 1.30. The original valuation basis is discussed separately in Chapter 9, though it shares some of the features of the methodology of the mainstream valuation basis.

• (2) Second, we consider how the process of valuation works in practice, from the commencement of the claim through to the completion of the claim. This discussion applies to both the mainstream valuation basis and the original valuation basis.

• 2.2 Throughout this report, we use four hypothetical enfranchisement claims to demonstrate the effect that the various options for reform might have on the premium payable. They are all claims to purchase the freehold of a house, but as we go on to explain below the same principles apply to a lease extension of a flat or the freehold purchase of a block of flats.²⁹ The examples are set out in Figure 3 below. The detailed calculations on which they are based are set out in Appendix 3.

• Figure 3: four examples

House 1

Value on a freehold basis: £250,000

Valuation date: 2019

Details of existing lease:

Granted in 1995 for 125 years

Unexpired term: 101 years

Value of lease: £245,000³⁰

Ground rent: £50 per annum, increasing by £50 every 25 years:

• - £50 per annum from 1995

• - £100 per annum from 2020

• - £150 per annum from 2045

• - £200 per annum from 2070

• - £250 per annum from 2095

House 2 (which we refer to as “House A” in the Summary)

Value on a freehold basis: £250,000

Valuation date: 2019

• 2.3 All four examples are fictitious leases that have been designed to be easily compared with each other. They have been chosen in order to demonstrate as simply as possible the valuation process and our options for reform, whilst still reflecting the sorts of terms that are found in real leases in the market.

• (1) We have not made any assumptions about what are typical terms of leases in the market, so our examples are not intended to be representative of all leases in the market. For example, House 4 is a lease with a doubling ground rent. Such leases have been the subject of much attention in the media, by Government, and in Parliament. There is no consensus between landlord and leaseholder groups as to how many leases with doubling ground rents exist in the market, but on any view they comprise a relatively small proportion - albeit an important proportion - of all leases. Nevertheless, we think it is important that reform takes account of these leases, because of the particularly severe impact the doubling ground rents have on the leaseholders. Indeed one of our options for reform is devoted to assisting leaseholders who have leases with doubling (or other onerous) ground rents.³¹ Our inclusion of House 4 as a worked example therefore allows us to demonstrate how that option for reform would operate in practice.

• (2) Nor do our worked examples demonstrate what premium would in fact be payable in such a claim; much will depend on the particular facts, on the parties’ professional advisers, on the parties’ negotiating positions and willingness (or financial ability) to argue the case before the Tribunal. This uncertainty about enfranchisement premiums is one of the arguments for reform, which we discuss further in Chapter 3.

• (3) We use a freehold value of £250,000 in all worked examples since that is a round figure that is close to average house prices in the UK. ³²

• 2.4 We use the worked examples to demonstrate the two most common enfranchisement claims under the current law, namely:

• (1) the right to acquire the freehold of a house; and

• (2) the right to a lease extension of a flat, which provides the leaseholder with a new

lease which is 90 years longer than the current lease (so it “extends” the lease by 90 years),³³ and under which the ground rent is a peppercorn (in place of whatever the ground rent is under the existing lease). Although the worked examples are freehold house purchases, the principles apply equally to lease extensions of a flat. ³⁴

• 2.5 There are two additional enfranchisement rights. First, there is a right to a 50-year lease extension of a house. ³⁵ This right is not often exercised. There is no premium payable for a lease extension of a house. Instead, the extended term of the lease is subject to what is called a “modern ground rent”. Essentially, what the leaseholder saves by not paying a premium he or she pays by way of rent over the extended 50-year term of the lease. We explain the calculation of the modern ground rent in paragraph 9.15 below. We have provisionally proposed replacing the current right to a lease extension of a house with a lease extension right like that available for flats. We do not discuss the existing right any further in this report.

• 2.6 Second, there is a right to acquire the freehold of a block of flats collectively. ³⁶ The principles that apply to a lease extension of individual flats apply equally to the freehold acquisition of a block of flats. However, there are some additional considerations when a block is acquired but some leaseholders do not participate in the collective enfranchisement claim, or in a claim where there is development, or other additional, value involved. We discuss those particular considerations later in this report, but for the purposes of providing worked examples, the same principles apply.

• 2.7 In the Consultation Paper, we provisionally proposed moving away from the distinction in the current law between houses and flats. We proposed instead the same lease extension rights for all residential units, and for freehold purchase rights to be available in respect of all residential units either by an individual leaseholder (where there is one residential unit in the building) or by a group of leaseholders (where there are two or more residential units in the building). ³⁷

(A): THE CURRENT VALUATION METHODOLOGY

• 2.8 We set out a detailed explanation of how premiums are calculated under the current law in Chapter 14 of the Consultation Paper. We do not repeat that explanation in this Report. Instead, we summarise how the current law operates using the four worked examples.

• 2.9 Our explanation of the current law is based on the mainstream valuation basis.

• (1) In the case of flats, the mainstream valuation basis applies to all claims - both lease extension claims and claims for the collective purchase of a block of flats.

• (2) In the case of houses, the mainstream valuation basis applies to many claims to purchase the freehold. Other claims, however, qualify for valuation under the original valuation basis, which results in lower premiums for leaseholders. These claims are considered separately in Chapter 9.

• 2.10 The basic principle underpinning the mainstream valuation approach is that the landlord is to be paid the market value for the interest the landlord has that will be acquired by the leaseholder - in other words, the freehold interest (in the case of the freehold purchase of a house) or an additional 90 years added to the existing lease (in the case of a lease extension of a flat).

• 2.11 The market value of the landlord’s interest is assessed with the input of expert valuers. We discuss their role in the second part of this chapter (paragraph 2.63 onwards). If the market value cannot be agreed by the parties’ valuers, the market value must be determined by the Tribunal. The enfranchisement legislation does not dictate precisely how valuers, and ultimately the Tribunal, should assess the market value of the landlord’s interest. The conventional valuation approach, which is used by valuers and the Tribunal in almost all enfranchisement claims, is to assess the market value by reference to different components of the landlord’s interest. We explain the three main components below, by reference to the worked examples. As we go on to explain below, however, valuers might in some circumstances assess the market value of the landlord’s interest using a different valuation methodology: see paragraph 2.61.

• (1) The “term”

Replacing the ground rent income with a capital sum

• 2.12 The result of an enfranchisement claim is that the landlord will no longer receive the ground rent income during the term of the existing lease.

• (1) For House 1, the landlord loses the right to receive the ground rent of £50 per annum (rising to £250 per annum) over the remaining 101 years of the lease.

• (2) For House 2, the landlord loses the right to receive the ground rent of £50 per annum (rising to £200 per annum) over the remaining 76 years of the lease.

• (3) For House 3, the landlord loses the right to receive the ground rent of £300 per annum (rising in line with RPI) over the remaining 241 years of the lease.

• (4) For House 4, the landlord loses the right to receive the ground rent of £300 per annum rising to £9,600 per annum) over the remaining 241 years of the lease.

• 2.13 In a freehold purchase claim, the landlord no longer receives any ground rent. In a lease extension claim, the “term” is not strictly lost since the landlord continues to receive a ground rent, but as the ground rent is reduced to a peppercorn, the landlord loses the existing value of the term.

• 2.14 To compensate the landlord for the loss of ground rent income, the future rent is “capitalised”. In other words, the value of that income stream is assessed to determine what capital sum the landlord needs to receive on the valuation date to replace the income stream represented by the rent being paid over time. This valuation is achieved by applying a capitalisation or yield rate: see Figure 4 below.

• 2.15 Capitalising a ground rent is one example of the process of capitalising a future income stream, which is done in other contexts. For example, an equivalent task is undertaken by actuaries when they assess the current value of the future liabilities of a pension fund, and by economists when they assess the current value of future costs and benefits arising from certain actions.

• 2.16 Once a capitalisation rate has been selected, it is converted into a “multiplier” (called a “Years Purchase” (YP) multiplier, which is calculated based on (a) the capitalisation rate, and (b) the number of years remaining on the lease). The only variable is the capitalisation rate itself. Once that rate is established, converting it into a premium is simply a mathematical calculation - which is uncontroversial, relatively easy, and could be done through an online calculator (on which see Chapter 7 below).

Future rent reviews

• 2.17 Where there are future rent reviews under a lease which will result in the ground rent increasing, account needs to be taken of the fact that the landlord has no immediate right to that increased rental stream. The landlord’s right to any increase in rent that would follow a rent review is “deferred” as it would not be received until a future date. Consequently, a deferment rate is needed to calculate the present value of that future entitlement (we explain deferment rates further in paragraph 2.34 onwards below).³⁸ So for House 1, the landlord is currently entitled to a ground rent of £50 per annum, but from 2020 that entitlement will go up to £100 per annum, and from 2045 it will go up to £150 per annum, and so on. The landlord’s future entitlement to £100 per annum, then £150, and so on, is taken into account, but it is deferred to reflect the fact that the landlord will receive a capital sum now in respect of an increased rent which would only have been payable from a future date.

• 2.18 This process of deferring the increased ground rent income is relatively straightforward when it is known what the future rent will be (as in Houses 1, 2 and 4). But in many cases it will be known that the ground rent will increase, but the amount of the increase will not be known. For example, the lease might provide for the ground rent to be reviewed to a level which is (say) 0.1% of the value of the property on the review date, or to increase in line with the Retail Prices Index (as in House 3). Since it is not possible to know what the level of the rent will be, it is not possible to calculate that future rent and defer it. As a consequence, valuers instead (a) calculate what the rent would be if it were subject to review on the valuation date, (b) use that level of rent in their calculation, and (c) use a lower capitalisation rate to reflect the fact that the rent is, to some or other extent, inflation-proof. The result is a higher enfranchisement premium.

Selecting the capitalisation rate

• 2.19 The capitalisation rate to adopt in an enfranchisement calculation depends on the facts of the case, and different valuers will have different views on the appropriate rate. Valuers will look at market evidence about how investors generally are investing their money and the returns that they receive from those investments, in order to arrive at a rate that is appropriate for the particular income stream that they are valuing.

• 2.20 The capitalisation rate reflects the “quality” of the income stream from the recipient’s point of view. The better the ground rent income stream, the lower the capitalisation rate (and the higher the enfranchisement premium).

• 2.21 Accordingly, the appropriate capitalisation rate will depend, for example, on:

• (1) the level of the ground rent. A ground rent of £300 per annum is more attractive to investors on a pound-for-pound basis than an income of £30 per annum, since (for example) the administrative cost of collecting the income is proportionately lower. So a ground rent of £300 per annum will usually be capitalised at a lower rate than a ground rent of £30 per annum. The result is that the premium for the £300 per annum ground rent is more than ten times higher than the premium for the £30 per annum ground rent because (a) the level of the rent itself is ten times higher, but (b) the capitalisation rate applied to the £300 ground rent is different, and so makes the premium higher.

• (2) the rent review provisions in the lease. Ground rents may be:

• (a) “fixed” (or “static”), for example, a ground rent of £300 per annum;

• (b) subject to a simple review, for example, a ground rent which increases by

£50 per annum every 25 years (as with Houses 1 and 2); or

• (c) subject to a “dynamic” review, for example a ground rent that increases at frequent intervals, or that increases in line with the Retail Prices Index, or is linked to capital or rental values (as with Houses 3 and 4).

A ground rent which is inflation-proof to some degree because it increases over time is more attractive to investors than a ground rent that is fixed over time. So a ground rent that is subject to review, particularly a dynamic review, will usually be capitalised at a lower rate than a static ground rent, resulting in a higher premium. There is a wide range of different types of ground rent review. Each, arguably, justifies a different capitalisation rate, because they are of variable attractiveness to investors.

• (3) reliability of payment and cost of collection and enforcement. An income stream from hundreds of flats in a good-quality, newly-built estate in a popular location will be more attractive to an investor than an individual dilapidated house in an unpopular location.

Selecting the capitalisation rate: the effect of high ground rents

• 2.22 The way in which “the term” is valued poses particular problems for leaseholders with high ground rents (including - but not limited to - onerous ground rents, such as those that double every 10 years). That is for two cumulative reasons.

• (1) First, a ground rent which is high (even if fixed) will, automatically, result in a higher premium, even if the same capitalisation rate is used. For example:

• (a) a (fixed) ground rent of £150 per annum for 70 years capitalised at 6% would be £2,458; whereas

• (b) a (fixed) ground rent of £300 per annum for 70 years capitalised at 6% would be £4,915.

• (2) Second, a high ground rent or a ground rent that is “dynamic” will command a lower capitalisation rate, resulting in a higher premium. For example:

• (a) a ground rent of £300 per annum which doubles every 10 years over 70 years capitalised at 6% would amount to £22,058; whereas

• (b) a ground rent of £300 per annum which doubles every 10 years over 70 years capitalised at 4% would amount to £50,034.

• 2.23 So the valuation of an already high ground rent is compounded by the use of a lower-than-usual capitalisation rate. Leaseholders with high ground rents (including those with ground rents that double every 10 years, or with ground rents that are otherwise onerous) are faced with the fact that the ground rent being capitalised is already high, and the capitalisation itself is done using a lower rate. Accordingly, for leaseholders with high ground rents, the way in which “the term” is valued under the current law results in their enfranchisement premiums being very significantly higher than for leaseholders with lower, fixed or more moderate ground rents.

• 2.24 As we go on to explain below (in paragraph 2.49 and 2.50, there is in fact a third compounding factor for leaseholders with high ground rents because the value of their existing lease will be lower, which results in the third part of the enfranchisement premium (the marriage value) being higher as well.

Selecting the capitalisation rate in our examples

• 2.25 Given that the capitalisation rate will depend on the details of the lease, and on various other factors, we have used rates in our examples which might, in appropriate cases, be used as the capitalisation rate. Given the high level of the ground rent for Houses 3 and 4, it is likely that a lower capitalisation rate would be used than for Houses 1 and 2. For the purposes of explanation, we have selected a capitalisation rate of 6% for Houses 1 and 2, and a capitalisation rate of 4% for Houses 3 and 4. In Chapter 3, we explain how those premiums would differ if the capitalisation rates selected were 1% higher or 1% lower (see paragraph 3.35 and Figure 15).

• 2.26 We are not suggesting that those rates would or should be used for these leases. We have provided the worked examples in order to aid our explanation of our options for reducing premiums in this Report.

• 2.27 Figure 4 below sets out how “the term” might be valued for Houses 1, 2, 3 and 4. The detailed calculations are set out in Appendix 3.

Figure 4: Calculation of the “term” for Houses 1, 2, 3 and 4

House 1: The current value of the right to receive £50 per annum rising to £250 per annum over the next 101 years of the lease based on a capitalisation rate of 6% is £1,844.

House 2: The current value of the right to receive £50 per annum rising to £200 per annum over the next 76 years of the lease based on a capitalisation rate of 6% is £1,806.

House 3: The current value of the right to receive £300 per annum, increasing in line with RPI every 10 years of the term, for the remaining 241 years of the lease based on a capitalisation rate of 4% is £9,554.

House 4: The current value of the right to receive £300 per annum, doubling every 10 years for the first 50 years of the term, for the remaining 241 years of the lease based on a capitalisation rate of 4% is £79,422.

• (2) The “reversion”

  • 2.28 The landlord loses the right to have the property back at the expiry of the lease, which is referred to as the landlord’s “reversion”.

• (1) For House 1, the landlord loses the right to have the property back in 101 years.

• (2) For House 2, the landlord loses the right to have the property back in 76 years.

• (3) For Houses 3 and 4, the landlord loses the right to have the property back in 241

years.

• 2.29 In a freehold purchase claim, the landlord loses the right to have the property back altogether. In a lease extension claim, the landlord’s right to have the property back is delayed by a further 90 years.

• 2.30 The valuation of the reversion seeks to compensate the landlord for the value today of the right to have the property back (the right to have “vacant possession”) at the expiry of the lease. The landlord receives a sum of money which is meant to be equivalent to the value of that right.

• 2.31 Two inputs are required in order to value the reversion:

• (1) the freehold vacant possession (“FHVP”) value of the property; and

• (2) a deferment rate.

Freehold vacant possession (FHVP) value

• 2.32 The FHVP value is usually calculated by ascertaining the value of the property if it were to be sold on a long lease, and adjusting the long lease value to arrive at a freehold value. We describe the process in detail in paragraphs 14.32 to 14.46 of the Consultation Paper.

• (1) Ascertaining the value of the property is a relatively familiar concept to homeowners. In a discussion between an estate agent and a prospective buyer or seller of a flat, it is the answer to the question: “how much is the flat worth?”. It is usually assessed by looking at comparable properties that have sold in the market: the sale price of the comparable property is adjusted to reflect any differences between the property and the comparable property.

• (2) Adjusting that long lease value to arrive at the FHVP value requires the use of a “relativity percentage”. The relativity percentage is the value of a leasehold interest in a property relative to the value of the same property were it to be held freehold. We discuss relativity in the context of marriage value at paragraphs 2.44 to 2.47 below. In the marriage value calculation, relativity is used to calculate the value of the short existing lease relative to the freehold value of the property. However, a long lease of a property will also be worth less than the same property held freehold and have a value relative to it. When calculating the short lease value, the relativity percentage is applied to the FHVP value. When calculating the FHVP value, the calculation can be done in reverse: a relativity percentage can be used in combination with the known (long) lease value in order to ascertain the FHVP value. It is generally accepted that the appropriate relativity in this context is:

• (a) 98% for leases with unexpired terms of 100 to 114 years;

• (b) 98.5% for leases with unexpired terms of 115 to 129 years; and

• (c) 99% for leases with unexpired terms of above 130 years. ³⁹

• 2.33 Taking our worked examples.

• (1) for House 1, the value of the 101-year leasehold interest is £245,000, and the relativity is 98%, so the value of the freehold interest in the property is £250,000.

• (2) for House 2 the value of the 76-year leasehold interest is £226,250, and the relativity is 90.5%, so the value of the freehold interest in the property is £250,000.⁴⁰

• (3) for Houses 3 and 4, the value of the 241-year leasehold interest is £247,500, and the relativity is 99% (ignoring the onerous ground rent⁴¹), so the value of the freehold interest in the property is £250,000.

The deferment rate

• 2.34 The landlord is not entitled to have the property back until the end of the lease. The benefit of the FHVP value of the property is therefore “deferred”. A deferment rate is used to calculate a capital sum which, if invested now, would provide a value equivalent to the FHVP value as at the expiry of the lease.

• 2.35 When discussing capitalisation rates above,⁴² we explained that capitalising a ground rent income was an example of the process of capitalising a future income stream, which is also done in other contexts. The same can be said of deferment rates: there are other contexts in which an assessment has to be made of the current value of a future entitlement. Indeed, there are similarities between the process of valuing the term (using a capitalisation rate) and valuing the reversion (using a deferment rate). Both involve ascertaining the value of a future entitlement, albeit that future entitlement is very different in both cases. The reversion is (in effect) an entitlement to a substantial single capital sum (the enjoyment of vacant possession of the property) due to be received some time in the future, whereas the term is an entitlement to smaller recurring sums for a fixed period. Since the nature of the two entitlements (a capital asset and an income stream) is different, they are attractive to different types of investor, and the rates used are therefore different too.

• 2.36 Once a deferment rate has been selected, it is possible to calculate the present value (“PV”) of £1 on the expiry of the lease at that rate. The only variable is the deferment rate itself. Once that rate is established (and the FHVP value is known), converting it into a premium is simply a mathematical calculation - which is uncontroversial, relatively easy, and could be done through an online calculator (on which see Chapter 7 below).

• 2.37 In Sportelli, the Tribunal decided that in Prime Central London, the generic deferment rate for leases with at least 20 years left to run was 4.75% for houses, and 5% for flats.⁴³ Different rates can be adopted for shorter leases, and for leases in other parts of England and Wales.

• 2.38 Figure 5 below sets out how “the reversion” might be valued for Houses 1, 2, 3, and 4, assuming the rates in Sportelli are adopted. The detailed calculations are set out in Appendix 3.

• 2.39 In Chapter 3, we explain how those premiums would differ if the deferment rate selected were 1% higher or 1% lower (see paragraph 3.35 and Figure 15).

  Figure 5: Calculation of the “reversion” for Houses 1, 2, 3 and 4
  House 1: The current value of the right to receive £250,000 in 101 years rate of 4.75% is £2,303.	based on	a deferment
  House 2: The current value of the right to receive £250,000 in 76 years rate of 4.75% is £7,349.	based on	a deferment
  House 3: The current value of the right to receive £250,000 in 241 years rate of 4.75% is £3.	based on	a deferment
  House 4: The current value of the right to receive £250,000 in 241 years rate of 4.75% is £3.	based on	a deferment

• (3) Marriage value

• 2.40 It is an observed fact that, if the value of the lease of a particular property is £x and the value of the associated reversion is £y, the value that the same property would command if held on a freehold basis with vacant possession will be greater than £x+y. Marriage value is the amount by which it is greater. In other words, it is the additional value an interest in land gains when the landlord's and the leaseholder's separate interests are "married" into single ownership. The aggregate value of those two interests held separately is often significantly less than the value if they are both held by the same person.

• 2.41 To take an analogy, a pair of Chinese vases are worth more as a pair than the sum of their individual values. The amount by which they are worth more is marriage value. That value can be realised either by sale (to the person with the other vase) or by purchase (of the other vase).

• 2.42 Applying the above to a landlord and leaseholder, if the lease is one Chinese vase and the freehold is its pair, when the leaseholder gains the freehold he or she gains the enhanced value from having a pair of vases: the marriage value. ⁴⁴ Because the leaseholder, unlike any other potential purchaser, will gain that value on purchasing the freehold, he or she is likely to outbid anyone else in the market. It is assumed in the valuation regime that the leaseholder will overbid half of the total marriage value.

• 2.43 We explain marriage value in more detail in paragraphs 14.53 to 14.69 of the Consultation Paper. In summary, where a lease has more than 80 years unexpired, the legislation provides that no marriage value is payable by the leaseholder.⁴⁵ That reflects an assumption that marriage value is insignificant where the lease has more than 80 years left to run. Where marriage value is payable to the landlord (because the lease has 80 years or less left to run), the legislation requires the leaseholder to pay half of the marriage value; that reflects an assumption that the leaseholder would overbid half of the marriage value, thus giving the landlord half and acquiring half for himself or herself. ⁴⁶

• 2.44 To calculate marriage value, it is necessary to establish the value of the existing lease. For consistency, the statutory assumptions that apply when assessing the FHVP value also apply when assessing the value of the existing lease.⁴⁷ In particular, the legislation provides that it has to be assumed that the leaseholder’s statutory enfranchisement right does not exist.⁴⁸ This assumption creates a problem for the valuer because the potential comparables - short leases (that is, leases of less than 80 years) being sold in the market - nearly all have the benefit of enfranchisement rights. There are two ways in which the valuer may approach this problem:

• (1) find the real-world value of a short lease (by reference to comparables) and then deduct from this the estimated value of the benefit of enfranchisement rights -this approach is referred to as the “no-Act deduction” or “a deduction for Act rights”; or

• (2) use a graph of relativity: see Figure 6.

• Figure 6: graphs of relativity

As explained at paragraph 2.32(2) above, relativity is the value of a property sold on a lease relative to its freehold value. Various organisations, predominantly firms of valuers, have devised graphs of relativity. To do this they have taken a data set, for example, settlements reached on enfranchisement claims,⁴⁹ and plotted the relativities derived from that data set on to a graph where the horizontal axis shows the length of the lease and the vertical axis shows the value of that lease relative to the freehold value of the same property expressed as a percentage, “the relativity”.

For example, if the data set being used is settlements and a particular settlement shows that the freehold value of a property was agreed to be £100,000 and the value of the property held on an existing lease with 63 years remaining was agreed to be £83,000 (that is, 83% of the freehold value), that relativity of 83% would be plotted on the graph at 63 years.

Having plotted all the relativities derived from the data set, a curve is drawn through the coordinates to link them. This means that anyone reading the graph can derive a relativity for any given lease length.

• 2.45 Neither of the approaches set out at paragraph 2.44 above is without its difficulties:

• (1) the no-Act deduction is arguably arbitrary in the absence of evidence, which we

discuss further in paragraph 3.17 onwards below; and

• (2) a number of different graphs of relativity have been devised, and there is no consensus as to which graph ought to be used: see Figure 7.

• 2.46 We discuss the problems associated with the uncertainty in Chapter 3.

• Figure 7: assessing relativity

In The Trustees of the Sloane Stanley Estate v Mundy, the Upper Tribunal considered the method which is generally to be used in order to value an existing lease of a flat on the assumption that the existing lease of the relevant flat does not have Act rights. ⁵⁰ In particular, it was asked to consider the use of the “Parthenia model” to calculate relativity. The Parthenia model was based upon sales of properties between 1987 and 1991 - that is, before the distortion of the market caused by the Leasehold Reform, Housing and Urban Development Act 1993 (“the 1993 Act”) and the prospect of the 1993 Act being brought into force. That data was then analysed using a statistical technique known as “hedonic regression”, a technique which extrapolates the effect of the lease length on the value of the lease. ⁵¹

The Mundy case is significant because when the Parthenia model was used to value the short leases in that case, it produced lower premiums for the lease extensions than the more commonly used relativity graphs. It is therefore claimed by Parthenia that use of its model is a way of reducing the premium payable by leaseholders to enfranchise. However, the model was rejected by the Upper Tribunal.

The main problem that the Upper Tribunal found with the Parthenia model was that it produced an impossible result. In the case of one of the flats, the value of the lease in the real world (with rights under the Act) was agreed at £2m. It was also agreed that a lease with rights under the Act was more valuable than a lease without rights under the Act. However, the Parthenia model produced a higher figure of £2.2m for the same lease without rights under the Act. The Upper Tribunal described the Parthenia model as “a clock that struck 13”: “Even if the application of the model produced an answer in another case which was not impossible, that does not mean that the model has been shown to be reliable. If a clock strikes 13, it is broken. It is not a reliable time piece. It cannot be relied upon as a reliable means of telling the time even when it strikes an hour, such as 11 or 12, which are possible times of day.”

The Tribunal heard a substantial amount of evidence in relation to a large number of other graphs of relativity which have been prepared over the years and summarised the effect of that evidence and the Tribunal’s reaction to it. The Tribunal found that the market was using a graph of relativity produced by the firm Gerald Eve (“the Gerald Eve graph”) and that the graph was the least unreliable. The main difference between the Gerald Eve graph and the Parthenia model is that the Gerald Eve graph is based on relativities derived from settlements reached on enfranchisement claims (between 1974 and 1996) whereas the Parthenia model derives relativity from sales in the market (between 1987 and 1991) using hedonic regression.

On appeal it was argued that the comparison between the value of the lease in the real world (with rights under the Act) and the value of the lease without such rights, as shown by the Parthenia model, was an illegitimate comparison. ⁵² The two interests were fundamentally different. The legal effect of the assumptions that the Act requires precludes the valuer (and the Tribunal) from having regard to any leasehold transaction in the real world where the lease attracts rights under the Act. In other words, there is no direct relationship between the no-Act and subject-to-Act valuations, and, therefore, a comparison of the two is illegitimate as a matter of law. Further, the reason why the value of the lease in the real world is an impermissible comparator is that the market itself had been "corrupted" by the Gerald Eve graph. This argument was rejected. Among other things, the Court of Appeal said that whether to accept or reject the Parthenia model was a question of fact for the Tribunal, which could only be interfered with on appeal if the decision was perverse.

• 2.47 Figure 8 below sets out how marriage value might be valued for Houses 1 to 4 assuming the Gerald Eve graph is used to assess relativity. ⁵³ The detailed calculations are set out in Appendix 3.

• Figure 8: Calculation of the “marriage value” for Houses 1, 2, 3 and 4

Houses 1,3 and 4: The current leases have more than 80 years unexpired, so no marriage value is payable.

House 2: The current lease has less than 80 years unexpired so marriage value is payable.

Marriage value payable by the leaseholder is £7,298 (being half of the marriage value).

The effect of high ground rents

• 2.48 We explained in paragraph 2.22 onwards above that high ground rents (including - but not limited to - onerous ground rents, such as those that double every 10 years) can make the calculation of the term very high.

• 2.49 In cases where marriage value is payable (because the lease has 80 years or less to run), onerous ground rents will also have a negative effect on the value of the existing lease and so will also increase the calculation of marriage value.⁵⁴

• 2.50 If the lease for House 3 was 70 years rather than 241 years, the marriage value payable would be £8,471 (though the capitalised ground rent would be lower, since the duration of that income stream would be only 70 years).

The effect on enfranchisement premiums of high or onerous ground rents

There are three compounding factors that result in leaseholders with high or onerous ground rents being required to pay very high enfranchisement premiums:

• (1) the ground rent that is being valued is already high, resulting in a high premium (see paragraph 2.22(1) above);

• (2) it is then capitalised at a lower capitalisation rate, resulting in an even higher premium (see paragraph 2.22(2) above); and

• (3) the ground rent de-values the existing lease, increasing the marriage value and resulting in a premium that is higher still (see paragraph 2.49 above).

Hope value

• 2.51 There is a value in the hope of being able to release marriage value in the future (“hope value”). Hope value is, in essence, a deferred form of marriage value. To return to the analogy of the Chinese vases we have used to explain marriage value at paragraphs 2.41 to 2.43 above the intrinsic value of each vase will be enhanced because of the hope of being able to do a deal with the other vase owner at some point in the future.

• 2.52 Applying to the context of a landlord and leaseholder, if the landlord is selling his or her freehold interest subject to a lease, but the leaseholder is not at that time interested in purchasing the freehold, there is “no immediate prospect of releasing the marriage value”. ⁵⁵ However, a potential purchaser of that freehold interest might well consider there to be a possible future benefit in selling the freehold to, or in acquiring the leasehold from, the leaseholder: the marriage value would be released at this later sale. This potential for a delayed release of marriage value is referred to as hope value. The hope of being able to do a deal in the future is generally and logically less than an actual deal that is done now. Hope value is therefore less than marriage value.

• 2.53 As hope value is a deferred form of marriage value, it is impossible for both to be payable in relation to the same house or flat. However, in a collective enfranchisement claim, it is possible for marriage value to be payable in respect of some flats (the flats of the participating leaseholders) and hope value to be payable in respect of others (the flats of the non-participating leaseholders).

Summary

• 2.54 Figure 9 provides a summary of Houses 1-4, all three parts of the premium, and the total premiums payable.

  Figure 9: enfranchisement premiums for Houses 1, 2, 3 and 4

  House 1 2 3 4 Details of existing leases Unexpired term 101 years 76 years 241 years 241 years Ground rent £50 pa - £250 pa £50 pa - £200 pa £300 pa, RPI increases £300 pa - £9,600 pa FHVP value £250,000 £250,000 £250,000 £250,000 Enfranchisement premiums Part (1): term £1,844 £1,806 £9,554 £79,422 Part (2): reversion £2,303 £7,349 £3 £3 Part (3): marriage value £- £7,298 £- £- Total premium £4,147 £16,453 £9,557 £79,425

Collective freehold acquisition claims

• 2.55 Houses 1, 2, 3 and 4 are all freehold house purchases. The same principles apply to lease extensions of flats and collective enfranchisement claims of blocks of flats, where a premium is calculated in respect of each flat, and then aggregated. As explained in paragraph 2.53 above, marriage value is only payable in respect of the flats of participating leaseholders, while hope value is payable in respect of the flats of nonparticipators. Further, there may be added to the premium additional sums, for example, to reflect any development value in the building, which we now explain.

Development value, additional value and other loss

• 2.56 We have set out the three main components of an enfranchisement calculation: the term, the reversion and marriage value. The value of the reversion and/or any marriage value may include development value or other additional value, such as the ability to release a restrictive covenant. ⁵⁶ Further, in some cases, landlords can demonstrate that the enfranchisement claim causes them loss in respect of other property they own (“other loss”). For example, the acquisition of one terrace house may prevent a landlord from developing the terrace as a whole. The legislation requires leaseholders to compensate landlords for this other loss as well.

• 2.57 In the case of enfranchisement rights that are most commonly exercised by individual leaseholders - namely acquiring the freehold of a house or a 90-year lease extension of a flat - the requirement to pay the type of additional compensation set out in paragraph 2.56 above is rarely encountered. An example of when a leaseholder may be required to compensate a landlord in respect of other loss is when a landlord can show that an individual lease extension claim will cause him or her to suffer loss in the event of a future collective freehold acquisition claim in relation to the whole block.⁵⁷

• 2.58 Most cases of additional compensation being payable to landlords concern collective freehold acquisition claims. For example:

• (1) There may be value to the landlord in being able to develop a block of flats, for example, by building a further floor of flats on the roof. When the participating leaseholders acquire the freehold to the block, they then have the ability to build an extra floor of flats and realise that development value.

• (2) There may be additional value which is referable to a particular flat, but which can only be released on the expiry of the lease or through an earlier deal between the leaseholder and the landlord. For example, if there is loft space owned by the landlord above the top floor flat, the value of being able to incorporate it into the flat could be realised on the expiry of the lease or through an earlier deal between the leaseholder of the flat and the landlord.

• 2.59 Where there is additional value which is not dependent on a deal between parties (such as example (1) above), it is relatively straightforward to compensate the landlord for the loss of this value.

• 2.60 But additional value that can only be released by striking a deal (such as example (2) above) is not so simple. The additional value can be characterised as a form of marriage value, as the effect of doing a deal is the same as if the leaseholders’ and landlord’s interests were in common ownership. Where there is only the hope of doing a deal, the value is a form of hope value.

Potential alternative bases for assessing market value

• 2.61 We have set out above the most common method by which valuers and the Tribunal assess the market value of the landlord’s interest. But as we explained in paragraph 2.11, the enfranchisement legislation does not require that method to be used. Broadly speaking, all that the legislation requires is an assessment of the market value of the landlord’s interest in the property. Alternative valuation methodologies could achieve that requirement. For example:

• (1) if a recent local transaction involved an interest being acquired on the open market which is directly comparable to the asset that is the subject of an enfranchisement claim, then that transaction could, in theory, be used as a basis for assessing the market value of the landlord’s interest;

• (2) in the case of very short leases (less than five years), valuers are directed by case law that:

• (a) the deferment rate should be the net rack rental yield⁵⁸ that the evidence shows to be appropriate for the property in question; and

• (b) in addition there should be an end allowance to reflect the owner's lack of control during the period of the reversion, which, in the absence of evidence establishing some other percentage, should be 5%.⁵⁹

• 2.62 More fundamentally, some consultees suggested to us that different valuation methodologies should be used in all cases in order to assess the market value of the landlord’s interest. They suggested that those methodologies should be used instead of the conventional approach that we have described above. We discuss these suggestions in Chapter 4 and explain why we have not pursued them.

(B): THE CURRENT VALUATION PROCESS

Introduction

• 2.63 Each enfranchisement claim is dealt with on its own merits. Usually, in all but low value claims, both the landlord and the leaseholder will appoint a valuer. Broadly speaking, the valuer for each party has three roles:

• (1) Stage 1: to advise on what that party should expect to receive or pay in respect of the claim;

• (2) Stage 2: to negotiate with the other valuer to seek to agree an enfranchisement premium; and

• (3) Stage 3: if agreement cannot be reached, to provide expert evidence to the Tribunal about the appropriate premium.

• 2.64 Valuers are likely to produce different valuations for each of these three purposes.

Stage 1: valuations for advice

• 2.65 The valuer’s advice about the likely premium will be based on the valuer’s best assessment of the likely outcome of a negotiated settlement or a Tribunal ruling, or perhaps a range of potential likely outcomes. This valuation will not be shared with the other party, and the valuer is acting solely for his or her client, and will act in the client’s best interests.

Stage 2: valuations for negotiation

• 2.66 A valuation prepared for the purpose of negotiation with the other party is unlikely to produce the same premium. That is because the valuation is the “opening shot” in a negotiation. It will be shared with the other party as part of the negotiation process. It is likely to be based on figures which would produce the best possible outcome for the valuer’s client, yet which are within the range of figures that are credible or defensible in a negotiation process. The valuer is still acting solely for his or her client, and will act in the client’s best interests. The valuer’s fee agreement with his or her client can be based on an incentive structure so that the better the deal ultimately achieved from the valuer’s client’s point of view, the higher the valuer’s fees will be. For example, the fee for a valuer acting for a leaseholder may be based on a percentage of the difference between (a) the premium initially sought by the landlord, and (b) the premium ultimately agreed after negotiation by the valuers.

Valuing the term

• 2.67 To value the term, the landlord’s valuer will consider the rent review provisions in the lease, including the level of rent, the frequency of reviews and the way in which each review is calculated, and then apply a capitalisation rate. The leaseholder’s valuer will follow the same procedure and invariably produce a lower figure. The difference arises because each valuer is viewing the situation from the point of view of their own client, and endeavouring to reach a settlement that is in their own client’s best interests. For example, the valuer acting for the landlord will naturally argue for the application of a lower capitalisation rate, as this will produce a higher premium. Conversely, a valuer acting for a leaseholder will argue for a higher capitalisation rate to produce a lower premium.

Valuing the reversion

• 2.68 In a similar way, the present-day value of the landlord’s right to have the property back at the end of the lease is quantified by applying a deferment rate to the current freehold value of the property. The landlord’s and the leaseholder’s valuers will again have different opinions regarding both the value of the property and the appropriate deferment rate, and so this will again result in two different views about the value of the reversion. The landlord’s valuer will value the reversion as highly as possible by using a high FHVP value for the property and applying a low deferment rate, because that is in the best interests of the landlord. Conversely, the leaseholder’s valuer will value the reversion as low as possible by using a low FHVP value for the property and applying a high deferment rate, because that benefits the leaseholder.

Assessing marriage value

• 2.69 The leaseholder must pay to the landlord 50% of the total marriage value (where the lease has 80 years or less to run)⁶⁰ and so, as in the case of capitalisation rates and deferment rates, the landlord’s and the leaseholders’ valuers will have contrary aims and will argue for what is in the best interests of their own client. The landlord’s valuer will argue for a low relativity, which increases the share of marriage value payable by the leaseholder, while the leaseholder’s valuer will argue for a high relativity.

Extent of the disagreement between valuers

• 2.70 The difference between valuers’ views about the appropriate rates to adopt in a valuation can be significant.

• (1) Capitalisation rates: until a few years ago, valuers commonly agreed a rate of between 5% and 7%. In a recent Tribunal decision, however, the landlord’s valuer argued that the appropriate capitalisation rate was 3.09%, whereas the leaseholders’ valuer argued that it should be 6%: the Tribunal determined in that case that the rate should be 3.35%.⁶¹

Many consultees gave us their views about what the appropriate capitalisation rate should be. The suggestions ranged from 3% to 10%.

• (2) Deferment rates: following the decision in Sportelli, deferment rates are effectively prescribed on a nationwide basis at 4.75% for houses and 5% for flats, and currently most settlements are reached on that basis. However, consultees had a range of views about what the current true deferment rate should be, based on their assessment of the market, and their valuation approach. Suggestions ranged from 2.25% to 9.75% or higher.

• (3) Relativity: in the decision in Mundy, the landlord’s valuer argued (in respect of one of the flats in that case) that relativity was 65.46% whereas the leaseholder’s valuer argued that it was 81.18%.

Worked examples

• 2.71 We have set out potential enfranchisement premiums for Houses 1, 2, 3 and 4 in Figure 9 above. But before those valuations were agreed between the valuers, or determined by the Tribunal, the valuers are likely to have prepared different valuations for the purposes of negotiation.

• 2.72 Figure 10 below shows what those different valuations might have been. The central column sets out the figures, rates and consequential enfranchisement premiums that might have been agreed by the parties or determined by the Tribunal. Those figures are taken from the worked examples above. The columns on either side set out the figures, rates and consequential enfranchisement premium that each parties’ valuer might have adopted at the outset of the negotiation process. We have used different rates based upon the range of rates that were suggested to us by consultees: see paragraph 2.70 above.

Figure 10: different valuations that could have been prepared for Houses 1, 2, 3 and 4 for the purposes of negotiating the premium

• 2.73 As we explain further in Chapter 4 below, we are not a body of expert valuers and it is not for us to say what the appropriate rates are. The examples above are therefore indicative only: different figures and rates will be used by different valuers. But the examples demonstrate how significantly different the parties’ valuations - prepared for the purpose of negotiations - can be. In turn, leaseholders will often be daunted by how high the enfranchisement premium might end up being, and will be uncertain about the likely outcome of their claim.

Stage 3: valuations for Tribunal determination

• 2.74 Despite the contrary aims of the two valuers, negotiated settlements are usually reached for most enfranchisement claims. But if agreement cannot be reached, then the premium will be determined by the Tribunal.

• 2.75 Each valuer will prepare a valuation for consideration by the Tribunal. That valuation is likely to be different from the previous valuations prepared by the valuer. The valuer is giving his or her expert opinion to the Tribunal as to what the enfranchisement premium should be. When giving expert evidence, the valuer is required by the Tribunal rules to act independently, rather than in the interests of his or her client.⁶² Accordingly, the valuation ought to be a balanced objective and independent assessment of the appropriate premium. In theory, the valuer would produce the same valuation whether his or her client is the leaseholder or the landlord. But this expectation is unrealistic because, as we explained previously, there are no “correct” rates for capitalisation, deferment and relativity, only ranges of what might be applicable. Each valuer will tend to consider the ends of the ranges that favour his or her own client to be correct (otherwise agreement would already have been reached) and so although a difference of opinion between the valuers may be reduced, it will still exist.

• 2.76 When giving expert evidence, incentive-based fees are not permitted, so the valuer’s fee cannot vary depending on the outcome of the Tribunal hearing. Rather, the valuer will usually charge an hourly rate for the work involved in the preparation for, and attendance at, a Tribunal hearing.

CONCLUSION

• 2.77 We have set out how enfranchisement premiums are calculated in principle and in practice. The next chapter explains the criticisms that have been made of the current regime.

• Chapter 3: Arguments about reform

INTRODUCTION

• 3.1 During our consultation, and throughout the course of our project, we have heard:

• (1) criticisms of the existence of any requirement to pay enfranchisement premiums;

• (2) criticisms of the basis on which those premiums are calculated and the process that must be followed; and

• (3) technical criticisms about the assessment of enfranchisement premiums.

• 3.2 We have also heard criticisms of one of the objectives for our project, set out in our Terms of Reference, namely to reduce premiums for leaseholders.

• 3.3 In this chapter, we summarise the various criticisms that have been made under three headings.

• (1) First, we explain the argument that leasehold ownership is inherently unfair, which permeates many of the arguments - particularly those made by leaseholders - about why premiums should not be payable in order to enfranchise, or should be reduced or otherwise reformed.

• (2) Second, we discuss and comment on some of the problems to which the current regime gives rise. Some of those problems are very practical and are felt by both leaseholders and landlords at the coalface as they are navigating the enfranchisement process. Others are very technical or difficult to understand by anyone other than a specialist lawyer or valuer. These are all problems with the law which, in our view, any reform should seek to address.

• (3) Third, we set out the arguments for and against reducing premiums that have been raised with us. We deliberately do not express a view on whether or not it is right to seek to reduce premiums, since that is a mixed question of law, valuation, social policy and - ultimately - political judgement. In our project, we have worked within Terms of Reference which ask us to examine the options to reduce premiums. Nevertheless, we set out the arguments for and against reducing premiums since consultees have commented on the issue, and since the objective of reform is crucial when it comes to assessing the compatibility with A1P1 of options for reform that would reduce premiums.

(1) OPPOSING VIEWS ON WHETHER LEASEHOLD OWNERSHIP IS INHERENTLY UNFAIR

3.4 A very firmly held view among a great many leaseholders is that leasehold ownership is inherently unfair to leaseholders. That perceived underlying unfairness then exhibits itself when enfranchisement premiums are discussed. The view has been expressed to us at consultation events, in consultation responses, and in correspondence, and we are aware that similar views have been expressed to Government, Parliamentarians and other organisations.

How representative of all leaseholders are the views that we have heard?

We have heard from or spoken to thousands of leaseholders during the course of our project, and over 1,500 leaseholders responded to our online survey to tell us about their experiences of the enfranchisement process. Similarly, Government’s consultations about leasehold reform have resulted in many thousands of responses from leaseholders complaining about leasehold.

We acknowledge that these leaseholders make up only a fraction of leaseholders - of whom there are at least 4.2 million in England, plus many in Wales (but about whom there are no data). Some landlords have suggested that the strong views that we have heard from leaseholders are not representative of all leaseholders, and that reform should not be based on the unrepresentative view of an aggrieved minority. We do not agree with that view. Although we do not have data that gather the views and experience of all of the millions of leaseholders in England and Wales in a representative way, there are various indications that dissatisfaction with leasehold is widespread. For example:

• - an opinion poll conducted by NAEA Propertymark found that 94% of leaseholders regretted buying a leasehold property.⁶³

• - an online petition to “abolish leasehold” gathered over 30,000 signatures.⁶⁴

• - complaints about leasehold have been raised with numerous Members of Parliament, and

177 Parliamentarians indicated their concern about leasehold by joining an All-Party Parliamentary Group (“APPG”) on Leasehold and Commonhold Reform.⁶⁵ The APPG is one of the largest in Parliament.

• - the Conveyancing Association’s research, which led to its White Paper on home moving, raised various problems with leasehold, in particular that it can cause additional unnecessary delay and expense in the conveyancing process.⁶⁶

• 3.5 Leaseholders who are bringing an enfranchisement claim are doing so as a result of having previously acquired an interest which is diminishing in value over time. When they bought their lease, many leaseholders will have paid a premium that was not substantially different (or not at all different) from the value of a freehold interest in the property. They would say that they had no choice but to acquire a leasehold interest, and consider that they are being asked to pay again for the home they have already bought. And many leaseholders will not have been aware of, or will not have understood, the diminishing value of their interest, or that the cost of extending their lease or acquiring the freehold would increase substantially over time.

• 3.6 We have also been told that many prospective purchasers of houses and flats -particularly first-time buyers - do not have a full understanding of the terms of the lease or of the implications of owning a leasehold property. In some cases, buyers of leasehold houses may not even realise when purchasing a leasehold house that they will not become its outright owner. As one stakeholder said to us, people have set their heart on a home and are measuring for curtains and furniture before the lease is explained to them. We discussed the exploitation of consumers’ “behavioural biases” in our project on Event Fees.⁶⁷ Consumers fail to give adequate weight to future costs in assessing the quality of an offer as a whole. This analysis may also explain consumers’ willingness to purchase long leases (perhaps at a similar price to a freehold interest) despite the further sums that will have to be paid in the future.

• 3.7 Leaseholders often find themselves compelled to make an enfranchisement claim, either (i) because they wish to sell their lease and a purchaser can only be found (or will only be able to obtain a mortgage) if the length of the lease is increased, or (ii) because they know that the cost of doing so in the future will likely be higher than it is at present. They are compelled to make a claim in order to be able to protect the value of their interest from reducing further. And in the majority of cases, that interest is not only an asset but also their home.⁶⁸

• 3.8 The mere fact that leaseholders have to engage with the enfranchisement process at all - no matter how simple, quick and cheap it is - can, therefore, be a cause of frustration and anger. And once they do engage with the process, they realise that they also have to pay their landlord a premium, plus the landlord’s legal costs, and their own legal costs - for a process that, in their view, should not be necessary in the first place. The aspirations of “home ownership” are undermined as leaseholders realise that they face the prospect of making a claim which will take emotional energy, will be lengthy and complicated, and will cost a large amount of money. Leaseholders will therefore often feel that they are being treated unfairly.

• 3.9 By contrast, landlords would argue that they only ever granted - and were only ever paid for - a time-limited interest. Those who purchased such an interest would have known, or ought to have known, that its expiry in the future would entail a process, and a sum of money being paid, in order to extend the interest. Landlords would argue that they are entitled to the assets that they own. To some, the very existence of a compulsory purchase regime that entitles leaseholders to force landlords to hand over their asset is objectionable. To others, such a power of compulsory purchase must be accompanied by an obligation to pay full compensation for the deprivation of the landlord’s interest.

• 3.10 So, to landlords, any feeling of unfairness amongst leaseholders is caused by a lack of consumer awareness about the nature of leasehold ownership, or by inadequate advice from their lawyers, rather than by a systemic failure of the leasehold regime. Landlords argue that they are merely seeking to protect their legitimate property interests. But for leaseholders, no amount of consumer awareness of the true position will overcome the fundamental feeling of unfairness of the leasehold system, and its inability to deliver the benefits they expect to achieve through owning their home.

• 3.11 These competing views are genuinely held and irreconcilable. Decisions about which side to favour, and how to strike the balance between the competing interests, depend to a large extent on political judgement.

• (2) PROBLEMS WITH THE LAW GOVERNING THE CALCULATION OF PREMIUMS

Problems with the current law

Complexity

• 3.12 The valuation process is complex:

• (1) there are various different valuation formulae for the purchase of a house, and which of them is applicable depends on historic rateable values; and

• (2) the valuation methodology and process (summarised in Chapter 2) for houses and flats are not readily understandable to the lay person. Many lawyers struggle to understand the methodology and many professional valuers struggle with the more complex cases.

• “Ma ny practitioners are not aware of the process and options... it took 6 months to find a law practitioner who is actually knowledgeable and reasonable”. (A leaseholder responding to our survey)

“Current methodology undoubtedly makes claims much more expensive, complex, costly and worrying for both parties, unless they are very practised in these ‘arts’”. (Jennifer Ellis, a surveyor)

“The current methodology is so complex that it must scare off most leaseholders. Very few professionals understand the different bases for valuation of a freehold in an enfranchisement claim in respect of a low value house: what chance does a layman have”? (Tapestart Limited, a commercial investor)

Unpredictable outcomes

• 3.13 Valuation is not an exact science. As we discussed in Chapter 2, valuers can have very different views on the way in which an enfranchisement premium should be valued. So there is a significantly wide valuation margin and a lack of standardisation. Different experts will form different views as to the appropriate inputs into the valuation and indeed the various inputs will vary between locations, properties and over time. This in turn gives ample scope for disputes, both during negotiations and before the Tribunal, and thereby increases costs, delay and uncertainty as to the ultimate price the leaseholder will have to pay.

“The methodology was misused by both sets of surveyors to reach wildly different amounts in my claim. This slowed down the whole process while they negotiated - why did they need to negotiate? The value should have been fixed using one method... This delay cost me thousands more in legal fees.” (Catherine Williams, leaseholder)

Room for argument

There is ample room to argue about what the various inputs into a valuation calculation should be. Different valuers will take different views when giving advice, during negotiations, or when giving evidence at the Tribunal. The parties, or their valuers, will therefore argue about, and litigate over, what the inputs should be. For example, disputes can arise in respect of the following.

• - FHVP values (see paragraph 2.32 above);

• - capitalisation rates (see paragraph 2.19 onwards above);

• - deferment rates (see paragraph 2.34 onwards above);

• - relativity (see paragraph 2.44 onwards above);

• - discount for leaseholder’s improvements (see paragraph 6.223 onwards below);

• - discount for the risk of holding over (see paragraph 6.250 onwards below);

• - development value (see paragraphs 2.56 above and 6.155 below); and

• - other appropriate assumptions. ⁶⁹

Inconsistency and irrationality in the regime

• 3.14 There are numerous inconsistencies in the enfranchisement regime as a whole, which we discussed in the Consultation Paper. In terms of valuation, the main inconsistency is between the treatment of (1) houses that satisfy particular criteria for which the “original valuation basis” applies, and (2) other houses, and all flats, for which the “mainstream valuation basis” applies.

• 3.15 Leaseholders in the former category enjoy a more favourable basis of valuation, but the criteria which must be satisfied in order to fall within that category are unsatisfactory and irrational. First, it can be difficult in practice to ascertain whether a particular property meets the relevant criteria, since it depends on historic values of properties which sometimes cannot be traced - or can only be traced at great expense. Second, the way in which those historic financial limits operate in the present day can be irrational: there are houses which were low value historically but which are now very valuable, yet they enjoy the original valuation basis; by contrast, there are houses which are currently worth far less, but which do not quite fall within the relevant financial limits, so the leaseholder must pay a premium based on the mainstream valuation basis. We give some examples of cases in which the different valuation regimes apply in Figure 11.

• Figure 11: some examples of the operation today of financial limits dating back to 1967

A mews house in London with a freehold vacant possession value of £2,528,750 fell within the financial limits and qualified for a valuation under the original valuation basis.

A flat above a shop (outside London) which we have been told about, with a freehold vacant possession value of £275,000, fell above the financial limits and therefore fell to be valued under the mainstream valuation basis.

A 3-bedroom semi-detached house in Sutton Coldfield, with a freehold vacant possession value of £285,000, fell above the financial limits and the enfranchisement premium was valued under the mainstream valuation basis.

3.16 Whether a property falls within the original or the mainstream valuation basis can make a significant difference to the premium: see Figure 12.

• Figure 12: difference between premiums under the original valuation basis and under the mainstream valuation basis

In the case of the mews house in Figure 11 above, which was valued under the original valuation basis, the premium was £45,000. Had the enfranchisement premium been valued on the mainstream valuation basis, the premium would have been in the region of £275,000.

In the case of the flat above a shop in Figure 11 above, which was valued on the mainstream valuation basis, the premium was around £82,000. Had the enfranchisement premium been valued under the original valuation basis, the premium would have been in the region of £20,000.

In the case of a property in Wales which we have been told about, with a freehold vacant possession value of £55,000, and which was valued under the original valuation basis, the premium was around £16,500. Had the enfranchisement premium been valued on the mainstream valuation basis, the premium would have been in the region of £46,000.

Artificiality

• 3.17 The price payable is to be ascertained by reference to the market value of the interest being acquired, but subject to various statutory assumptions. Most notably of these is the assumption that there are no enfranchisement rights attached to the interest - that is to say, that the leaseholder of a property has no right to buy the freehold of that property or claim a lease extension of it. In reality, nearly all leasehold properties benefit from statutory enfranchisement rights and therefore “the market value” is, to a certain extent, artificial. This leads to two problems: (1) how to value an interest on a hypothetical sale in the market; and (2) circularity.

“As most of the comparable evidence ... [is] derived from transactions in a market where the effects of the legislation are prevalent and ubiquitous, it is difficult to determine and isolate the effect of the legislation to adjust sales evidence to derive an accurate "no Act world" value, as required by the legislation. Both practitioners and tribunals continue to struggle with this impossible task.” (Cerian Jones, surveyor)

Artificiality: hypothetical valuation

• 3.18 We referred to the decision in Mundy above.⁷⁰ The leaseholders’ valuer argued that relativity should be calculated using the Parthenia model, which was based on sales of properties between 1987 and 1991, that is, before the distortion of the market caused by the 1993 Act and by the prospect of the 1993 Act. The landlords’ financial experts, who the Tribunal thought were probably right, rejected the application of the Parthenia model because they considered that there had been substantial changes in the market and the economic environment since 1991, so historic data lacked relevance when calculating current values.

• 3.19 If historic real-world sales are no longer relevant and all recent sales are tainted by the enfranchisement legislation, then it is hard to see how the value of an existing lease without enfranchisement rights can ever be ascertained with certainty. While the valuation is said to be directed at ascertaining market value, it is attempting to value something which no longer exists to be valued.

Artificiality: circularity

• 3.20 Buyers of leasehold property in the real world are buying on the basis that the enfranchisement legislation confers the right to buy the freehold of such property (or to extend the lease of it). Consequently, in deciding what to pay for a relatively short lease of a property,⁷¹ buyers in the market will have regard to what they are likely to have to pay in order to acquire the freehold interest of the property (or to extend that lease), through exercising enfranchisement rights. The value of the relatively short lease will be the cost of exercising the enfranchisement rights subtracted from the freehold value of the property (or the value of an extended lease of the property): see Figure 13 below.

• 3.21 In turn, however, the cost of exercising the enfranchisement rights in respect of the relatively short lease will be determined by the price that similar short leases are selling for in the market. The premium for the exercise of enfranchisement rights will be the value of similar short leases in the market subtracted from the freehold value of the property (or subtracted from the value of an extended lease of the property).

• 3.22 In other words:

• (1) the market value determines the price payable under the enfranchisement legislation; and

• (2) the price payable under the enfranchisement legislation determines the market value.

There is a strong element of circularity.

freehold value, existing lease value, and lease

• 3.23 This circularity is arguably compounded by Tribunal decisions. In Mundy the Tribunal said that valuers are to focus on actual market forces at the valuation date. In other words, they are to take account of factors which were influencing the market at that date - for example, a particular case or graph of relativity - and ignore the fact that the market was badly informed or operating illogically or inappropriately. The Tribunal found that the market was using the Gerald Eve graph and that the graph was the least unreliable. The premiums assessed by tribunals in future cases will now follow the Tribunal’s decision and that, in turn, produces the result that in the market, when a purchaser of an existing lease with rights under the enfranchisement legislation is advised on the amount of the estimated premium for a lease extension, he or she will be advised on the basis of the Gerald Eve graph.

• 3.24 In other words:

• (1) the Tribunal bases its decisions on the behaviour of the market; and

• (2) the market bases its behaviour on the decisions of the Tribunal.

• 3.25 The problem can be further exemplified by considering the decision in Mundy relative to the decision in Kosta v Carnwath.⁷² Mr Kosta, the leaseholder, attempted to rely on the Parthenia model. The landlord’s valuer thought reliance on an average of the available graphs of relativity would be more palatable than reliance purely on the Gerald Eve graph. Consequently, he adopted an average relativity in circumstances where that relativity coincided with the relativity derived from the Gerald Eve graph. The Tribunal in Mundy said of Kosta:

In Kosta the Tribunal held that a prospective purchaser of an existing leasehold interest, acting prudently, would have taken an average of the relevant graphs contained in the RICS 2009 report when assessing relativity. We have had the benefit of hearing detailed evidence about the construction and use of those graphs. From such evidence we are satisfied that at the valuation dates a prospective purchaser would not have taken an average relativity from those graphs. It is most likely that they would have referred to the [Gerald Eve] graph first and foremost. The evidence was that the market had only started to adopt an average relativity from the graphs following the decision in Kosta.

• 3.26 In other words, as a matter of legal precedent, the approach in Kosta cannot be relied upon following the decision in Mundy. However, where the valuation date falls after the decision in Kosta, but before the decision in Mundy, applying the guidance in Mundy that one must look at factors which influenced the market at the valuation date, the decision in Kosta can be taken into account.

Other technical problems

• 3.27 There are a number of technical criticisms of the valuation provisions in the 1967 Act and the 1993 Act, which we referred to throughout Chapters 14 and 15 of the Consultation Paper. We also listed some technical problems with the original valuation basis in paragraph 14.106 of the Consultation Paper.

Practical consequences of those problems

• 3.28 We have described various problems with the current law. Those problems - particularly the complexity and unpredictability of the regime - result in some very practical difficulties for leaseholders and landlords who engage with the enfranchisement process, which we now explain.

Uncertainty

• 3.29 The valuation methodology (set out in Part 1 of Chapter 2) is relatively clear. But in practice the outcome of any given enfranchisement claim can be far from certain. That is because there is considerable uncertainty about how the valuation methodology will operate in any given case (the process is set out in Part 2 of Chapter 2). Valuation is not an exact science. It involves a number of known and unknown variable factors. It depends on the particular features of the lease and the property, it depends on the appropriate rates, and so on: see Chapter 2.

• 3.30 The result is that, from the outset of the claim all the way through to the agreement or determination of the claim, leaseholders and landlords do not know what the premium will be: see Figure 14 below.

by Tribunal determination). Taking those figures, the leaseholder and landlord will not know what figure the premium is going to be:

• - (for House 1) between £1,940 and £10,984;

• - (for House 2) between £10,069 and £27,327;

• - (for House 3) between £4,739 and £15,364;

• - (for House 4) between £18,736 and £184,059.

whereas the landlord’s valuer contended that the correct figure was £10,000. The

Tribunal determined a premium of £185.⁷³

• 3.33 For an ordinary leaseholder, the potential sums involved can be daunting, or, indeed, beyond their reach.

“A Lease Valuation Expert provided estimates for the cost of lease extension in May 2017. With a remaining sub-lease of 97.56 years, a ground rent of £450 which doubles every 25 years, and assuming a wholly positive profit rent situation, the estimate to extend the sub-lease of our flat was £15,600. The second estimate of £59,100 assumed a wholly negative profit rent situation”. (A leaseholder responding to our survey)

“I looked into enfranchisement but I was quoted that it could cost between 15K and 60K to buy my share of the freehold and no one could say exactly how much until we had spent the money on the surveyors to get a ballpark, and this wouldn't even give us legal costs (landlady's and ours)”. (A leaseholder responding to our survey)

“Have no idea what the premium is going to be and whether such figure would be reasonable. This has prevented exercising enfranchisement rights.” (Graham Foster, leaseholder)

• 3.34 Different people have different tolerances to uncertainty. A large organisation is better able to plan for and cope with uncertainty than an individual. For individuals, particularly leaseholders who own their own homes, the uncertainty will often bring with it emotional stress, exhaustion and frustration.

The stakes are high

• 3.35 Much can turn on which valuer’s view prevails during negotiations. A difference of just 1% in the capitalisation rate, deferment rate and relativity can have a significant effect on premiums: see Figure 15.

• 3.36 The parties can therefore find themselves in an invidious position. Do they stick to their valuation and run the risk of an unfavourable decision by the Tribunal? Can they afford to pay their lawyer and valuer to attend the Tribunal hearing (and those costs are irrecoverable, regardless of the outcome of the decision)? The parties must decide whether to take a gamble, or whether a bird in the hand is worth two in the bush. And for the leaseholder that decision must often be made (as we explain in paragraph 3.45 below) against the background of an inequality of arms.

  Figure 15: effect on enfranchisement premiums of a 1% change in the various rates

  House 1 Rate 1% change in rates in favour of leaseholder As per Figure 9 above 1% change in rates in favour of landlord Capitalisation rate 7% 6% 5% Deferment rate 5.75% 4.75% 3.75% Relativity N/A N/A N/A Effect of changing rates on enfranchisement premium Part (1): term £1,528 £1,844 £2,305 Part (2): reversion £882 £2,303 £6,069 Part (3): marriage value £- £- £- Total premium £2,410 £4,147 £8,374

  House 2
  Rate	1% change in rates in favour of leaseholder	As per Figure 9 above	1% change in rates in favour of landlord
  Capitalisation rate	7%	6%	5%
  Deferment rate	5.75%	4.75%	3.75%
  Relativity	91.5%	90.5%	89.5%
  Effect of changing rates on enfranchisement premium
  Part (1): term	£1,511	£1,806	£2,219
  Part (2): reversion	£3,570	£7,349	£15,235
  Part (3): marriage value	£8,085	£7,298	£4,398
  Total premium	£13,166	£16,453	£21,852

  House 3

  Rate 1% change in rates in favour of leaseholder As per Figure 9 above 1% change in rates in favour of landlord Capitalisation rate 5% 4% 3% Deferment rate 5.75% 4.75% 3.75% Relativity N/A N/A N/A Effect of changing rates on enfranchisement premium Part (1): term £7,628 £9,554 £12,756 Part (2): reversion £- £3 £35 Part (3): marriage value £- £- £- Total premium £7,628 £9,557 £12,791

  House 4
  Rate	1% change in rates in favour of leaseholder	As per Figure 9 above	1% change in rates in favour of landlord
  Capitalisation rate	5%	4%	3%
  Deferment rate	5.75%	4.75%	3.75%
  Relativity	N/A	N/A	N/A
  Effect of changing rates on enfranchisement premium
  Part (1): term	£50,908	£79,422	£135,021
  Part (2): reversion	£-	£3	£35
  Part (3): marriage value	£-	£-	£-
  Total premium	£50,908	£79,425	£135,056

Expensive procedure

• 3.37 The complexity of valuation means that it is very difficult to enfranchise without some professional assistance, and expensive specialist expertise will often be necessary. In turn, the scope for disagreement between valuers gives rise to even higher valuation costs.

“Firstly the leaseholder has to pay for 2 surveyors and 2 solicitors to even get a price of the leasehold extension. After spending £4-5,000 on the surveyors and solicitors the leaseholder may well not be able to afford the lease extension so will have wasted time and a lot of money ... . The calculation is too complicated which is why the leaseholder needs to pay for 2 surveyors and 2 solicitors”. (Jeanette Allen, a leaseholder)

• 3.38 The legal and valuation costs will increase when (for example) the enfranchisement claim takes longer, or when it raises complicated issues, or where the parties disagree on many issues. The costs will increase even further when agreement cannot be reached and the claim has to be decided by the Tribunal.

• 3.39 But even in relatively straightforward claims, the professional costs can be significant. Where the capital value of the property is low, the professional fees may be disproportionate to the price payable. In some cases, the costs involved actually exceed the premium payable.

• 3.40 The professional costs are borne by both leaseholders and landlords, though leaseholders are currently required to pay towards their landlords’ costs so will often feel the burden of costs more acutely.⁷⁴

Delays

• 3.41 The scope for argument about valuation can delay the enfranchisement process. That is because there can be a lengthy period of negotiation between valuers followed, in some cases, by lengthy proceedings before the Tribunal. Those delays cause problems for both landlords and leaseholders. For example, a leaseholder may need to extend his or her lease before it can be sold; a lengthy enfranchisement process can therefore result in a delay to the leaseholder moving home.

Potentially arbitrary outcomes

• 3.42 The current valuation regime results in a tailored premium for each particular enfranchisement claim. The purpose of that tailored premium is to try to ensure that the premium reflects, as far as possible, the market value of the landlord’s property interest which is being acquired by the leaseholder.

• 3.43 But in reality, the premiums that are agreed can be arbitrary. As a result of the uncertainty about the figures to use in the premium calculation, the premium can depend on the identity of the valuer that each party has selected. Some valuers might be particularly good negotiators; some might give particularly compelling evidence at the Tribunal; some who deal with enfranchisement on a daily basis might have a better understanding of the valuation provisions than others; some might make mistakes, or make unwise concessions during negotiations.

“My problem was with my choice of surveyor. His report recommended a fair price for the premium to be between £58,000 to £68,000 with an opening figure of £42,000 and the landlord’s counter notice was for £69,000. After we served the notice I discovered that my immediate neighbours who had exactly the same lease and landlord as me had settled a premium of £51,000 in January 2018, just before I started the process. At the time my notice was served my lease was ten months shorter than theirs, but I was hopeful that I would pay the same as them as they had a larger maisonette due to a loft extension. However, four months into the process my surveyor informed me that he had managed to negotiate down to £61,000 and tried to insist I settle at that. I told him about my neighbours and asked him to negotiate further. The landlord claimed that a similar flat had sold in my road for £705,000, that my lease was ten months shorter than my neighbours had been at the time of application and that the Appeal court’s ruling in January 2018 in the Sloane Stanley versus Mundy had favoured the way landlords calculate premiums. I discovered that the £705,000 flat had a share of the freehold and a double width garden so was not comparable. My surveyor again tried to insist I accept £61,000 but I refused.

As the deadline for applications to Tribunal approached I heard nothing new from my surveyor so I went ahead with the application in October and requested 3 month’s abeyance. Within a week my surveyor informed me that the landlord had agreed a figure of £55,500 which I reluctantly accepted.

My neighbour’s surveyor’s report included his calculations and yet my surveyor told me I had to trust him when I asked to see his. In March 2017 one surveyor calculates £45,000 to be a fair price to pay and nearly one year later another calculates it to be £61,000. The market value of these flats has not increased in the last two years. In hind sight I wish I had asked my neighbours for their surveyor who would have been through negotiations with the landlord but I assumed all surveyors worked on the same principles and would have arrived at similar figures in their calculations”.

(A leaseholder responding to our survey)

Undesirable incentive structures

• 3.44 Various aspects of the enfranchisement regime create undesirable incentive structures. The regime can encourage an unhelpful tactical “gaming” approach to negotiations, which tends to favour more experienced landlords over leaseholders. The complexity of the regime gives plenty of scope for parties to disagree, or to argue different positions. The threat of litigation about those points, and the time it can take to resolve disputes, can be used tactically against a party who is seeking to complete the process speedily and at minimal cost.

a sale or remortgage until the deal is done. The costs and delays have got out of control and history shows that this is cyclical and requires Government control to bring the bargaining positions back into balance.” (Beth Rudolf, Rupert Houltby and the Conveyancing Association)

Inequality of arms

• 3.45 In Chapter 1, we explained that there was a systemic inequality of arms between leaseholders (as a group) and landlords (as a group), and we explain that further here.

• 3.46 If the parties do not reach agreement about the premium, a claim must be decided by the Tribunal. As we have said above, litigation can be a lengthy, uncertain and expensive process, with much at stake for both parties. That has various consequences.

• 3.47 First, landlords are often better able than leaseholders to incur the costs, and cope with the uncertainty, of a Tribunal determination. It has been pointed out to us that, for a landlord, the costs are a tax-deductible business expense; for ordinary leaseholders (as opposed to buy-to-let investors), the costs must be paid from their post-tax earnings.

• 3.48 Second, a relatively small difference in premium for one individual claim can translate into a much larger amount in the context of an entire building or estate. A landlord may therefore decide to pursue a claim all the way to the Tribunal on a point of principle in order to try to set a helpful precedent for future claims (for example, about capitalisation rates, deferment rates and or relativity), even though the amount in dispute for that particular claim may be low: see Figure 16.

• Figure 16: what is at stake in a lease extension claim?

In a block of 100 flats, one leaseholder claims a lease extension.

The landlord’s valuer argues for a premium of £10,000. The leaseholder’s valuer argues for a premium of £6,000.

From the leaseholder’s point of view, the dispute is worth £4,000.

From the landlord’s point of view, if the claim sets a precedent in the block, it could be worth £400,000 (that is, £4,000 multiplied by 100 flats in the block).

If the legal and valuation costs of a Tribunal hearing would be £8,000 for each party:

• - the best possible outcome for the leaseholder is a determined premium of £6,000 (giving a total enfranchisement price of £14,000), so the leaseholder is better off accepting the landlord’s valuer’s premium of £10,000.

• - by contrast, from the landlord’s point of view, the claim could be worth £400,000, so it is well worth incurring £8,000 of professional costs for a Tribunal determination.

• 3.49 The consequences are:

• (1) The costs involved may be disproportionate (and sometimes higher than the premium) for the leaseholder, but well worth incurring for the landlord. A leaseholder may therefore agree to pay too high a premium to avoid the cost and uncertainty of a Tribunal hearing, particularly as the decision may go against them.

• (2) Even if the leaseholder does proceed to a Tribunal hearing, the decision is worth relatively little to the leaseholder and so it is not worth the leaseholder incurring significant costs. By contrast, the decision is worth a lot to the landlord, and so it is worth incurring significant costs to maximise the chances of a helpful decision. Stakeholders have complained that landlords are able to, and it is worthwhile for them to, engage the expensive services of Queen’s Counsel; doing so is beyond the reach of ordinary leaseholders and does not make financial sense, given (from their point of view) that a relatively low financial sum is at stake. The result is an inequality of arms between leaseholders and landlords.

The decision in Mundy involved a 9-day hearing, with numerous experts giving evidence. The case concerned three leaseholders. For them, the difference between their own valuer’s calculations (based on the Parthenia model) and the landlord’s valuer’s calculations (based on the Gerald Eve graph) was significant: in respect of two of the cases, the differences between the parties’ suggested premiums at the Tribunal were £89,750 and £54,000. But for the landlords involved, if the Parthenia model had been accepted, their income from other enfranchisement premiums would have greatly reduced, and therefore the value of their estates as a whole would have significantly reduced. So as far as the implications of the decision were concerned, the dispute at the Tribunal was worth £89,750 to one party (a leaseholder) but it was worth significantly more to the other party (a landlord).

In cases such as this: (1) leaseholders and landlords around the country have much to gain or lose from individual decisions, but (2) as for the individual parties themselves involved in the litigation, frequently it is the landlord who has the most to gain or lose, and so the greater financial incentive to litigate (and to spend significant sums of money on such litigation), owing to the wider implications of the decision for the landlord’s portfolio. The professional costs in such cases can be considerable.

In more typical enfranchisement claims, where the premiums are much lower than in Mundy (but which are still significant for the leaseholders concerned), the ability to instruct an array of professionals might be possible for landlords with a large portfolio, but is beyond the grasp of most leaseholders.

• (3) If the leaseholder does not wish to run the risk of, and incur the cost of, a Tribunal determination, and so instead agrees to pay the landlord’s proposed premium, that agreement can - in turn - be used by the landlord in future negotiations with other leaseholders as setting a precedent that supports their own figures.

Uncertainty being used as a bargaining counter

• 3.50 The uncertainty of outcome can be used by the commercially and financially stronger party as a bargaining counter against the weaker party.

• 3.51 For example, the deferment rate is, in theory, effectively set at 5% (for flats) and 4.75% (for houses) since the decision in Sportelli. But we have heard anecdotally that there remains scope to argue for a different rate, and in practice the uncertainty about which rate a Tribunal will accept can be used as a bargaining counter by landlords. We have heard of a landlord who routinely seeks a lower deferment rate (say, 3%) in its initial valuations and sometimes beyond that. Although the landlord will usually agree to the 5% Sportelli rate during the course of negotiations, there is uncertainty for the leaseholder as to whether the landlord is going to use their case to go the Tribunal to argue for 3%. If the landlord does so, the leaseholder (a) will have to incur substantial legal costs, and (b) runs the risk that the Tribunal will decide the rate should be 3% rather than 5%, so the enfranchisement premium also goes up considerably. In these and other circumstances the threat of a Tribunal hearing and the risk of a disadvantageous outcome can cause anxiety for the leaseholder, and can be used by landlords as a bargaining counter in relation to other aspects of the claim. For example, leaseholders can be compelled to accept the landlord’s higher figures in relation to other aspects of the valuation (such as the landlord’s suggested capitalisation rate, or relativity percentage, or the landlord’s legal costs) in order to secure a settlement which avoids (a) the cost, and (b) the risk, of a Tribunal hearing about the deferment rate or any other aspect of the claim.

Problems for leaseholders with onerous ground rent obligations in their leases

• 3.52 Some leaseholders have leases that contain obligations to pay an onerous ground rent. There is no set definition of an onerous ground rent, though it seems to have become generally accepted in the market (reflecting a view that has conventionally been held by valuers for many years) that a ground rent above 0.1% of the property’s freehold value is onerous.⁷⁵

• 3.53 Onerous ground rents have been brought into sharp focus relatively recently following media coverage of the practice adopted by some developers of selling leases of new houses or flats under which the ground rent doubles every ten years. As a result, what looks at first glance to be a modest ground rent will become a substantial annual sum in the future. For example, where the initial rent is £295 and the lease provides for it to double every ten years, the rent will be £9,440 per annum by the 50^th anniversary - in other words, 32 times higher.

• 3.54 Such rent reviews make the need to enfranchise and buy out that ground rent more imperative, whilst at the same time significantly increasing the price the leaseholder has to pay to do so under current valuation methods: see paragraph 2.48 onwards above and House 4.

• 3.55 Although onerous ground rents have become particularly newsworthy recently, the existence of onerous ground rents is nothing new. There have been examples of leaseholders exercising enfranchisement rights in relation to older leases and having to pay a higher premium to reflect an onerous ground rent.⁷⁶ Having said that, the financial implications of onerous ground rents has not, historically, been anywhere near as significant as the financial implications of onerous ground rents which have been newsworthy more recently.

• 3.56 The current enfranchisement regime does not provide any assistance to leaseholders with onerous ground rents who are making an enfranchisement claim. They have to pay a sum to the landlord which reflects the onerous ground rent (since that is the landlord’s contractual entitlement). In addition, and many leaseholders would say perversely, the more onerous a ground rent obligation is (and so the more lucrative it is for a landlord), the lower the capitalisation rate that will be used to assess the premium (therefore making the premium even higher). There will also be an onerous ground rent adjustment that reduces the value of the existing lease, and increases both the marriage value and the premium.⁷⁷

• 3.57 Leaseholders who have an onerous ground rent therefore face a series of compounding factors which result in very high premiums when they come to enfranchise: see paragraph 2.48 onwards above.

• 3.58 The enfranchisement premium for House 4, with its doubling ground rent, is extremely high. But it should not be assumed that the purpose of our project is simply to address problems faced by leaseholders with onerous ground rents. The complaints that leaseholders have about enfranchisement are applicable to all four of our worked examples. The scale of the problem is very pronounced in the case of a doubling ground rent, or other onerous ground rent, but the concerns that we heard about enfranchisement from leaseholders were held not only by those with onerous ground rents, but by leaseholders with a wide variety of leases.

Summary

• 3.59 The problems with the current enfranchisement regime outlined above cause unnecessary conflict, stress, uncertainty, costs, and delay. Ordinary leaseholders tend to be less able to shoulder these consequences than landlords. In addition, the incentive structures, inequality of arms and negotiating tactics that can be deployed create unfairness for the financially weaker party. The weaker party is usually the ordinary leaseholder rather than the landlord - though there are equally cases where the leaseholder is financially stronger (for example, an investor) and the landlord is financially weaker (for example, a leaseholder-owned company).

• (3) ARGUMENTS FOR AND AGAINST REDUCING PREMIUMS

  • 3.60 The policy objectives identified by Government and set out in our Terms of Reference are “to examine the options to reduce the premium payable by existing and future leaseholders to enfranchise”. It is no surprise that landlords raised objections to that decision in their consultation responses, and made detailed arguments about why in their view premiums should not be reduced. In this section, we summarise the arguments made by landlords. These arguments are important for Government to consider, given that the objective behind a decision to reduce premiums is significant to the question of whether reducing premiums is compatible with A1P1. Counsel has advised:

A key factor affecting the compatibility of the scheme with A1P1 will be the aims and objectives of the eventual scheme. For example, if the primary aim of the scheme is to remedy perceived injustice faced by leaseholders, that will have a bearing on the scope of the reforms (including the identity of those who are to benefit from the reforms) and will feed into the assessment of proportionality, including the degree of scrutiny (or conversely, deference) the courts will apply to the scheme. If the Government’s aim is to reform the leasehold enfranchisement system in order to make enfranchisement more simple, quick and cost-effective, that will change the scope of the scheme and the proportionality assessment accordingly. If the Government’s aims are more ambitious - for example, deliberate redistribution of wealth from one group (landlords) to another (leaseholders) or even ending the system of leasehold altogether - that will also feed into the nature and scope of the scheme and the assessment of where the fair balance is to be struck in terms of compensation.

• 3.61 We did not ask any consultation questions about whether premiums should be reduced, since we are working within Terms of Reference which already set that objective. Leaseholders made general comments to us about the need to reduce enfranchisement premiums, but did not generally set out detailed arguments in favour of reducing premiums. That is unsurprising. There was no need for them to do so, since reducing premiums was the basis of our project in our Terms of Reference, and we did not ask any consultation questions about whether premiums should be reduced.

• 3.62 Accordingly, most of the arguments that we heard about whether premiums should be reduced, as a matter of principle, came from landlords who objected to that policy direction - and we summarise those arguments below. In the interests of balance, we also set out the counter-arguments that were raised with us, or could be raised, by leaseholders. Many of the arguments for and against reducing premiums do not correlate with each other, but where there are corresponding arguments and counterarguments, we include cross-references to assist the reader. As explained above, we deliberately do not express a view on whether or not it is right to seek to reduce premiums, since that is a mixed question of law, valuation, social policy and - ultimately - political judgement. In our project, we have worked within Terms of Reference which ask us to examine the options to reduce premiums.

The competing interests of leaseholders and landlords

• 3.63 When it comes to enfranchisement premiums, the interests of the landlord and leaseholder are inevitably polarised. As noted in Chapter 1 and in paragraph 3.5 above, the leaseholder may feel that he or she should not have to pay for something that is already his or hers, or may feel that the premium payable is too high; the landlord may feel that he or she is entitled to the full market value for the property interest which is being compulsorily taken from him or her.

• 3.64 As we explained in the Consultation Paper, in drawing a balance between the competing interests of the landlord and leaseholder, the “original valuation basis” under the 1967 Act favoured the leaseholder.⁷⁸ It was viewed by many as providing leaseholders, including some relatively wealthy leaseholders in Central London, with a windfall gain.

• 3.65 The various amendments to the 1967 Act and the introduction of the 1993 Act have shifted the balance between landlord and leaseholder, so that the subsequently introduced bases of valuation seek to compensate the landlord at full market value for the loss of the landlord’s interest. While there are many examples of landlords arguing that they have not been so compensated, leaseholders may argue that premiums are too high and do not reflect the fact that the asset they are buying is their home. In other words, leaseholders may feel that the pendulum has swung too far back in favour of landlords.

• 3.66 In addition, the discontent amongst leaseholders has been fuelled more recently by the practice of some developers - explained above - of selling leasehold properties with rent review clauses leading to very high ground rents. As well as leaseholders feeling stung simply by having to pay those onerous ground rents, they are also surprised to discover the financial consequences of such ground rent provisions feeding in to the valuation methodology. The current valuation methodology effectively endorses those onerous ground rent terms because it values the landlord’s actual contractual entitlement to ground rent.

Different types of leaseholders and landlords

• 3.67 In considering where the appropriate balance between the competing interests lies, it is necessary to consider the variety which exists amongst leaseholders and landlords:

• (1) Landlords come in all shapes and sizes: private family estates (for example, the Grosvenor Estate and Cadogan Estate), charities (for example, the National Trust), developers, pension and other funds, private individuals, investors, and leaseholder-owned companies.⁷⁹ From their point of view, they have investments which are being expropriated from them compulsorily. They are likely to object to any reduction in the premium.

• (2) Leaseholders are also varied: ordinary homeowners (ranging from those with limited means through to very wealthy owners), non-resident owners (such as buy-to-let landlords, those with a second home, and those who have invested in property), and some speculative investors and developers who purchase flats with a view to exercising enfranchisement rights and profiting from selling on an enhanced interest. From their point of view, they have properties which are held on a leasehold basis for one of two reasons: either because the property is a flat, and leasehold is the standard method by which flats can be owned in England and Wales; or because the property is a house, but the developer insisted upon, or incentivised, the house being sold on a leasehold basis. They are likely to argue that the current basis for assessing premiums is “unfair” because the resulting premiums are too high.

• 3.68 Government’s desire - set out in our Terms of Reference - to reform the enfranchisement regime in order to provide a better deal for leaseholders as consumers is, of course, directed at individual homeowners rather than investors. However, any reduction in premium is likely to benefit all leaseholders.⁸⁰

Landlords’ arguments against reducing premiums

(A) Unfairness

• 3.69 Landlords have said to us that it is unfair to reduce premiums. They relied on various arguments.

• 3.70 First, they have said that they have a valuable asset, and it is unfair to deprive them of that asset unless they are receiving compensation at market value. The strict position as a matter of property and contract law is that leaseholders have signed a lease, they will ordinarily have received legal advice (and in any event, bad legal advice does not invalidate a contract), and the terms of that lease are enforceable. Any compulsory purchase of the landlord’s property must be compensated at full open market value.

“... as a retired property developer, my pension is the ground rents on 53 flats. All of these flats were bought by [buy-to-let] investors. The ground rents were set at £150 pa or £250pa, increasing by RPI .. Thus, our ground rents are reasonable, and will stay reasonable in the future. All of our buyers had professional advisors - in every case. In the past I have been offered 36 times the ground rent to sell the freehold of this estate, and so any formula to reduce this value is a direct confiscation of my property. There is no justification for the Government to arbitrarily take money from my pension fund and give it to [buy-to-let] investors”. (Bretton Green Ltd, a commercial investor)

(For a counter-argument, see paragraphs 3.88 to 3.90 below.)

• 3.71 Second, some landlords have explained the purpose for which they hold their freehold assets - such as to fund charitable work or to fund pensions. They have explained the negative impact on the future achievement of those purposes if premiums are reduced.

“All options suggested by the Law Commission, other than Option 2C [which is Scheme 3 in this Report], will have a considerable impact on the Wellcome’s charitable giving. That Option 1A [a ground rent multiplier] will be considered at all is abhorrent because of the significant negative impact that it would have on the value of Wellcome’s ground rented freehold investment assets: on the basis of a ten times multiplier, the day one value of the ground rented freehold properties in the Estate would fall by 97% (in excess of £100m). Even a multiplier of 100 times would reduce the day one value of the ground rented freehold properties by 71%”. (The Wellcome Trust, charitable sector)

“The Charity only exists to give grants to benefit children and young people up to the age of 25 who live in nine boroughs in North and West London. To date, we have given over £110 million since 1991 to a range of organisations that seek to encourage the aspirations of children and young people through education in its widest sense. Enfranchisement proceeds make up a significant part of the capital required for our charitable giving. The proposed changes from the Law Commission would dramatically affect our annual grant giving programme. While the Charity is a landlord, it is not profiting in the true sense from leaseholders as all proceeds are granted to charities, thereby performing a public benefit to the local community in London. Our fundamental objection to the proposals is on valuation. ... I have undertaken detailed analysis on the Charity’s residential estate in St John’s Wood. All options are financially detrimental to the Charity. This would be catastrophic for the Charity and would result in the Charity’s activities being cut back at a time when demand for its services has never been greater.” (The John Lyon Charity, charitable sector)

“On behalf of its clients, Long Harbour has invested in UK ground rent portfolios valued in excess of £1.6bn, comprising over 160,000 leasehold properties, including some specialist age-restricted retirement housing. The funds invested are provided by regulated UK pensions and insurance companies and the income derived from the ground rents is used to service the retirement income of many thousands of pensioners.

The proposals for reducing premiums generally, and thus reducing what is currently fair compensation payable to Landlords enshrined in legislation are neither proportionate nor reflective of the current realities of the residential leasehold market. They would also result in a significant detriment to, and deprivation of reversionary interest value held by major institutional investors as UK pension assets for the ultimate benefit of a much larger body of private pensioner consumers.

We believe that the significant detriment that would result from reducing reversionary values, and thus appropriating value away from, amongst others, significant UK pension fund holdings benefitting hundreds of thousands of ordinary pensioners is a disproportionate response to address the need for reform of enfranchisement.” (Long Harbour and HomeGround, commercial investors)

Prescribing a capitalisation rate to reduce premiums “would have a catastrophic effect on the freehold ground rent sector and to the stakeholders that depend upon it, principally pension funds and insurance companies who would be required to impair their assets and reduce payments to their pensioners or annuity holders.” (Consensus Business Group, a commercial investor)

(For a counter-argument, see paragraph 3.91 below.)

• 3.72 Third, some landlords have explained that they are, in reality, a group of leaseholders, albeit wearing a different hat. For example, a group of leaseholders may have previously exercised their enfranchisement rights to acquire the freehold to their block, so they are now the landlord. If some leaseholders did not participate in the original enfranchisement claim (non-participating leaseholders), the participating leaseholders will themselves have had to fund the purchase price in respect of the non-participating leaseholders’ flats. They did so in the expectation that, when the non-participating leaseholders came to extend their leases, the participating leaseholders would receive the premium as repayment for the that extra sum that they originally paid to purchase the freehold. Accordingly, reducing premiums would cause detriment to leaseholders in a block which had previously exercised enfranchisement rights, to the benefit of leaseholders in the block who did not join in that previous enfranchisement claim.

we continue to use to calculate lease extension premiums, being 6.5% capitalisation and 5% deferment), the premium would be £12,785 (before any allowance for expenses), comprising £9,091 for the ground rent stream and £3,694 for the reversion. That compares to £2,000 under [Option 1A in the Consultation Paper]”. (Southlands College Estate Wimbledon Limited, a leaseholder-owned freehold company)

(For a counter-argument, see paragraph 3.91 below.)

• 3.73 Fourth, some landlords explained that leaseholders are often well-advised, knowledgeable, and wealthy, and that they can currently take advantage of the enfranchisement legislation to make a profit. Some leaseholders are investors. All of these leaseholders would be benefited - unfairly and unnecessarily, in their view - by a reduction in premiums. Reducing premiums would involve a reallocation of wealth from (for example) charities and pension funds to (for example) buy-to-let investors.

“As in other areas of Prime Central London those buying leasehold properties on the John Lyon Estate are not ill-advised, naive buyers but sophisticated, professionally-advised customers often with a detailed knowledge of the Prime Central London property market who understand that they are buying a time limited interest. Given the nature of the Charity’s residential portfolio if the valuation changes are introduced, a small, very wealthy percentage of its inhabitants will pay substantially less for extending their leases or obtaining their freeholds, directly impacting upon the Charity’s ability to help those children and young people most in need”. (John Lyon Charity, charitable sector)

“For the numerous commercial investors who use enfranchisement to disenfranchise a different class of commercial investor then the current methodology of calculating premiums works massively in their favour. It speeds up the number of enfranchisement cases, prevents none and the profits the investors will make far outweigh the costs of so doing.” (Geraint Evans, surveyor)

• 3.74 Fifth, it has been argued that reducing enfranchisement premiums is inappropriate because it would result in windfall gains for existing leaseholders, and no benefit to future leasehold purchasers. That is because lower enfranchisement premiums will result in the value of existing leases increasing: see our explanation of the circularity problem in paragraphs 3.20 and Figure 13 above. So future leaseholders will not benefit from reduced premiums because any reduced premium will have resulted in a corresponding increase in the initial purchase price that they paid for the property: see Figure 17 below.

Figure 17: reducing premiums benefitting existing, but not future, leaseholders

Take a leasehold flat which would be worth £225,000 if held on a long lease.

In fact, only 70 years remain and the premium for a lease extension will be £20,000.

A purchaser will therefore only pay £205,000 for the lease. That is because the purchaser will have to pay to extend the lease, and so the total cost of acquiring a long lease of the flat will be £225,000 - namely a £205,000 purchase price plus £20,000 enfranchisement premium.

If enfranchisement premiums are reduced, so that the lease extension will now only cost £10,000, then the purchaser would pay £215,000 for the lease. The total cost to the purchaser of acquiring a long lease of the flat will still be £225,000. But the existing leaseholder will have sold the flat for a higher sum (£215,000 rather than £205,000). That increased sale price reflects the fact that the incoming purchaser will be paying a reduced enfranchisement premium.

(For a counter-argument, see paragraph 3.92 below.)

3.75 Sixth, it was argued that standardising the rates used in the valuation process at either market-rates or below-market rates would fail to take into account the low-risk nature of investing in freeholds.

“The income from reversions is essentially risk free, because non-payment of rent can lead to forfeiture. An assiduous (and litigious) landlord will nearly always get his or her rent from the leaseholder and, if he or she does not, he or she will end up with a windfall gain through forfeiture. The windfall gain will usually exceed the capital value of the reversion many times over: for example, if a landlord has paid in the wholesale market, say, £6,250 for a reversion generating a fixed ground rent of £250 p.a. and the leaseholder fails to pay the rent so that the leaseholder’s interest is forfeited, the landlord could end up with a property worth (say) £150,000, which would be 24 times the landlord’s original investment. Nothing like that can happen in the world of bonds. Essentially the income from reversions is risk free: indeed, a mercenary landlord may well welcome default on the part of leaseholders as an opportunity to maximise returns on his or her investment”. (Tapestart Limited, a commercial investor)

(B) Impact on the economy

Leaking of wealth out of England and Wales if reforms benefit commercial investors

• 3.76 Some consultees said that, if premiums are reduced for commercial investors, wealth will leak out of England and Wales.

“Pursuing an option which makes the enfranchisement price cheaper, will result in a one-off transfer of equity from present freeholders to present leaseholders. For central London, which is a market that is overrepresented by overseas investors, there may be a resulting leakage of wealth out of the UK”. (Cluttons, surveyors)

Reducing enfranchisement premiums would increase the value of existing leases, which in many cases would “disproportionately benefit overseas and domestic investors given the make-up of our market” (Cadogan Estate, landlord).

Reputation of the property market

• 3.77 Some consultees said that legislative intervention would threaten the reputation of the property market.

“The UK is (so far rightly) widely perceived throughout the world as a country subject to a stable legal system and therefore a safe place to do business. Any legislation which in effect tears up contracts which have been freely entered by willing buyers and sellers will put the UK in the same category of the many foreign countries that cannot be trusted to provide a stable environment in which to do business”. (Consensus Business Group, a commercial investor)

“There are also a number of foreign controlled funds who have invested on the basis of stable law and stable institutions in this country, and it is likely to be the case that any shift in value from landlords to lessees is likely to damage this country's international reputation as a safe haven for investors”. (Morgoed Investments Ltd, a commercial investor)

Tax revenue for Government through Stamp Duty Land Tax

• 3.78 Some landlords argued that reducing premiums should not be permitted because it would reduce the tax revenue from Stamp Duty Land Tax.

“A further consequence of reducing enfranchisement premiums would be to depress the amount of Stamp Duty Land Tax which the Government receives”. (The Wellcome Trust, charitable sector)

Leaseholders’ arguments in favour of reducing premiums

• 3.79 Leaseholders made various comments supporting a reduction in premiums. Some leaseholders also expressed their disagreement with arguments made by landlords about unfairness to them.

Cost is prohibitive

• 3.80 Very many leaseholders have said to us that enfranchisement premiums are too high. In our Leaseholder Survey, for example, we asked leaseholders who had considered exercising enfranchisement rights but then decided not to do so (or were unable to do so) why that was the case. Nearly 1,000 leaseholders responded, and the most common reason given for their decision not to (or inability to) exercise their enfranchisement rights was the price. There are clearly many leaseholders in England and Wales who would like to exercise their enfranchisement rights but the likely premiums are too expensive for them to be able to do so.

• 3.81 The inability to enfranchise means that leaseholders may be compelled to sell the lease to someone who would be able to pay to enfranchise in order to preserve the lease. The alternative would be for the term of the lease to come to an end, in which case the property would return to the landlord, and the leaseholder would be left without their home.

“We wanted to enfranchise but were dissuaded by costs and the time it would take ... ”. (A leaseholder responding to our survey)

“The current methodology has prevented thousands of leaseholders from enfranchising”. (National Leasehold Campaign, a leaseholder representative body)

The current valuation methodology “has had an incalculable [e]ffect on the cost of lease extensions and the legal costs payable by leaseholders . . Freeholders have made billions using the courts to extort money from leaseholders for hundreds of years. It is a national embarrassment”. (Leasehold Knowledge Partnership, a leaseholder representative body)

The current valuation methodology “has made it far too contentious and the increased professional fees have deterred many leaseholders from extending their lease or enfranchising”. (Parthenia, surveyors)

“The cost of extending this lease would be totally unaffordable although I have owned this property since 1976 (lease length was 98 years at time of purchase). I have used lease extension calculator available online . and the cost including paying for the freeholder and my solicitor plus surveyor would be around £65,000!!!!” (A leaseholder responding to our survey)

“It was far too expensive!!! My 97 year old partner bought this flat in 1994 for £95,000. Now after living in our home for 25 years, the landlord claimed he was 'retiring' last January 2017 and offered to sell us the freehold for almost £20,000!!! So we have invested and protected our home for that time and now we are expected to buy our home yet again for almost 20% of the original purchase price. How is that even fair or moral?” (A leaseholder responding to our survey)

Inherent unfairness of leasehold ownership

• 3.82 We have already explained, in paragraph 3.4 onwards above, the common argument made by leaseholders that leasehold ownership is inherently unfair. That, in itself, is put forward as an argument by leaseholders in favour of reducing premiums, since reducing premiums would go some way to addressing that inherent unfairness.

Political and social policy arguments

• 3.83 Various political and social policy arguments can be made in favour of reducing premiums.

• 3.84 First, there are social policy and political arguments about the importance of the home, and the fact that long leasehold ownership does not provide the level of security that home-ownership should provide. Such arguments can be raised to justify lower premiums, alongside enhanced enfranchisement rights (which will be considered in our second report on enfranchisement reform).

• 3.85 Second, policy aims of improving the housing stock and ensuring the liquidity of the housing market could justify lower premiums. An enfranchisement claim “improves” the quality of the asset owned by the leaseholder, and therefore makes it more attractive to potential purchasers, and more attractive to lenders as security for mortgages. Reducing enfranchisement premiums will make claims by leaseholders more likely, thereby improving the quality of the assets owned by homeowners and, in turn, the liquidity of the housing market.

• 3.86 Third, leasehold homes are an asset class to landlords.

• (1) Landlords derive income from (for example) the ground rent and enfranchisement premiums, and often in other ways (such as charging permission fees to leaseholders, which can be permitted by the terms of the lease).

• (2) Landlords often trade these assets - the freeholds - with other investors, very often without the leaseholders’ knowledge.⁸¹

• 3.87 Many leaseholders object to their home, which is their place of shelter, safety and security, being used as a source of profit by an external landlord. They feel that they have purchased their home, and it is not acceptable that someone else has a significant financial stake in their home. Leaseholders would say that they purchased a leasehold, rather than a freehold, home because that is all that was on offer - and in the case of flats, that is the only ownership mechanism generally available in the market (see paragraph 1.12 and Figure 1 above).⁸² By purchasing a leasehold property, they were not (either willingly or knowingly) agreeing to “share” their financial stake in their home with an external investor. Enfranchisement claims involve shifting the landlords’ financial interest in a property to the leaseholder, either completely (in the case of a freehold purchase) or very significantly (in the case of a lease extension at a peppercorn ground rent). So reducing premiums will allow leaseholders - more often and more cheaply - to correct the perceived injustice of landlords having a significant financial stake in their homes, since that financial stake will (largely or entirely) be transferred to the leaseholder.

“We leaseholders had no idea that we were somebody's investment and nowhere in any lease is such a situation referred to.” (A leaseholder responding to our survey)

“We do not think it is appropriate to use home owners as a source of continuing profit simply because they are leaseholders rather than freeholders ... ”. (National Housing Federation)

Leaseholders are not voluntarily acquiring an enhanced asset

(For a counter-argument, see paragraph 3.70 above.)

• 3.88 Leaseholders often say that enfranchisement is “too expensive”. Landlords might respond to such arguments by saying that many things might be too expensive, and therefore beyond the reach, of certain individuals. House prices, for example, are often said to be too high for first-time buyers.

• 3.89 But, arguably, the analogy is not an appropriate one. When first-time buyers purchase a home, they are seeking for the first time to acquire an asset: they go from the position of not owning their home to owning their home. Leaseholders exercising enfranchisement rights in respect of their home are not in the same position. Rather, they have already purchased their home, paying a large sum to do so, and often having had no choice over whether to buy the freehold of their home rather than the leasehold. The need to make an enfranchisement claim arises not because they voluntarily decide that they want to improve the value of their asset, but because they are compelled to engage with a process to avoid the loss, or de-valuation, of their home.

• 3.90 So, whilst the traditional view - and property lawyers’ and valuers’ view - of an enfranchisement claim is the acquisition by the leaseholder of a property right belonging to the landlord, in fact an enfranchisement claim could equally - as a matter of housing and social policy - be seen as akin to an administrative charge which comes with owning a particular type of home, and that the fee is too high when compared to the service that the leaseholder receives.

Identity of landlord irrelevant for leaseholders

(For a counter-argument, see paragraphs 3.71 and 3.72 above.)

• 3.91 Leaseholders could argue that, if they are paying an enfranchisement premium, it is largely irrelevant who their landlord is and what they use the income for. Whether enfranchisement premiums are paid to large or small, commercial or not-for-profit, or co-operative or exploitative landlords, ultimately leaseholders are having to pay the same sum of money to rectify the problems associated with owning a time-limited asset. So reducing premiums is not about different types of deserving or undeserving landlord (however that may be defined), but rather about acknowledging a systemic problem with leasehold ownership, with the requirement for leaseholders to “pay twice” for their home. The impact on the leaseholder of the requirement to pay enfranchisement premiums is the same, regardless of the landlord’s identity.

Reducing premiums does benefit future leaseholders

(For a counter-argument, see paragraph 3.74 above.)

• 3.92 We explained above the argument that only existing leaseholders would benefit from reduced premiums, and that future leaseholders would not. The argument is that the sale price that would be obtained by existing leaseholders is the value of a long lease less the enfranchisement premium. The effect of reducing premiums is that the sale price that would be obtained by existing leaseholders would increase, because the purchaser would pay the same amount overall. Accordingly, existing leaseholders would benefit from reduced premiums because the value of their lease would increase, but future leaseholders would not benefit because the total price that they pay (the purchase price to the vendor plus the enfranchisement premium to the landlord) would stay the same: see Figure 17 above.

• 3.93 In response to that, leaseholders could point out that there are at least 4.2 million existing leaseholders and argue that that constitutes a substantial number of home owners who would still stand to benefit. But even if future leaseholders would not benefit from reform and would end up paying more when acquiring a lease (reflecting the fact that they will now pay less by way of an enfranchisement premium), it is arguable that there are significant benefits to those future leaseholders not encountering unexpected and expensive enfranchisement premiums further down the line. All leaseholders will know the initial purchase price for the property and they will budget accordingly. By contrast, leaseholders may not know about the need to enfranchise at a later date, and they will definitely not know with any certainty what premium they will have to pay (see paragraph 3.29 onwards above). So reduced enfranchisement premiums still have significant benefits for future leaseholders even if - taken together - the purchase price plus enfranchisement premium end up being broadly similar. That is because future leaseholders will not have to shoulder such unexpected, expensive and uncertain premiums - which they may not be able to afford.

The value of landlords’ assets can already go up or down

• 3.94 Leaseholders suggested that, since landlords are investing in an asset, they should not be surprised that the value of that investment could go down - just as the value of many other types of investment can go down. Even under the current valuation regime, the value of landlords’ assets can change.

• (1) Since markets change, it is inherent that “market value” can vary over time. For example:

• (a) If there are changes in the economy (for example, if interest rates change),

there can be consequential changes to (say) capitalisation rates, which in turn will change the value of landlords’ assets.

• (b) A change in property prices will affect the value of landlords’ assets (in so far as they have any reversionary value).

• (2) The value of landlords’ assets can change as a result of significant Tribunal or court decisions. For example:

• (a) Prior to the decision in Sportelli, deferment rates were commonly around 6% in London and 7% elsewhere. Following Sportelli, the rate was reduced to 5% (or 4.75% for houses), which resulted in enfranchisement premiums rising significantly, and consequentially the value of landlords’ assets increasing overnight.

• (b) In Mundy, had the Tribunal or court accepted the Parthenia model to assess relativity, enfranchisement premiums (in so far as they comprise marriage value) would - in general - have reduced, and consequently the value of many landlords’ assets would have been significantly reduced overnight.

• 3.95 So, a change in the value of assets is to be expected, and is part of the risk of owning any asset.

• 3.96 Moreover, landlords cannot assume that the existing valuation methodology, or existing legal regime, will continue indefinitely. The introduction of the first enfranchisement legislation in 1967 (which provided a favourable basis of valuation to leaseholders) would have significantly reduced the value of many landlords’ assets. Similarly, when the enfranchisement regime was extended to flats in 1993 and further expanded in 2002,⁸³ that had significant implications for landlords. The law is reformed, and that has implications for very many people. Landlords cannot expect that the current valuation methodology will always remain the same. When investing, it is standard practice to consider the risk, and make allowances for risk. For example:

• (1) there is a risk of higher taxes being levied on property owners who are not owneroccupiers; and

• (2) when landlords have invested in ground rents, particularly onerous ground rents, they should have considered the risk of future regulatory intervention which could reduce their contractual entitlement to the ground rent.

• Figure 18: Is investing in freeholds risk-free?

The valuation of enfranchisement premiums - through the capitalisation rate - reflects the level of risk of investing in that particular asset. Some consultees argued that prescribing the capitalisation rate risked de-valuing landlords’ assets by failing to reflect the risk-free nature of the asset: see paragraph 3.75 above.

We noted in paragraph 3.96 above the risk of regulatory intervention in respect of onerous ground rents. The risk of regulatory intervention in fact goes further.

The argument set out in paragraph 3.75 above is that investing in freeholds is currently a riskfree investment since leaseholders who do not pay their ground rent can have their lease forfeited by their landlord, which results in a windfall gain to the landlord.

We have in the past recommended that forfeiture be abolished and replaced with a proportionate regime to address any failure by leaseholders to comply with the terms of their lease.⁸⁴ So, for example, if leaseholders do not pay their ground rent, landlords would have to commence a process to enforce the payment obligation against the leaseholder, and the ultimate sanction would be an order requiring the lease to be sold to pay the debt to the landlord, but with the equity going to the leaseholder; landlords would no longer receive windfall gains. The consequence of implementation of our recommendations would be to remove the windfall gain for landlords and the sword of Damocles that currently looms over leaseholders. That would, on the argument set out in paragraph 3.75 above, reduce the risk-free nature of investing in freeholds.

So the level of risk associated with investing in freeholds, from a landlord’s point of view, is already liable to change at any point - indeed, we have recommended a change that would have that effect.

• 3.97 Essentially, there is no guarantee under the current law that the value of landlords’ assets will always stay the same, or go up - the value of their assets can fluctuate. And there is no guarantee that the level of risk associated with holding a particular type of asset will always stay the same.

• 3.98 Landlords, of course, do not want premiums to reduce, and they may argue that the problems leaseholders face are caused simply by bad advice from their lawyers or valuers. But conversely, landlords’ assets are not risk-free, and leaseholders can equally argue that any unexpected reduction in the value of landlords’ assets is caused by bad investment advice obtained by landlords about the risk of owning such assets.

“If professional freeholders invest in a morally questionable asset class they should not be surprised if the value of that asset class reduces when people wake up to the underlying issues; this is no different to any other equity type investment value falling where the company or industry is involved in a scandal. It will doubtless form part of their responses but role of the morally questionably practices needs to be remembered. No compensation should be paid for loss of permission fees. The primacy of the home "owner" needs to be foremost over the speculator using that home as an asset class. Ground rent fees other than peppercorn serve no purpose beyond creating an asset class out of a home”. (Michael Kelly, a leaseholder)

Requirement to pay marriage value

• 3.99 Leaseholders with less than 80 years remaining on their lease are required to pay marriage value. If the freehold were to be purchased by an external investor, that investor would not pay marriage value - and so the price would be lower. Leaseholders would say that it is unfair that they have to pay more to exercise enfranchisement rights than an external investor would pay in the open market for the same asset; they are being penalised for being the leaseholder. We explore this argument further in our discussions of Schemes 1 and 2 in Chapter 5.

“Our lease had 61 years remaining which incurred the further legal penalty of 'Marriage Value'. This is an inexplicable artifice of no merit other than to serve as a penalty to longstanding leaseholders”. (A leaseholder responding to our survey).

• Chapter 4: Law and valuation: our role and Government’s role

INTRODUCTION

• 4.1 We said in Chapter 1 that our task is to set out the options that are available to Government for reducing premiums payable by leaseholders. We explained that, as our Terms of Reference make clear, it is not our role to decide whether or not premiums should be reduced since that question involves considerations of law, valuation, social policy, and, ultimately, political judgement. As a law reform body, we can guide Government as to which option to take forward only in so far as Government’s decision raises legal questions, including compatibility with A1P1.

• 4.2 Before setting out the options for reducing premiums, we explain in this chapter what our role does, and does not, involve.

SETTING THE LEGAL FRAMEWORK AND PROCESS FOR VALUATION

• 4.3 Our task is to set out the options for a new legal framework for the valuation of

enfranchisement premiums, including the process that must be followed to set enfranchisement premiums. Therefore, we comment on what the legal framework should seek to achieve and how it should do that. By contrast, it is not for us to comment on the precise answer that the framework should generate in given cases. Accordingly, we do not comment (for example) on what is the correct valuation technique to assess the “market value”, nor on what figure is the correct capitalisation rate, save in relation to questions of whether such techniques are legal. For the purposes of explanation, we reflect that distinction by referring to:

• (1) setting the legal framework, which is part of our role; and

• (2) setting the valuation methodology within (and the outputs generated by) that framework, which is not part of our role.

THE ROUTE TO VALUATION REFORM

• 4.4 Broadly speaking, reforming the valuation regime will require Government to address four principal questions.

• (1) What should the overall valuation framework be?

  • 4.5 The first question is: what should the overall valuation framework be? This is a legal question on which we comment throughout this Report. In particular, in Chapter 5, we discuss - and ultimately reject - frameworks based on simple formulae. Instead, we put forward three possible schemes, all of which are based on the market value of the asset. It is for Government to decide whether, and if so which, of these overall valuation frameworks to adopt.

  • 4.6 In addition, all of the “sub-options” that we discuss in Chapter 6 could form part of the overall valuation framework. These sub-options all involve legal questions on which we comment, and on which it is for Government to make a final decision.

• (2) What is the correct methodology for assessing “market value”?

  • 4.7 Assuming Government decides that the overall valuation framework should be based on market value, the second question is what the correct methodology is for assessing market value. This is a valuation question (and partly a political question) on which we cannot comment. But it is something that Government might have to decide.

  • 4.8 The current enfranchisement legislation does not set out what valuation methodology must be adopted. All it requires is an assessment of the market value of the landlord’s interest: see paragraph 2.11. Valuers almost always adopt the conventional valuation methodology that we set out in Chapter 2. In Chapter 6, we discuss the possibility of prescribing the rates that are used in that conventional methodology. If Government wants to prescribe those rates, it must also - as a preliminary step - establish that conventional methodology as the sole means by which enfranchisement premiums can be calculated.⁸⁵ There is little point prescribing rates under the conventional methodology if valuers would then be free to bypass those prescribed rates by arguing for an altogether different valuation methodology which does not require those rates to be used.

  • 4.9 Accordingly, although we cannot comment on what is the “correct” methodology to assess the market value of an asset, if Government wishes to prescribe rates it must also provide in statute the permitted methodology to assess the market value of an asset, and mandate the use of that methodology. In Chapter 5, we set out three possible valuation Schemes. If Government decides that one of those Schemes should be adopted and that, within it, rates should be prescribed, then Government will also need to create a requirement in the legislation that the conventional valuation methodology be used in all cases. That is because the prescribed rates are only of relevance if that conventional valuation methodology for assessing market value is used.

  • 4.10 In this Report, we proceed on the assumption that, if Government wants premiums to be based on market value, and if it wants to prescribe rates, then it will do so according to the conventional valuation methodology. If, instead, Government wishes to explore whether other valuation methodologies could be used to assess market value (as suggested by some consultees: see paragraphs 2.62 above and 4.15 below), Government would need to assess whether those valuation methodologies are appropriate and whether and how rates could be prescribed within them. The decision to adopt a new valuation methodology would raise valuation and economic questions on which we cannot comment.

• (3) If rates are prescribed, by what process should they be set?

4.11 If Government decides to require the conventional valuation methodology to be used in all cases, and decides to prescribe the rates within it, the third question is: by what process should the rates be set? This is a legal question on which we comment in Chapter 6 in so far as (a) it goes to what the legislation needs to say in order to achieve the aim of prescribing rates, and (b) it involves the identification, as a matter of law, of what process and procedure must be followed in order to make that decision. We discuss who could set rates and how they could do it. It is then for Government to make a final decision about what process to adopt.

• (4) If rates are prescribed, what should the rates be?

  • 4.12 If rates are to be prescribed, the fourth question is at what level (or levels) they should be set. This is a valuation and political question on which we cannot comment. If rates are to be prescribed at a level that is intended to reflect market values, then the correct rate is a question of valuation. If rates are to be prescribed at below-market levels, then the correct rate is also a political question. Depending on the process that is adopted (in response to the third question above), it is a question on which Government might have to make a decision.

CONSULTATION RESPONSES ABOUT VALUATION METHODOLOGY

• 4.13 In the Consultation Paper, we asked questions about what a new legal framework for the valuation of enfranchisement premiums should be, and consultees provided helpful responses to those questions. Understandably, many consultees also commented on valuation methodology, as we now go on to explain. For the reasons set out above, it is not our role to comment on valuation methodology.

The correct method for assessing market value

• 4.14 As explained above, the conventional practice of valuers specialising in the enfranchisement field has been to assess the market value of the landlord’s interest by following the methodology that was set out in Chapter 2.

• 4.15 A few consultees argued that a different approach should be used to assess the market value of a landlord’s asset, and therefore enfranchisement premiums.

The deferment rate can be simply estimated from the net rental income from the property (i.e. gross income net of management, void and maintenance costs), using the standard dividend discount model. A simpler method benefits lessees who typically find the cost of subjective ‘professional’ advice prohibitive”.

He concluded that the deferment rate should be between 3.3% (in Durham, Southampton, Cumbria (Carlisle) and Leeds) and 6.9% (in Sunderland).

Rothesay Life PLC also made specific suggestions relating to the valuation methodology.

First, Rothesay Life PLC said that capitalisation and deferment rates should be prescribed, and that “to facilitate the prescription of the capitalisation rate, and to improve the accuracy of the term valuation for inflation linked leases, we propose that, when determining the capitalised ground rent for an inflation linked lease, inflation-linked leases are treated in the same manner as leases with other types of review. This approach would require that the expected future rent for inflation linked leases (i.e. leases that are linked to CPI, RPI or the capital value of the property) be projected through assuming a long-term inflation rate for that index. We recommend that such long-term inflation rates are also prescribed and updated with the same frequency as other rates (capitalisation, deferment etc)”.

Second, it was argued that marriage value for lease terms of less than 80 years could be replaced with an altered deferment rate:

“Our suggestion is that a lower deferment rate of x% could be used at 21 years, interpolating upward linearly to the current deferment rate of 5% at 80 years and above (with each rate being updated from time to time). As for the setting of a lower deferment rate x, we would favour the selection of 2.25% based on the independent recommendation from Oxford Economics for what would currently be the appropriate deferment rate (for all tenors) based on the same framework as used in Sportelli. The proposal to interpolate up to 5% at 80 years (rather than introduce a rate of 2.25% for all tenors, as Oxford recommend is appropriate) is made in recognition of the Law Commission’s terms of reference to provide a better deal for leaseholder as consumers (i.e. to ensure decreases, rather than increases, in premium for the vast majority of leaseholders)”.

• 4.16 These suggestions raise questions about the correct economic model to use in order to assess the market value of a landlord’s interest. It calls into question the conventional approach that has, until now, been adopted by valuers in the field. These suggestions raise both valuation and wider economic arguments. They form part of question (2) above (see paragraphs 4.7 to 4.10) and are not something on which we, as a body of lawyers, can express a view.

The correct rate or relativity graph

• 4.17 As explained in Chapter 2, the conventional valuation methodology requires valuers to decide the most appropriate capitalisation and deferment rate, and, where marriage value is payable, the value of the existing lease, which involves either deciding on an appropriate relativity or no-Act deduction.

• 4.18 Many consultees commented that the capitalisation or deferment rate should be set at a particular level.⁸⁶

Comments on capitalisation rates

“We think the capitalisation rate should initially be set for PCL at 5%, and reviewed by a panel of experts at five-yearly intervals”. (Grosvenor, landlord)

“If capitalisation rates are set, they need to reflect the capitalisation rates that have been used in recent years for valuation purposes; 7-8% to ensure that enfranchisement premiums are attainable for leaseholders”. (National Leasehold Campaign, a leaseholder representative body)

“Cap rates need to be prescribed as a matter of urgency.... The rates should be prescribed as

they have historically been at between 8-9%”. (Leasehold Knowledge Partnership, a leaseholder representative body)

“Capitalisation Rates should be fixed at 10%”. (Millbrooke Court Residents Association, a leaseholder representative body)

“We believe the capitalization rate should be set according to long term financial data and correspond to the lease term. We know investors require a premium over and above the Bank of England rate and this may be circa 3%. Therefore, rates should be reflective i.e. average interest rate over the last ten years is circa 0.5% and therefore for a lease of ten years the rate is set at 3.5% and for a lease of 100 years it might be 9% (long term average Bank base rate of circa 6% for last l00 years plus 3% premium). This would mean capitalization rates will vary for short leases according to fluctuations in the Bank base rate, which is what happens now”. (Parthenia, surveyors)

“If you start with the premise the RPI reviews should be linked to the risk free rate, say for 30 year GILTS (currently 1.5%). Add in cost of collection at another 1.5% so 3% is lowest cap rate. So for example

• (a) RPI with % increase every review (RPI + 2% every 5 years) should 3% cap rate (100%).

• (b) RPI without % increase should be 3.5% cap rate.

• (c) Doubling less then every 22 years should be 5% cap rate.

• (d) Increasing by original sum less than every 22 years or doubling every 22+ years should be 6% cap rate.

• (e) Increasing by original sum more than every 22 years should be 7% cap rate.

• (f) Fixed ground rent should be 9% cap rate”. (Xuxax Ltd, a commercial investor) as far as eligibility is concerned, but in fact the distinction as far as deferment rate is concerned is based on sound valuation principle, namely, that flats involve more management than houses, and the extra 0.25% reflects that extra cost”. (Church Commissioners for England)

“We think the deferment rate should initially be set for PCL at 2.25% (in line with current residential market yields in PCL) and reviewed on the same basis as the prescribed capitalisation rate. It would be fair to adopt higher deferment rates for properties outside PCL to reflect the lower historic growth rates and the greater risk of deterioration and obsolescence, which has been acknowledged in a number of Tribunal cases”. (Grosvenor, landlord)

• 4.19 Other consultees commented that relativity should be set by reference to a particular graph or a particular model.

“The easiest way to prescribe is to adopt one of the graphs of relativity which have been devised by firms that specialise in this area. Following the test case of Mundy, where all the graphs were considered, we would favour the adoption of the Gerald Eve 1996 graph”. (John Lyon’s Charity, charitable sector)

“Relativity may have changed, but we do not know how and the freeholders continue to rely upon the Gerald Eve graph which uses data from the 1970s. We have offered the Parthenia dataset to the Government and this would allow them to set relativity for the entire market (relativity is a ratio and is therefore not geographically dependent)”. (Parthenia, surveyors)

• 4.20 These comments from consultees about how these rates should be set reflect different views amongst valuers as to the correct figure to use when undertaking the conventional valuation.

• 4.21 These suggestions raise questions of valuation. They form part of question (4) above (see paragraph 4.12) and are not something on which we, as a body of lawyers, can express a view.

• 4.22 The “correct” capitalisation rate to adopt can be the subject of disagreement between professional valuers, which sometimes has to be resolved by the Tribunal hearing evidence and deciding which professional’s opinion to accept. Until fairly recently, capitalisation rates were usually agreed or decided by the Tribunal in the range of 57%, but a recent Tribunal decision found that the appropriate capitalisation rate in that case was 3.35%.⁸⁷ It is not appropriate for us to decide whether 3%, 5%, 7% or any other percentage is the correct capitalisation rate generally or for any particular area or property. While Tribunals do make decisions about which rate is correct, that is not our role. And in any event, Tribunals make their decisions about which rate is correct on the basis of the evidence put before them by valuers on a case-by-case basis. That is different from setting a prescribed rate to be used in all cases, the purpose of which includes the avoidance of litigation before the Tribunal.

• 4.23 The “correct” relativity percentage to use can also be the subject of disagreement between professional valuers. Indeed, as set out at Figure 7 in Chapter 2 above, the Tribunal and then the Court of Appeal recently considered extensive evidence from valuation professionals as to which model should be used. The case considered a variety of graphs that have been prepared by different firms over the years, and a new model for assessing relativity, called the Parthenia model. After lengthy and technical evidence from a variety of experts, the Tribunal (and subsequently the Court of Appeal) concluded that the assessment of relativity depends on the individual facts of each case, but went on to reject the Parthenia model, concluding that the Gerald Eve graph, in this case, was “the least unreliable”.⁸⁸

• 4.24 The different views about the appropriate rates is one of the problems with the current valuation regime that we discussed in Chapter 3, and is one of the arguments in favour of prescribing rates. Whilst it is not for us to comment on what the rate should be, we do comment in Chapter 6 on the process by which they could be prescribed - which is part of question (3) above (see paragraphs 4.11).

CONCLUSION

• 4.25 Our Terms of Reference require us to set out options to reduce the price payable while providing sufficient compensation for landlords. In doing so, we consider options for the creation of a new legal framework for valuation, including the process that must be followed to set premiums. We address the legal questions that must be considered in creating that framework, including compatibility with A1P1. That is the focus of the remainder of this Report, and is what the overall schemes and the various sub-options - which we set out in Chapters 5 and 6 respectively - would achieve. We do not comment further on the appropriate valuation methodology to be adopted within the new legal framework, but we have set out above the four principal questions (raising legal, valuation, and political issues) that will need to be resolved by Government in order to reform the valuation regime. We consider, in our discussion, the process by which Government may address those questions. Those questions will also be relevant to assessing the economic impact of reform.

• 4.26 We now turn to consider the options for a new valuation framework that would reduce premiums whilst ensuring sufficient compensation for landlords.

• Chapter 5: Possible new valuation “schemes” to reduce premiums

INTRODUCTION

• 5.1 In this chapter, and in Chapter 6, we explain how the valuation regime could be reformed in order to reduce premiums and to improve the enfranchisement valuation process.

• 5.2 We split our explanation of the options for reducing premiums into two parts: first “schemes”, and second “sub-options”. There are three alternative options for an overall “scheme” which could be adopted. Those schemes would set the general framework for the reformed enfranchisement valuation regime. We explain those three alternative schemes in this chapter.

• 5.3 After setting out those schemes, we then - in Chapter 6 - discuss various “sub-options” for a reformed scheme. These sub-options for reform could be incorporated within the three overall valuation schemes. Whichever “scheme” is adopted, one, some, or all of the sub-options could be adopted within it.

• 5.4 In Chapter 8, we draw together the schemes (from this chapter) and the sub-options (from Chapter 6) to summarise how they relate to each other and could work together. On page 22, we provide a diagram summarising the options for reform.

OVERVIEW OF THE “SCHEMES” SET OUT IN THIS CHAPTER

• 5.5 In this chapter, we discuss the possible overall valuation schemes that could be adopted in order to reduce premiums for leaseholders.

• 5.6 In the Consultation Paper, we divided the possible schemes into two categories.

• (1) First, we considered two schemes (which we called Options 1A and 1B) which were based on a simple formula to calculate an enfranchisement premium, rather than being based on the market value of the asset being acquired. These schemes could result in enfranchisement premiums reducing for all leaseholders, regardless of the remaining length of their leases.

• (2) Second, we considered three schemes (which we called Options 2A, 2B and 2C) which were based on taking different components from the current valuation methodology. These schemes would result in enfranchisement premiums reducing for leaseholders with 80 years or less remaining on their leases. For leaseholders with more than 80 years remaining, the schemes would not - in themselves - have any effect on enfranchisement premiums, but could do so if combined with other sub-options for reform (for example, prescribing rates at less than market value).

• 5.7 In this chapter, we summarise consultees’ views on those schemes and set out our conclusions about them, including the question of whether they would comply with A1P1. We conclude that:

• (1) schemes based on a simple formula (namely Options 1A and 1B in the Consultation Paper) - if applied to all cases - present difficulties and would not be compliant with A1P1, and so they should not therefore be pursued.

• (2) three alternative schemes based on the current valuation methodology could be pursued in order to reduce premiums. Whether these schemes would reduce the premiums for all leaseholders, or only for some of them, is dependent on which sub-options they are combined with. We refer to them as Schemes 1, 2 and 3.

• (3) there is a potential role for a simple formula in a limited category of cases, but the same result could be achieved in those cases by adopting Schemes 1, 2 or 3 in combination with Sub-option (1) (that is, the prescription of rates).⁸⁹ Nevertheless:

• (a) if a new overall scheme is introduced, based on Schemes 1, 2 or 3 together with the prescription of rates, then a simple formula could be used in a limited category of cases as the mechanism for implementing that new scheme; or

• (b) if a new overall scheme is not implemented, it would remain possible to introduce a simple formula for a limited category of leases.

• 5.8 Schemes 1, 2 and 3 have some similarities with Options 2A, 2B and 2C presented in the Consultation Paper, but there are significant differences. Our revised approach in Schemes 1, 2 and 3 is the result of our further consideration of valuation reform in the light of responses to our consultation. In summary, the options in the Consultation Paper were based on taking different components from the current valuation methodology and excluding others. By contrast, Schemes 1, 2 and 3 are all based on the market value of the asset, but reflecting three different assumptions. Those different assumptions have different effects on enfranchisement premiums.

• 5.9 The benefits of the three schemes that we set out would be different for different leaseholders:

• (1) For leaseholders with 80 years or less left to run on their leases:

• (a) Schemes 1 and 2 (like Option 2A in the Consultation Paper) would reduce premiums.

• (b) Scheme 3 (like Option 2C in the Consultation Paper) would not - in itself - reduce premiums, but could do so if combined with sub-options for reform (on which see Chapter 6).

• (2) For leaseholders with more than 80 years left to run on their leases, the three schemes (like Options 2A, 2B and 2C in the Consultation Paper) would not - in themselves - reduce premiums.⁹⁰ Again, however, premiums could be reduced for these leaseholders if those schemes are combined with one or more of the sub-options for reform set out in Chapter 6.

SETTING PREMIUMS BY REFERENCE TO A SIMPLE FORMULA

• 5.10 In the Consultation Paper, we discussed the possibility of setting enfranchisement premiums by reference to a simple formula, and we considered two possible formulae.⁹¹ Option 1A involved setting premiums by using a multiplier of ground rent.⁹² Option 1B involved setting premiums by using a percentage of freehold value. Our preliminary view, as expressed in the Consultation Paper, was that such formulae, if of general application, would be difficult to justify under A1P1.

• 5.11 Those simple formulae have similarities with the valuation approach in the Scottish legislation concerning long leases, and with rentcharges legislation.⁹³

• (1) The Long Leases (Scotland) Act 2012 provided for the automatic conversion of certain leasehold interests into outright ownership and the compensation payable to landlords under that Act was based on a capitalised amount of annual rent. The Act only applied to leases granted for more than 175 years, with more than 100 years left to run in respect of houses, and more than 175 years left to run otherwise. Further, the Act only applied where the annual rent was fixed and less than £100.

• (2) A rentcharge is an annuity secured on some specified land. The Rentcharges Act 1977 allows the owner of land which is subject to a rentcharge to redeem it by paying an equivalent capital sum to the owner of the rentcharge. The sum payable is calculated according to a formula set out in the Rentcharges (Redemption Price) (England) Regulations 2016.⁹⁴

• 5.12 We discuss the Scottish legislation and the rentcharges formula further in paragraph 5.28 onwards below.

A multiplier of ground rent: Option 1A in the Consultation Paper

Consultees’ views

• 5.13 The majority view of leaseholders responding to our consultation was that enfranchisement premiums should be based on the current ground rent multiplied by 10. The views expressed by these leaseholders were strongly-held and unequivocal.

Many leaseholders’ responses demonstrated their exasperation with the current regime, and their view that a simple formula of 10 times ground rent was an obvious and fair solution to many of the problems associated with calculating enfranchisement premiums.

“Mr Justin Madders proposal of 10 x annual ground rent as a valuation method for buying freehold is simple and fair, and should be adopted”. (David McArthur, consultee)

“I fully believe a simple formula such as 10x ground rent to buy the freehold would bring a sigh of relief to many leasehold properties as many uncapped costs would then be eradicated. Additionally freeholders would still obtain money back for their investments”. (Jason Smith, a leaseholder)

“Freehold valuations should be prescribed. That way no room for abuse or arguments. Justin Madders bill x10 ground rent is a simple formula that many will agree with”. (Malgorzata Zymla, consultee)

Some consultees suggested different multipliers.

“I propose following the multiplier used for Northern Ireland of 9 times ground rent”. (Lee Dickinson, a leaseholder)

“A simplified method for calculation of the cost of a lease extension should be as it is in Northern Ireland and Scotland, it should be 9 times the leaseholder’s starting ground rent”. (Jeanette Allen, a leaseholder)

• 5.14 It is clear to us that there is extensive support amongst leaseholders for the introduction of a ground rent multiplier to set enfranchisement premiums. We think that there are three main reasons for that support.

• (1) First, leaseholders want a methodology that produces a lower premium for them to pay. Some leaseholders had been given quotations by their landlords of enfranchisement premiums calculated on the basis of 40 or 50 times their ground rent, and so clearly a statutory formula based on 10 times their ground rent has the potential to reduce the premium that they would otherwise have to pay significantly.

• (2) Second, leaseholders want a regime that produces an easy, simple and certain calculation. The current uncertainty about the premium that they have to pay, compounded by (what they perceive to be) very high quotations from their landlords, means that they want to know where they stand.

• (3) Third, some leaseholders of houses have had quotations to purchase their freehold (either at the time of purchase of the house or later) that were in fact a multiple of the ground rent. Therefore, they consider a ground rent multiplier to be a device for valuing the freehold which is already being used.

• 5.15 Setting premiums by using a multiplier of the current ground rent would have the potential to reduce premiums significantly in many cases, and to provide certainty for leaseholders as to what their premiums will be: see Figure 19.

Figure 19: enfranchisement premiums based on the ground rent multiplied by 10

The enfranchisement premium:

• - for House 1 would be £500 (instead of £4,147 at present);

• - for House 2 would be £500 (instead of £16,453 at present);

• - for House 3 would be £3,000 (instead of £9,557 at present);

• - for House 4 would be £3,000 (instead of £79,425 at present).

• 5.16 A ground rent multiplier would be of particular benefit to leaseholders with ground rents which are due to increase in the future (either by doubling or by reference to an index), since such ground rent income streams are generally more attractive to investors and could therefore be assessed using a lower capitalisation rate, resulting in a higher premium.

The current use of ground rent multipliers

• 5.17 It is apparent that leaseholders have become familiar with discussing enfranchisement premiums using the concept of a multiplier of ground rent, and that seems to be because landlords have often used ground rent multipliers when giving leaseholders a quotation for an informal lease extension or freehold purchase (that is, a voluntary lease extension or freehold acquisition, which is agreed by the landlord without the leaseholder invoking the statutory scheme). Landlords have often given leaseholders a quotation based on (say) 10, or 20, or 50 times the ground rent. The very fact that landlords sometimes use a ground rent multiplier demonstrates that, from a landlord’s point of view, in certain circumstances, a ground rent multiplier can be a legitimate and acceptable basis on which to set enfranchisement premiums.

• 5.18 Our understanding is that landlords who use ground rent multipliers as a basis for calculating an enfranchisement premium tend to be ground rent investors, who are interested in long leases which yield a steady, reliable, and inflation-proof, income stream. That means that they do not have any interest in (a) the reversionary value of the lease (because the current value of the reversion in, say, 250 years, is virtually nothing), or (b) marriage value (because no marriage value is payable when a lease has more than 80 years still to run). For ground rent investors, therefore, the key consideration is the ground rent during the term of the lease - that is, “the term” (see Chapter 2). Accordingly, the most important input in the current valuation methodology is the capitalisation rate, since that is used to calculate the value of the right to receive the ground rent for the duration of the lease. A ground rent multiplier will do in a direct way the same job as a capitalisation rate currently does in an indirect way: see Figure 20.

• Figure 20 ground rent multiplier compared to capitalisation rate

Taking House 1, a capitalisation rate of 6% gives rise to a valuation of “the term” at £1,844. (See Figure 4 above.) That calculation could, just as easily, be done by using a ground rent multiplier of 36, since £50 multiplied by 36 gives (approximately) the same premium (£1,800). For any lease of more than around 100 years, with a ground rent that is similar (in terms of amount and review structure) to that of House 1, then a valuation of “the term” based on (a) a 6% capitalisation rate or (b) a ground rent multiplier of 36 would give rise to very similar premiums.

Taking House 3, a capitalisation rate of 4% gives rise to a valuation of “the term” at £9,554. (See Figure 4 above.) That calculation could, just as easily, be done by using a ground rent multiplier of 32, since £300 multiplied by 32 gives (approximately) the same premium (£9,600). For any lease of more than around 100 years, with a ground rent that is similar (in terms of amount and review structure) to that of House 3, then a valuation of “the term” based on (a) a 4% capitalisation rate or (b) a ground rent multiplier of 32 would give rise to very similar premiums.

• 5.19 So, where the value of a lease to the landlord is solely in “the term”, a ground rent multiplier is currently sometimes used, and could be used, as a basis for calculating enfranchisement premiums. In order to reflect current practice, the multiplier would have to be set at a level that reflects the value of the asset in the market, rather than being based on an arbitrary figure (such as 10 times ground rent). From the point of view of a ground rent investor, the multiple that they currently use will reflect (a) the current market (just as a capitalisation rate can currently vary according to the current market), and (b) the nature of the asset (for example, a higher multiplier might be used for leases where the ground rent includes a review in line with inflation, than for a ground rent which remains static throughout the term of the lease). Adopting a multiplier, or different multipliers for different leases, would be very similar to prescribing capitalisation rates under the current method for valuing “the term”.

• 5.20 In summary, ground rent multipliers are currently used by landlords in the market. But they are only used to reflect the value of “the term”, and they would vary depending on the market and on the rent review provisions in the lease.

Problems with a ground rent multiplier, if used in all cases

• 5.21 We referred to various problems with a ground rent multiplier in the Consultation Paper, and landlords and valuers who opposed a ground rent multiplier thought that those problems were insurmountable.

• 5.22 If enfranchisement premiums were to be based on a ground rent multiplier in all cases, it is very unlikely that the regime would be compatible with A1P1. We do not, therefore, put it forward as an option for reform. Counsel has advised as follows:

Under this valuation method, the only factor that would be used to determine the premium is the ground rent. The ground rent figure itself may be an arbitrary amount which bears no relation to the capital value of the property. This means that the resulting premium on enfranchisement would be arbitrary. The valuation method would take no account of the reversionary value (which may be substantial) or the length of the lease. Consequently, a premium based solely on the ground rent is likely to be arbitrary, bear no relation to the value of the landlord’s asset and be too inflexible to take account of differing situations. I consider that such a valuation method is unlikely to be compatible with A1P1, and I estimate the risk of a successful challenge to such a valuation method as High. It should be disregarded.

• 5.23 We think that there are three main difficulties with a ground rent multiplier, if it were to apply in all cases.

• 5.24 First, a universal ground rent multiplier would not reflect the true value of the term.

• (1) When the lease has (say) less than 100 years unexpired, the value of the term

depends on the unexpired term. A premium based on 10 times ground rent would be the same whether the lease had 10 years or 200 years unexpired, but clearly the value of the right to receive an annual ground rent for 10 years is far less than the value of the right to receive that annual ground rent for 200 years.

• (2) The value of the term also depends on the rent review provisions (regardless of the length of the lease). A lease may have a ground rent of £100 per annum for the remainder of the term. Another lease with the same unexpired term may have a ground rent of £100 per annum which increases by £50 every 10 years. The landlord’s entitlement under the second lease is more valuable than under the first lease, yet a premium based on a ground rent multiplier would be the same for both leases.

• 5.25 Second, even if a ground rent multiplier could be used to reflect the value of “the term”, it would not reflect the value of the reversion or marriage value. Where the value of the lease to the landlord is not solely in “the term”, then a ground rent multiplier would not currently be used by landlords in the market, and would be opposed by landlords. For example:

• (1) for House 1, over half of the enfranchisement premium of £4,147 is the value of the reversion, as opposed to the value of the term; and

• (2) for House 2, the vast majority of the total enfranchisement premium of £16,453 comprises the value of the reversion (£7,349) and the marriage value (£7,298). The value of the term (£1,806) is relatively low.

• 5.26 So a multiplier of ground rent, if applied in all cases, would not be reflective of the true value of the asset to the landlord. That is because a ground rent multiplier takes no account of the length of the lease and so it does not reflect the value of the reversion or marriage value. It would therefore create unfairness to landlords.

In September 2009, leaseholders of flats in 82 Portland Place, London made a collective enfranchisement claim.⁹⁵ 82 Portland Place is a purpose-built 1920's mansion block comprising 25 units of accommodation. The flats in the building included one used to accommodate the resident porter. Twelve of the remaining flats were held on leases which, at the valuation date, had unexpired terms of 11.8 years, and an obligation to pay ground rents of between £70 and £170 per annum. Most of the value of those flats was therefore in the reversion and the marriage value. The value of the reversion to those 12 flats based on their market value was determined as being £16.8 million. An enfranchisement premium in relation to those flats based on 10 times the ground rent would have been £15,410, which is 0.09% of the value of their reversions.

• 5.27 Third, as well as creating unfairness to landlords, a ground rent multiplier - if applied in all cases - would create unfairness and inconsistency as between leaseholders. The enfranchisement premium for a short lease at a peppercorn ground rent would be nothing, whereas the enfranchisement premium for a long lease at a relatively high ground rent would be high.⁹⁶ That is the opposite result to what would be expected.

Analogy with the position in Scotland and with rentcharges

• 5.28 We explained in paragraph 5.11 above the calculation of compensation under the Long Leases (Scotland) Act 2012 and the rentcharges formula. Both adopt a relatively simple formula, which is analogous to a ground rent multiplier. However, they both apply to interests which have no reversionary value, where the income stream being purchased is fairly low and static, and the calculation uses what can be described as “market” rates - so the difficulties set out above do not arise.

• (1) As explained above, the Long Leases (Scotland) Act 2012 only applies to leases

with more than 175 or 100 years left to run, and where the annual rent is fixed and less than £100. In other words, the Scottish legislation applies to leases with little or no reversionary value and with a very low annual rent, since this allows a simple formula (analogous to a ground rent multiplier) to be applied. The formula involves the ground rent being capitalised by reference to the “2.5% Consolidated Stock”,⁹⁷ so it can be described as a market rate.

• (2) Rentcharges, like the leases to which the Long Leases (Scotland) Act 2012 applies, have no reversionary value; they are a fixed income stream for a fixed period of time. Again, that allows a simple formula (analogous to a ground rent multiplier) to be applied. The formula involves the rentcharge being capitalised by reference to one of the “National Loans Fund interest rates”,⁹⁸ so it can be described as a market rate.

• 5.29 Consequently, the interests being valued in the Scottish legislation and in the rentcharges legislation lend themselves to a simple formula, and the figure produced is more reflective of a market value than that produced if a multiplier of ground rent were used in all cases.

Using a simple formula for certain types of lease

• 5.30 We have set out above the problems that arise if a ground rent multiplier were to be used in all cases. However, as we said in the Consultation Paper, we think that there is scope for using a simple ground rent multiplier (or a multiplier based on a capitalisation rate, which could be prescribed and changed over time) in certain cases where there is no reversionary value to a lease.⁹⁹ A scheme similar to the Scottish legislation or to the rentcharges legislation could be introduced. It could apply to leases which are similar to the leases to which those regimes apply, namely very long leases (so with little or no reversionary value) and where the ground rent is fairly low and static. But many leases in England and Wales would not fall within a scheme based on the Scottish legislation or the rentcharges legislation. That is because a wide range of leases exist in England and Wales, including those with more significant reversionary value, or with high ground rents or complex review structures. Consequently, the applicability and, therefore, the benefit of such a scheme is likely to be limited.

• 5.31 Moreover, under the current law, the calculation of the premium in respect of leases which would fall within this category (namely leases with no reversionary value and with low and static ground rent) is already relatively simple: it is the capitalised value of the ground rent. If a capitalisation rate was prescribed (see Sub-option 1 in Chapter 6) and an online calculator was provided (see Chapter 7), then Schemes 1, 2 and 3 that we put forward below could be made as accessible and as easy to apply as a ground rent multiplier or the provisions of the Long Leases (Scotland) Act 2012 and the Rentcharges Act 1977. Schemes 1, 2 and 3 would have the added benefit of being a standard universal regime, rather than being limited to particular categories of lease. Nevertheless, we set out two options for introducing a simple formula in paragraph 5.125 onwards below.

Conclusion

• 5.32 We acknowledge the strong support from leaseholders for the adoption of a ground rent multiplier. There are, however, problems with using a ground rent multiplier as a basis for calculating enfranchisement premiums in all cases, which we have set out above. Moreover, many of the benefits of a ground rent multiplier can be achieved by other means. First, in so far as a multiplier can legitimately be used to value “the term”, the same result can be achieved by prescribing the capitalisation rate or rates (see Suboption 1 in Chapter 6). Second, in so far as a multiplier can provide much-needed certainty and simplicity for leaseholders, the same result can be achieved by prescribing all rates (see Sub-option 1 in Chapter 6) and by providing an online calculator (see Chapter 7). We acknowledge, however, that a key potential benefit from a multiplier of ten times ground rent favoured by so many leaseholders - namely significantly reducing enfranchisement premiums for certain leaseholders - cannot be achieved by those other means.

• 5.33 Crucially, a ground rent multiplier - if used in all cases - is very unlikely to be compatible with A1P1. It would not therefore provide landlords with sufficient compensation, as required by our Terms of Reference. Accordingly, we do not put forward a ground rent multiplier as an option for a new overall valuation scheme for reducing premiums. However, that is not to say that a ground rent multiplier has no potential role in a reformed valuation regime. We discuss below the potential role of a ground rent multiplier, namely (i) as a mechanism - in a limited category of cases - to implement one of the three new valuation schemes that we put forward, or (ii) (in the absence of any other reform) as a stand-alone regime for a limited category of straightforward or low-value claims.¹⁰⁰

Set percentage of freehold value: Option 1B in the Consultation Paper

Consultees’ views

• 5.34 The second simple formula that we suggested in the Consultation Paper was a set percentage of the freehold (FHVP) value.¹⁰¹ This suggestion received some support from consultees.

“I agree that there should be a simple formula for the valuation of the freehold as a percentage i.e 10% of the value of the house”. (Brenda McMahon, consultee)

“I think a simplified regime would be hugely beneficial as the domain is so complex. Perhaps it could be based on the price of properties with an exception made to areas such as London where they may be disproportionately high”. (Stephen Heslop, a leaseholder)

“Personally it should be a set value compared to the value of the property: 3% cap max of the property value”. (Chris Burns, a leaseholder)

Problems with a set percentage of freehold value, if used in all cases

• 5.35 If enfranchisement premiums were to be based on a percentage of freehold value in all cases, it would be very unlikely that the regime would be compatible with A1P1. We do not, therefore, put it forward as an option for reform. Counsel has advised as follows:

Under this valuation method, the premium would be set at a percentage of the capital value of the freehold. The premium would not reflect the length of the lease or any difference in the ground rent payable. It would therefore be equally as inflexible as a ground-rent multiplier. Depending on what percentage was set, it may result in higher premiums. I consider that such a valuation method is unlikely to be compatible with A1P1, and that the risk of a successful challenge to such a valuation method is High. It should also be disregarded.

• 5.36 The problems with basing enfranchisement premiums on a set percentage of the freehold value are analogous with the problems of a ground rent multiplier (see paragraph 5.21 above).

• 5.37 We explained above that a ground rent multiplier could, in some ways, reflect the value of “the term”, but it ignores the value of “the reversion” and marriage value. Conversely, whilst an enfranchisement premium based on freehold value might, in some ways and in some circumstances, reflect the value of the reversion, it ignores the value of the term.

• 5.38 Moreover, a percentage of freehold value does not reflect the true value of the reversion when the lease has (say) less than 175 years unexpired. A premium based on (say) 1% or 10% of the freehold value would be the same whether the lease had 10 years or 200 years unexpired, but clearly the value of the right to have the property back in 200 years is far less than the value of the right to have the property back in 10 years. For example, an enfranchisement premium based on 1% of the freehold value would result in an enfranchisement premium of £2,500 for both Houses 1 and 2, but:

• (1) for House 1, the value of the right to get the property back in 101 years is £2,303; whereas

• (2) for House 2, the value of the right to get the property back in 76 years is £7,349.

• 5.39 Accordingly, a set percentage of freehold value does not reflect even the value of the reversion, let alone the term and marriage value.

• 5.40 Finally, whilst a ground rent multiplier could eliminate disputes because the ground rent is easily ascertainable from the lease or the latest ground rent demand, the freehold value of the property is not fixed and ascertainable: see paragraph 2.32 above. If enfranchisement premiums were based on a percentage of the freehold value, that freehold value could become significant in many cases in circumstances when it would not, under the current valuation methodology, make a significant difference to the premium.¹⁰² Using the freehold value as the basis of calculating the enfranchisement premium could therefore prompt disputes and litigation between the parties, which our three schemes seek to prevent or minimise.

Conclusion

• 5.41 Just as with a ground rent multiplier, there are problems with using a percentage of the freehold value as a basis for setting enfranchisement premiums in all cases, which we have set out above.

• 5.42 Crucially, as with a ground rent multiplier, a set percentage of freehold value - if used in all cases - is very unlikely to be compatible with A1P1. It would not therefore provide landlords with sufficient compensation, as required by our Terms of Reference. Accordingly, we do not put forward a percentage of freehold value as an option for a new overall valuation scheme for reducing premiums. However, that is not to say that a percentage of freehold value has no potential role in a reformed valuation regime. We discuss below the potential role of such a formula, namely (in the absence of any other reform) as a stand-alone regime for a limited category of straightforward or low-value claims.¹⁰³

SETTING PREMIUMS BY REFERENCE TO MARKET VALUE

The Consultation Paper

• 5.43 In Chapter 3, we explained that enfranchisement premiums are currently assessed on the basis of the market value of the landlord’s interest, and we explained the valuation methodology that is usually adopted in order to make that assessment. There are three main components to the valuation:

• (1) the term (see paragraph 2.12 onwards);

• (2) the reversion (see paragraph 2.28 onwards); and

• (3) marriage (or hope) value (see paragraph 2.40 onwards).

In some cases, there will be further components:

• (4) additional value, such as development value (see paragraph 2.56 onwards); and/or

• (5) compensation for other loss (see paragraph 2.56 onwards).

• 5.44 In the Consultation Paper, we discussed the possibility of setting enfranchisement premiums by taking some, and excluding other, components of the existing valuation regime. We presented three options, and explained that those options could be combined with prescribing rates. We discuss the possibility of prescribing rates in Chapter 6 of this Report and we do not repeat that discussion here. Instead, we focus on what the overall valuation regime should be. Whichever regime is selected, prescribed rates could form part of it.

Option 2A in the Consultation Paper

• 5.45 Under Option 2A in the Consultation Paper (“Option 2A”), enfranchisement premiums would comprise (1) the term and (2) the reversion.

• 5.46 Compensation would be based on what the landlord would receive if the lease ran its course: the capitalised ground rent and the deferred freehold value. Marriage value (and hope value) would not be payable. We explain marriage value by analogy with a pair of Chinese vases in paragraph 2.41 above. Option 2A would be the equivalent of one of the Chinese vases being smashed. The holder of the other vase (the landlord) still has his or her vase, but the value of that vase has been reduced as there is no longer any additional value referable to the possibility of it being reunited with its pair.

• 5.47 Option 2A would also exclude any compensation for additional value, including development value.

• 5.48 In our worked examples in Chapter 2, Option 2A would reduce the premium for House 2, since marriage value would no longer be payable. It would not, on its own, reduce the premiums for Houses 1, 3 or 4. For those leaseholders, Option 2A would provide benefits only if combined with other reforms, such as prescribing rates.

• 5.49 In a collective enfranchisement claim, Option 2A would reduce the premium by removing the requirement to pay marriage value (in respect of the participating leaseholders), hope value (in respect of the non-participating leaseholders), and additional value, including development value.

Option 2B in the Consultation Paper

• 5.50 Under Option 2B in the Consultation Paper (“Option 2B”), enfranchisement premiums would comprise (1) the term, (2) the reversion, and (3) marriage (or hope) value where it exists.

• 5.51 Option 2B would therefore exclude any compensation for additional value, including development value.

• 5.52 In our worked examples in Chapter 2, Option 2B would not, on its own, reduce the premiums for any of Houses 1, 2, 3 or 4. For those leaseholders, Option 2B would provide benefits only if combined with other reforms, such as prescribing rates.

• 5.53 In a collective enfranchisement claim, Option 2B would reduce the premium by removing the requirement to pay additional value, including development value.

Option 2C in the Consultation Paper

• 5.54 Under Option 2C in the Consultation Paper (“Option 2C”), enfranchisement premiums could potentially comprise all of the existing components of the valuation.

• 5.55 In our worked examples in Chapter 2, Option 2C would not, on its own, reduce the premiums for any of Houses 1, 2, 3 or 4. Nor would Option 2C, on its own, reduce the premium in a collective enfranchisement claim. Rather, Option 2C would only provide benefits if combined with other reforms, such as prescribing rates.

Summary

• 5.56 Through the three Options that we presented in the Consultation Paper, we were exploring whether two significant aspects of the value of landlords’ interests (under the conventional valuation methodology) should be payable.

• (1) First, we were considering whether marriage value should be payable; that was the difference between Option 2A (no marriage value payable) and Option 2B (marriage value payable).

• (2) Second, we were considering whether development and other additional value should be payable; that was the difference between Options 2A/2B (no development or additional value payable) and Option 2C (development and additional value payable).

Consultation responses

• 5.57 Unsurprisingly, leaseholders generally favoured Option 2A, since it would produce the greatest reduction in premiums, and landlords favoured Option 2C, since it would not (in itself) reduce premiums.

Fairness

• 5.58 Consultees raised the same arguments about the fairness or unfairness of reducing premiums as they raised in response to our other questions about valuation.

• 5.59 Landlords and many valuers and lawyers argued that Option 2A and (to a lesser extent) Option 2B would be unfair, and that Option 2C (that is, retaining the existing valuation methodology) was the only appropriate scheme.

“Option 2C ... is the only proposed option which sufficiently compensates the landlord for their interest being acquired”. (Grosvenor, a landlord)

“Making enfranchisement cheaper “cannot be achieved simply by penalising one party to the advantage of the other”. (Wallace Partnership Group Ltd, a commercial investor)

“Ultimately the government needs to decide . if it is right to transfer asset value from one class of owner (i.e. freeholders) to another (i.e. leaseholders including buy to let landlords).” (Richard Stacey, a surveyor)

Options 2A and 2B “would be catastrophic for the industry and create overnight devaluations for landlords including pension funds, family investors and put many companies out of business”. (Trowers and Hamlins LLP, solicitors)

• 5.60 Some landlords provided their estimates of the effect that Options 2A and 2B would have on their income from enfranchisement premiums. John Lyon’s Charity said that Option 2A would reduce their annual receipts from enfranchisement premiums by 31% (resulting in a £3.1 million reduction in their grant-making), and that Option 2B would reduce their annual receipts by 10% (resulting in a £1.1 million reduction in their grantmaking). The Church Commissioners for England said that Option 2A would reduce their annual receipts from enfranchisement premiums by 27%, or £34.75 million, and that Option 2B would reduce their annual receipts by 7%, or £9.25 million.

• 5.61 Conversely, leaseholders argued that Option 2A was the appropriate scheme, although as explained earlier in this chapter, the majority of leaseholders in fact favoured the scheme that we set out as Option 1A in the Consultation Paper, since that would result in an even greater reduction in premiums. A few valuers also favoured Option 2A.

• 5.62 We have addressed arguments about the fairness or unfairness of reducing premiums in Chapter 3 above. We do not repeat those arguments here.

Compliance with A1P1

• 5.63 Most landlords who objected to Options 2A and 2B referred to A1P1 and asserted, sometimes in reliance on opinions that they had commissioned from barristers, that those options would breach their human rights under A1P1. We address the compatibility of our options for reform with A1P1 below.

Marriage value

• 5.64 As noted above, the difference between Option 2A and Option 2B was whether marriage value was payable by the leaseholder. Some consultees commented specifically on why - as a matter of principle - marriage value should, or should not, be payable by the leaseholder.

• 5.65 Landlords and many valuers said that marriage value exists, and that it is “realised” by the leaseholder on enfranchisement. Taking the Chinese vase analogy (see paragraph 2.41 above), the leaseholder acquires the second vase, so has an asset that is now worth more than the two separate parts. Accordingly, they argued that it is fair that the leaseholder should pay half of that marriage value to the landlord.

“This combining of the interests creates the marriage value, and it seems fair and reasonable that this should be shared equally between the landlord(s) and the tenant.” (John Lyon’s Charity, charitable sector)

“The exclusion of such a logically necessary component of the valuation to reflect what has long been accepted as an element of the landlord’s legitimate interests, will be viewed as arbitrary and as failing to strike a fair balance.” (Cadogan, a landlord)

“The concept of marriage value is a fundamental and well-established part of the property market both for commercial and residential properties, where two or more parties with an interest in the same property are seeking to release value by the merger of their interests as part of a sale to one of the parties.” (The Portman Estate, a landlord)

• 5.66 Conversely, many leaseholders did not think that marriage value should be payable. As we explained in the Consultation Paper, arguably the landlord’s loss is only the term and the reversion, since there is never any guarantee that marriage value will be realised; the lease might simply run its course, in which case marriage value would never be realised (by the landlord or leaseholder).

• 5.67 Some consultees dismissed various components of the valuation, including marriage value, as artificial constructs. The National Housing Federation, for example, argued that marriage value was “essentially speculative and intangible”.

• 5.68 Other consultees accepted that marriage value exists, but pointed out that it is only payable because leaseholders are “special purchasers”. No other purchaser of the freehold interest would pay marriage value, because they would not be a special purchaser.

“The price paid to the freeholder should reflect the price he would obtain if selling in the open market to an investor. That purchaser would not benefit from marriage value, which is only available to the leaseholder. It has been suggested ... that as the leaseholder had a special interest in buying, marriage value should be taken into account. However if the freehold were being sold in the open market, the leaseholder would only need to pay one pound more than an investor to secure the purchase, not half of the marriage value. Therefore marriage value should be excluded. . In the analogy in paragraph 14.53 [of the Consultation Paper] the seller is selling one Chinese vase, the purchaser will therefore pay the value of one vase; if the owner of the other vase is interested he only has to outbid the next highest bidder by £1.” (Caxtons Commercial Ltd, surveyors)

“. it seems to me that the simplest way of making the cost cheaper is to stop lessees paying marriage value. I think that is justified because: (a) the freeholder cannot sell to any other party/investor and expect to receive marriage value, and (b) so far as I am aware, no other compulsory purchaser pays marriage value”. (Jennifer Ellis, a surveyor)

• 5.69 The options that we presented in the Consultation Paper would have seen the leaseholder either (i) paying no marriage value (under Option 2A), reflecting the position if the lease simply ran its course, or (ii) paying full marriage value (under Options 2B and 2C), reflecting the fact that the leaseholder acquires the freehold (or extended lease) and therefore realises the marriage value.

• 5.70 A variation on that approach was suggested by Bruce Maunder-Taylor (a surveyor), whose reasoning was similar to that of Caxtons Commercial (above).

“In my opinion, the guiding principle should be that the landlord should be compensated for damage (as with other compulsory purchase situations) and not for damage plus profit. .

In reality, the hypothetical buyer for the landlord’s interest will pay hope value, and therefore that is an item of damage. 50% marriage value is an item of profit and I really do not see why the landlord should receive that.” (Bruce Maunder-Taylor, a surveyor)

• 5.71 Hope value is the prospect of realising marriage value in the future; a purchaser of a freehold, who is not the leaseholder, will pay hope value to reflect the fact that they might, in the future, realise marriage value by doing a deal with the leaseholder. In an enfranchisement claim, marriage value is only payable because the purchaser happens to be the leaseholder. Bruce Maunder-Taylor’s suggestion was that enfranchisement premiums should be based on what the landlord’s asset would be worth if sold in the open market to another investor. An investor would pay hope value, but not marriage value. The landlord’s loss is therefore limited to the hope value, which is what the landlord would have received from an investor. By contrast, marriage value is not “lost” by the landlord because it had never been held by the landlord; it is potential future profit. All that the landlord has lost is the opportunity to realise marriage value, and the value of that opportunity is reflected in hope value. This suggestion falls half-way between Option 2A and Options 2B/2C, and was not an option that we discussed in the Consultation Paper.¹⁰⁴

• 5.72 The reasoning expressed by Caxtons Commercial, Jennifer Ellis and Bruce Maunder-Taylor is similar. Jennifer Ellis and Caxtons Commercial did not address hope value, as Bruce Maunder-Taylor did. It seems to us that there is a key difference between whether the leaseholder’s presence in the market is ignored altogether, or ignored only at the point of valuation.

• (1) If the leaseholder is assumed never to be in the market (that is, not wanting to buy the freehold or extend the lease), then no marriage value will ever be realised. It follows that no hope value would be paid by the purchaser either, because there will never be any prospect of the purchaser realising marriage value in the future by transacting with the leaseholder). Accordingly, no marriage value or hope value is ever payable.

• (2) If the leaseholder is ignored at the point of valuation (that is, treated as not being in the market), then no marriage value will be realised at that point, and so marriage value is not payable. But if the leaseholder may be in the market in the future, then there is a prospect of realising marriage value in the future (by transacting with the leaseholder) and so an investor would be expected to pay hope value to reflect that prospect. Accordingly, hope value is payable.

Development value and other additional value

• 5.73 As noted above, the difference between Options 2A/2B and Option 2C was whether development and other additional value should be payable. Some consultees commented specifically on why - as a matter of principle - that additional value should, or should not, be payable by the leaseholder.

• 5.74 Landlords said that additional value (like marriage value) exists, that leaseholders acquire that additional value on enfranchisement, and that they should therefore pay for it.

“[Additional] value can be significant ... There is no justification given for excluding this element of the valuation and it is difficult to think of one” (Cadogan, a landlord)

“Where this element of value exists, there is no reason why the landlord should be deprived of it or why the tenants should get something for nothing.” (The Alan Mattey Group, a commercial investor)

• 5.75 Following Bruce Maunder-Taylor’s comment that enfranchisement premiums should reflect “damage” but not “profit”, he said:

“If there is retained property or development value, then its loss would be a matter of damage and the landlord should be paid a reasonable sum for it. But not one which reflects the potential for profit. Damage only.”

• 5.76 Few leaseholders commented specifically on development value, though by favouring Option 2A they clearly considered that it should not be payable. An anonymous leaseholder responding to our consultation favoured Option 2B over 2C in order to remove development value, saying that landlords should not be paid development value in circumstances when the leaseholder has to go to significant lengths in order to realise it.

“I would like to purchase the freehold of the house which contains my flat and extend my flat into the roof space, which is not currently demised ... Why should my local authority freeholder be due approximately half of the development value in respect of the roof space, as I believe it could under [Option] 2C? It is an accidental owner of these spaces, which are useless on their own. It does nothing with them. The leaseholders are responsible for paying for maintenance of this space through service charges, including compensating the freeholder for managing the maintenance. This is a free lunch for the freeholder.

If the local authority freeholder released these spaces freely to leaseholders who could use them, they would quickly be made useful. This might create a windfall for the leaseholder, but it would extend and improve the housing stock. .

Consider the difference in risk and effort in developing these spaces. The leaseholder has to go through the planning process, building control, find a builder, perhaps an architect and an engineer, supervise works and budget, work around issues, and fund the whole thing, during which the property will be uninhabitable, all in their spare time. Meanwhile the freeholder is paid its half share of the expected increase in value, less the expected development costs, up front, for taking no risk and expending no effort. This is not fair.

The Chinese vases analogy used to describe marriage value is misleading in this instance. There is no equal pair coming together. Instead it is as though the freeholder holds one tea cup and the leaseholder has the other eleven”. (an anonymous leaseholder responding to our consultation)

A revised approach: from “components” to “assumptions”

• 5.77 As a result of our further consideration of valuation reform in the light of the responses to our consultation, we have changed the options for reform that we are suggesting to Government in this Report.

• 5.78 Options 2A, 2B and 2C in the Consultation Paper were all intended to yield a result that in some way was reflective of the market value of the asset. The Options were predicated on the basis that the conventional valuation methodology (see Chapter 2) would be adopted, since they were based on taking some, and excluding other, components from that conventional valuation methodology.

• 5.79 We now present three alternative valuation “schemes” which are not based on taking components of the conventional valuation methodology. Instead, our three schemes are based on taking the market value of the asset reflecting three different assumptions about the market in which the asset is being sold. We explain our revised approach, and our reasons for adopting it, in more detail below. But first we say something about the meaning of market value and the existing role of “assumptions” in assessing market value.

Market value and assumptions

• 5.80 “Market value” is defined in the International Valuation Standards 2017 as:

the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.¹⁰⁵

• 5.81 The market value is an estimated amount and, within limits, there is room for differences of opinion, resulting in different valuers having different opinions of market value: see Chapters 2 and 3.

• 5.82 Enfranchisement premiums are not, in fact, based on a market value within the meaning of the International Valuation Standards estimate. First, “an arm’s length transaction” is one between parties who do not have a particular, or special, relationship. A landlord and leaseholder do have a particular, or special, relationship and the enfranchisement legislation reflects that by requiring the payment of marriage or hope value. Second, the valuation of enfranchisement premiums is based on assumptions, which do not exist in the market. Assumptions are useful, helpful and necessary, and can be uncontroversial: see Figure 21.

• Figure 21: the role of assumptions

Various assumptions are required to be made when enfranchisement premiums are calculated. For example, there is a need to assume that the leaseholder has complied with the covenants in the lease, otherwise a leaseholder could rely on his or her own wrong in order to obtain a cheaper price. That is because if the leaseholder has let the property get into a very poor state of repair, then the current market value, and therefore the premium, would be lower. Conversely, an assumption that a property is in repair and no more¹⁰⁶ would prevent a landlord benefiting from work carried out by the leaseholder at the leaseholder’s expense: if the leaseholder spends money on works of improvement such that the market value of the property is higher, then -without that assumption - the resultant premium would also be higher.

• 5.83 In the context of enfranchisement, a crucial assumption is whether the leaseholder is “in the market” - that is, that the leaseholder wants to buy the landlord’s interest or extend the lease. That assumption is crucial because the leaseholder can be expected to pay more for the freehold (or extended lease) of his or her property than anyone else would. As the owner of the leasehold interest, there are benefits to the leaseholder of acquiring the freehold (or an extended lease) which would not accrue to any other purchaser. The benefit of owning both the freehold and leasehold interest can accrue not only if the leaseholder purchases the freehold but also if the freeholder purchases the leasehold. This additional value, which arises on the coalescence of the freehold and leasehold interests is the “marriage value”. Under the current law, the landlord’s interest being acquired is valued, in the first instance, on the assumption that the leaseholder is not in the market. Where, however, the lease has 80 years or less left to run, it is then assumed that the leaseholder is in the market and the additional amount which he or she would pay (which is assumed to be half of the total marriage value) is added to the premium.

• 5.84 So an assumption that the leaseholder is “in the market” results in a requirement to pay marriage value. If instead the assumption is that the leaseholder is not currently in the market, but may be in the market in the future, then the result would be a requirement to pay hope value. Since the assumption is that the leaseholder is not acquiring the asset at the valuation date, marriage value will not be realised. But a purchaser of the asset who knows that the leaseholder may be in the market in the future would be expected to pay an additional amount - hope value - to reflect the possibility of selling the asset to the leaseholder in the future and, in doing so, realising marriage value.

Our revised approach

• 5.85 The three schemes that we now put forward reflect three different assumptions about the market in which the landlord’s interest is being valued. They are assumptions about the existence of the leaseholder, as a special purchaser, in the market.

• (1) Under Scheme 1, it is assumed that the leaseholder is not in the market at the time the premium is calculated and will never be in the market.

Using the conventional valuation methodology, this assumption produces a premium based on the term and the reversion only (plus in some cases additional value and/or other loss). The value attributable to the leaseholder being in the market (marriage value and hope value) is therefore not payable.

Scheme 1 is similar in effect to Option 2A in the Consultation Paper, except that additional value may be payable (see further below).

• (2) Under Scheme 2, it is assumed that the leaseholder is not in the market at the time the premium is calculated, but may be in the market in the future.

Using the conventional valuation methodology, this assumption produces a premium based on the term, the reversion, and possibly hope value (plus in some cases additional value and/or compensation for other loss). The value attributable to the leaseholder being in the market on the valuation date (marriage value) is therefore not payable.

Scheme 2 is not an option that we put forward in the Consultation Paper.

• (3) Under Scheme 3, it is assumed that the leaseholder is in the market at the time the premium is calculated.

Using the conventional valuation methodology, this assumption produces a premium based on the term, the reversion, and marriage value (where it exists) (plus in some cases additional value and/or other loss).

Scheme 3 is, in effect, the same as Option 2C in the Consultation Paper.

• 5.86 The result produced under each option can be justified as being a “market value”, by reference to the assumed market. It is no less than a landlord could expect to receive, in that market, for his or her interest in the absence of enfranchisement legislation.

• (1) Scheme 1 is what the landlord would receive if the lease ran its course and the leaseholder never chose to extend the lease or acquire the freehold.

• (2) Scheme 2 is what the landlord would receive for his or her interest if sold to a third party.

• (3) Scheme 3 is what the landlord would receive for his or her interest if sold to the leaseholder.

Why have we adopted the revised approach based on assumptions?

• 5.87 We have adopted a revised approach of setting assumptions, rather than taking components of value, for three main reasons.

• 5.88 First, our thinking set out in the Consultation Paper has evolved with the benefit of consultation responses. The reasons underlying the approach we were suggesting in the Consultation Paper reflected assumptions about what would happen to the lease (for example, under Option 2A, an assumption that the leaseholder would never enfranchise, and so marriage value is not payable). Another way of expressing that idea is by saying that market value is payable but making an assumption that the leaseholder is not in the market. Our approach in the Consultation Paper took the outcome from that underlying reasoning (namely, inclusion or exclusion of a given component of the valuation), without expressing the underlying reasoning. We think the more intellectually coherent approach is to base a new scheme directly on the underlying reasoning itself.

• 5.89 Second, we think that the more appropriate starting point for how the law should approach valuation issues is by setting assumptions, rather than by taking components of value from a particular valuation methodology. The purpose of enfranchisement premiums is to compensate landlords for their loss as a result of an enfranchisement claim. The options in the Consultation Paper were based on taking elements of that assumed loss. We think that it is more coherent for the legislation to determine the landlord’s loss by assessing what the landlord’s interest is worth in the market, and dictating what that market is, rather than by adopting different categories of loss. Moreover, we discussed the distinction between (a) the legal framework and (b) valuation methodology in Chapter 4. Deciding on the assumptions to be made when assessing market value falls within determining the legal framework (question (1) in Chapter 4: see paragraphs 4.5 to 4.6), whereas deciding on the components of value that should be paid comes closer to determining valuation methodology (question (2) in Chapter 4; see paragraphs 4.7 to 4.10).

• 5.90 Third, we think that options for reform that are based on these assumptions, rather than on components as we provisionally used, are less likely to be susceptible to challenge by landlords, as they would be less likely to be found to be incompatible with A1P1.¹⁰⁷