Dr Mark Andrew & Dr James Culley – Q&A on leasehold reform
Dr Mark Andrew, Senior Lecturer at Bayes Business School, and Dr James Culley, Partner at Knight Frank LLP, speak to CaCHE about their recent research publication entitled “Leasehold reform proposals in England and Wales: The unconsidered financial implications of reducing the premium in lease extensions.”
What was the impetus behind your research?
The government intends to introduce legislative reforms targeting existing leaseholds to make extensions ‘easier, faster, fairer and cheaper’ as the current process often leads to disputes between leaseholders and freeholders.
Our paper investigates the wider financial implications of the government proposals that relate to abolishing the concept of marriage value and extending existing leases to a maximum of 990 years at zero ground rent rather than the 90 years currently in place. Although not considered in this paper, our method can also assess statutory changes to deferment rates or, more generally, any reductions to the premium.
We identify several financial implications and knock-on effects beyond the ones considered by the Law Commission, some of which contradict current government policy on promoting housing affordability and levelling up. They include;
– potential financial gains to lessees beyond the premium reduction
– the primary recipients being investors and a significant minority of high-income occupier lessees
– short and longer-term deterioration in housing affordability, particularly for low-income households.
How did you assess the financial implications for leaseholders?
Our foundation for assessing financial implications was the realisation that a premium reduction does not affect the freehold value of a property but instead the distribution of its value between the freehold and leasehold legal interests. The reduction in premium payable will reduce the value the freeholder holds in the property and increase the value the leaseholder has in the property. This is shown in the diagram below.
We exploit the fact that a leaseholder has the right, but not the obligation, to extend a lease, implying that the sale price of a leasehold property contains an embedded option value. Leasehold values can be expressed relative to the freehold value, and this difference is known as relativity.
Two types of relativity exist. The enfranchised relativity represents the value of a leasehold with extension rights relative to its freehold value. The unenfranchised relativity represents the value of a leasehold without extension rights relative to its freehold value. We argue that the proposed reforms will adjust the enfranchised relativity but will not affect the unenfranchised relativity. This means that we can derive the post-reform enfranchised relativity curve by adding the new option value to the existing unenfranchised relativity curve and assessing the extent of the premium capitalisation.
We estimate hedonic apartment price models to validate the existence of price discounts, test for the presence of a freehold premium, assess the effectiveness of owning a share of the freehold to protect against selling at a price discount and obtain inputs required for numerical analysis. An option price simulation model estimates the post-reform embedded option value, thereby capturing the new anticipated payoff from exercising the right to renew the lease.
What does your analysis indicate when it comes to implications for leaseholders?
The average reduction in the premium is worth between 4.7% to 7.5% of the freehold value, depending on which agent’s unenfranchised relativity curves are used to calculate marriage value. The capitalisation gains from the reduced premium are estimated to lie between 6% to 10% of the freehold value. Therefore, ignoring this source of potential gain understates the overall financial impact of the premium reduction. We find that a share of freehold does not protect the lessee from having to sell at a discount.
We predict an immediate increase of £10.9 bn to the short leasehold stock value from the premium capitalisation, equivalent to a weighted average price increase of 9.9%. The impact is not homogeneous across the regions because the short leasehold stock, lease lengths, and housing price varies. The expected increase in this stock value is highest at £4.2 bn for London, followed by the West Midlands (£2.2 bn) and the South East (£1.3 bn). For London, this translates to an average price increase of £43,142, compared to £22,297 in the West Midlands and £21,338 in the South East. There are implications for general housing affordability too, in the North East, West Midlands and Wales, as total leasehold prices are projected to rise by £16,232, £22,297 and £20,278, respectively.
Since the premium reduction is substantial, it should encourage current short leaseholders to extend their lease. The projected cumulative impact on the national leasehold market is a rise in prices by 3.2%, with double-digit rises in the West Midlands and Wales leasehold markets.
Did you identify any notable demographic differences?
We investigated the likely distribution of financial gains among high-, middle- and low-income owner occupiers and investor lessees. Nationally, investors owning short leasehold stock in the private sector will be the primary recipients, followed by middle- and low-income occupier lessees. A significant minority of high-income occupier leaseholders stand to benefit too. Depending on how investors respond, there may be further knock-on effects on the lower income segment of the private rented market.
As the potential financial gains are not confined to low- and middle-income homeowners, along with regional disparities in the concentration of different lessee groups, there are several implications for the government’s levelling up agenda.
A final aspect to consider is that the potential impact of a premium reduction on leasehold prices and the distribution of financial gains among lessees is likely to be much larger than that considered so far due to the pipeline of leases expiring. London, the South East and Eastern, the least affordable regions in England, are projected to have the largest pipeline over the next five to 10 years.
You can access the full research here.
Date: June 7, 2023 12:37 pm
Categorised in: Markets