Risks and rewards of investing in freeholds

    4 March 2017

    Is being a buy-to-let investor just a bit too respectable for you? There’s an alternative: become a landlord’s landlord and buy the freehold to a block of flats instead. It may not win you popularity or social prestige — but will it bring you wealth?

    Under the English leasehold system (it’s a different matter in Scotland), millions of people who think of themselves as property-owners aren’t real property-owners at all. Buy a leasehold property and you are in effect a tenant, albeit one whose tenancy can last into the distant future. The ‘owner’ is the person or company who owns the underlying freehold. Sometimes this is a company collectively owned by leaseholders. But it might be a shady company above a chip shop in north London. Or it might be you.

    Owning such a freehold doesn’t give you the right to occupy your building (unless you also own the lease to one of the flats). But you do have the right to collect ‘ground rent’ from leaseholders, typically a couple of hundred pounds a year.

    You or your heirs can also look forward to earning money from lease renewals or extensions when the leases eventually run down. And you may find opportunities to develop the building, such as by adding a penthouse — or excavating a fashionable mega-basement — for which you can sell a new lease.

    In most cases you don’t even have to pay for the upkeep of the building. Most leases contain a provision committing the leaseholders, through service charges, to pay for all maintenance — not just for the interior of their own flats but collectively for the building as a whole and its common parts, even when it needs a new roof.

    Compared with near-zero interest rates on savings accounts, residential freeholds have become an attractive form of investment for steady income. How much income depends on the length of leases, whether and at what rate the ground rents increase over time, and whether there are development opportunities.

    For example, two lots sold recently in Canterbury had widely different prices. One, the freehold to a block of 14 flats, sold for £130,000. The other was the freehold of five blocks containing a total of 72 flats and houses — but it fetched just £10,000. The difference is that in the first block, leaseholders pay ground rents of £260 to £325 a year, rising with the Retail Prices Index and giving a total income of £3,714. In the second they pay a ‘peppercorn’ ground rent, or next to nothing; the attraction for the freeholder is the potential windfall from lease extensions which will start to roll in once the leases, currently 114 years, reduce to 80 years or less — the point at which leaseholders usually start to think about extending.

    Some ground rents are at a flat rate, others rise with inflation or at a fixed rate at preset intervals — perhaps doubling every ten or 20 years. An income which doubles every 20 years is equivalent to annual growth of 3.5 per cent; one which doubles every ten years is equivalent to a 7 per cent annual return.

    The freehold to a house in St Johns, south London, fetched £13,000 in December for a property earning £700 a year in ground rent, giving a yield of 5.3 per cent. At the same auction, the freehold of a block in Chingford fetched £97,000, even though it brings in only £990 a year in ground rent — a yield of just over 1 per cent. The main difference is that the latter block has planning permission for an extra flat on the roof that could sell for more than £300,000. Besides construction costs, of course, there’s a price to pay for this: you are guaranteed to annoy leaseholders who have nothing to gain from the extra storey, but will suffer months of disruptive building work.

    Therein lies the problem with freeholds. The relationship between freeholder and leaseholder can be fraught, and some unscrupulous freeholders have used complex lease terms to exploit tenants. In one high-profile battle in Manchester, footballers Ryan Giggs and Phil Neville were among 82 leaseholders who won a court battle for the ‘right to manage’ the block in which they live, after complaining of ‘excessive’ service charges averaging nearly £7,000 a year.

    There are laws to help leaseholders, either by giving them the right to manage their blocks or collectively to buy out the freehold, but expensive legal battles can be involved.

    As much as it’s a matter of caveat emptor and reading the small print for the leaseholder, potential freeholders should likewise beware. A future government seeking to rein in dubious practices may limit the ability of freeholders to make positive returns out of their tenants.

    Freeholds offer opportunities for those who know what they’re doing — but being in a business that’s next in line for a government crackdown is never risk-free.