Abolition of residential ground rents: key questions answered

After much anticipation, the legislation effectively banning new residential ground rents in England and Wales will come into force on 30 June 2022.

We now have the detail developers, investors, lenders and prospective leaseholders have been waiting for. In this insight, we take a deeper look into the provisions of the Leasehold Reform (Ground Rent) Act 2022 and answer some key questions about them.

Which leases are covered by the ban on ground rents?

Once fully in force, the Act will apply to new leases:

• Of a single dwelling.

• Granted for a term of more than 21 years, disregarding any early termination provisions. Shorter leases may also be caught where they can be renewed perpetually.

• Granted for a premium.

• Not granted pursuant to a contract entered into before the prohibition comes fully into force.

If the lease satisfies all of the above, it will be regulated by the Act, unless it is within an exception.

What is a dwelling for the purposes of the Act?

“Dwelling” has a common-sense definition: “a building or part of a building occupied or intended to be occupied as a separate dwelling, together with any yard, garden, outhouses and appurtenances belonging to it or usually enjoyed with it”.

This is wide and will capture, for example, student and retirement accommodation provided they are occupied or intended to be occupied as separate dwellings.

What exceptions are there?

• Business leases. If a lease is not of a single dwelling, it is not regulated by the Act. In rare cases where a lease containing a single dwelling also allows the leaseholder to use the property for business purposes, the lease may be excluded, but only where the use of the property as a dwelling significantly contributes to the business use and the landlord and tenant give each other notice before the lease is entered into that the property is be used for business purposes.

• Statutory lease extensions of either houses or flats.

• Community housing leases

• Home finance plan leases

What exactly is prohibited by the Act?

Leases within the Act must not contain a ground rent of more than a peppercorn (that is, zero financial value). Any attempt to reserve a financial ground rent will take effect as the reservation of a peppercorn only.

As an anti-avoidance measure, the Act also provides that no administration charge may be payable for, in connection with or in respect of a peppercorn rent.

In shared ownership leases, the ground rent prohibition applies to rent in respect of the tenant’s share in the property only. A financial rent may be charged in respect of the landlord’s share (that the tenant does not own).

When does the Act come into force? Are there any transitional provisions?

Whilst minor elements of the Act are already in force, the prohibition on ground rents will apply from 30 June 2022.

Leases of retirement homes are an exception to this. The prohibition on ground rents in these leases will not come into force before 1 April 2023 and more details will be confirmed in due course.

In terms of transitional arrangements, leases are only regulated by the Act where they are not granted pursuant to a contract entered into before the prohibition comes into force. This only applies to binding contracts: a prior option or right of first refusal will not be enough to take the resulting lease outside of the Act. This gives some flexibility to developers who have already sold units off-plan on developments which have not yet completed. 

For example, say a development is currently in progress and several units have already been pre-sold on the basis that financial ground rents will be reserved. Provided those units are subject to a binding contract for sale/purchase before the main provisions of the Act come fully into force, it will be valid for the lease to reserve the ground rent.

The nature of the pre-commencement contract exclusion would appear to cover any pre-commencement contracts, even those put in place by developers between group companies.  It may be that developers put in place a number of intra-group pre-commencement contracts for unsold units on incomplete/recently completed developments in order to preserve contracted ground rent disposals.  Any developers seeking to protect their position in this way would need to do so before commencement of the Act.

As a matter of best practice and to allow the future collection of ground rent under leases granted pursuant to a pre-commencement contract, developers should ensure that the leases contain an express provision stating that they are so granted.  Copies of the relevant sale contracts should also be retained with the lease.

Subject to their lending policies, development finance lenders will be able to take such ground rent income/value into account when making decisions on credit.

What about existing leases?

The prohibition in the Act only affects new leases. The Government’s programme of leasehold reform is ongoing and we will have to await any potential further developments in respect of existing ground rents.

Special provisions apply to renewal leases. Where a new lease is granted to replace a lease which is pre-existing before the prohibition comes into force, the renewal lease may reserve a financial ground rent for the period up to what would have been the end of the term of the pre-existing lease, but not beyond that.

How will the Act be enforced?

Landlords demanding or accepting (and failing to return) prohibited ground rents will face a fine ranging from £500 to £30,000 per lease.

Local authorities may also order landlords or their agents to repay prohibited rent. Repayment can be ordered against the landlord or agent who demanded or accepted the payment, or a subsequent landlord who has since bought the reversion even where that subsequent landlord is not at fault. Investors and their lenders will want to carry out due diligence to satisfy themselves that no prohibited payments have previously been demanded or accepted.

Leaseholders will be able to apply to the Tribunal for a declaration that a term reserving prohibited ground rent is replaced with a peppercorn rent.

Implications

Businesses investing in ground rent portfolios will be affected as new ground rent investment opportunities will cease to exist.  There nevertheless could be mitigation if the effect of the ban is to increase the value of existing ground rent assets on the basis of scarcity.  Ground rent business will no doubt focus their activities on existing ground rent schemes and on leases which fall outside the scope of the Act, for example, commercial ground rents.

Residential developers will have what was once seen as a legitimate source of additional income cut off. Concerns have been expressed that the changes could lead to further increases in house prices as developers may need to charge more for properties to offset lost ground rent income streams.

Prospective future leaseholders will welcome the Act on the basis that they don’t have to pay a ground rent. However, as mentioned it could lead to a higher purchase price in order to keep developments viable. 

Existing landlords, leaseholders and lenders will keep a close eye on further leasehold reform developments particularly in respect of existing leases. For now, the Act effectively creates a two-tier system of leasehold properties: those with peppercorn ground rents and those with a more typical ground rent of a few hundred pounds per year.

Potential pitfalls

A number of concerns were raised during the consultation for this legislation which do not appear to have been adequately catered for. 

Whilst the ground rent industry had received a large amount of bad press due to a small number of onerous and accelerating ground rents, the majority of ground rents were low value and increasing with RPI.  There was a legitimate industry view that stewardship and maintenance of apartment blocks may be affected if professional landlords are dissuaded from acquiring apartment blocks due to ground rents being set at a peppercorn level rather than a low RPI linked rent. The lack of a professional landlord will at the very least place the burden of managing the building onto apartment owners, who will be required to become directors of the management company.  Experience shows us that this can result in issues going forward for apartment owners, especially if the management company directors do not keep abreast of their filing obligations at Companies House.

Similarly, in relation to transitional provisions.  The industry view was that whilst there would be a macro-level two-tiered system (some buildings would have ground rents and some would not) it would be preferable for consumers to avoid two-tiered systems on an individual building basis.  As a result of the transitional provisions in the Act, where a building is part-sold on commencement of the Act, it will inevitably have some leases with a ground rent and some without.  A suggestion was to allow all remaining leases in that building to be sold with the same ground rent so as to not prejudice the position of existing tenants, but the transitional provisions of the Act do not cater for this.  Such a micro-level two-tiered system could actually be detrimental to existing tenants, which wasn’t the intention of the legislation.

A sizeable part of the residential development industry has operated on a forward funding ground rent model for a number of years. Headleases would be granted at a ground rent equivalent to the total of the individual apartment ground rents, but prior to those apartments being granted.  This would allow the developer to receive accelerated value pending the sale of the remaining apartments.  Where those schemes exist but apartments are not yet fully sold, some apartment leases will be prohibited from being granted at the anticipated ground rent.  This will lead to a shortfall in the headlease rent vs the total apartment rents and the potential for forfeiture risk in the near future.  On a worst-case basis, both existing and new tenants could find themselves in a position where their leases fall away on forfeiture of the headlease.

It remains to be seen whether these potential issues and other unforeseen consequences could arise as a result of this legislation.  It has the potential to have the opposite effect on apartment owners from that intended.

Contributor: Matt Battensby

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at April 2022. Specific advice should be sought for specific cases. For more information see our terms & conditions