Commonhold: a quick guide for lenders

The second reading of the Leasehold and Freehold Reform Bill took place on the 11th December 2023.

Markedly absent was any mention of commonhold and the abolition of leasehold flats especially considering both the Law Commission and Michael Gove, the current Secretary of State for Levelling Up, Housing and Communities mooted it as the desired, future method of home ownership. It is generally recognised that the commonhold system requires a lot more work to make it a viable option to the current leasehold system and the lack of time prior to the next General Election can explain the absence. However, the dialogue around commonhold still persists and it has been signalled that the Act could be amended in the future to prohibit new leasehold flats, so commonhold remains extremely relevant.

What is commonhold?

Commonhold is effectively a system of collective freehold ownership of units in a building. Anyone who buys a commonhold unit becomes a member in a commonhold association.

The Law Commission states that the advantages of commonhold include:

• The unit holder has a freehold interest in the unit, which the Law Commission states that, unlike a lease, is not a wasting asset.
• There is no landlord so there is no requirement to pay ground rent.
• The unit holder does not risk having its interest forfeited.
• There will be consistency in the terms of the commonhold community statement (CCS) and articles of association of the commonhold association, as these will be prescribed by law.
• Management will be simplified as all rights and obligations of unit holders will be set out in the CCS.

However, matters are not necessarily as straightforward as they may seem.  Lenders would need to be aware of the risks that some of the stated advantages for homeowners may pose to lenders in an enforcement scenario.

How do you convert to commonhold?

Given the scarcity of commonhold schemes, for it to be successful there would need to be conversion to commonhold on a huge scale.

When a building converts from leasehold to commonhold, each flat becomes a ‘commonhold unit’. Leaseholders who participate in the conversion become owners of their commonhold units, and the freehold of common parts is transferred to the commonhold association (of which the unit owners will be members, in the same way as they would commonly be members of a management company under some leasehold schemes). The landlord is taken out of the picture.

The current system of conversion requires the agreement of the freeholder, all leaseholders and every lender with a mortgage secured over the properties. The Law Commission suggests changing this so that:

• The freeholder’s consent is not required. If a freeholder does not agree to a conversion (which is likely to be the case in many scenarios), leaseholders should acquire the freehold compulsorily through a collective freehold acquisition claim. The conversion would then follow.
• The unanimous consent of tenants is not required. If this recommendation were implemented, what would be the status of tenants who did not agree to the conversion? Would their leasehold interests be automatically converted to commonhold? How would this be funded? Would consenting tenants have to fund non-consenting tenants? Should they then obtain charges over the properties of the non-consenting tenants? What would happen if the non-consenting tenants’ leasehold interests were charged? These were issues considered by the Law Commission, which recommends that, on conversion, the interests of non-consenting tenants would automatically convert to commonhold. The Law Commission’s view is that the government should provide equity loans to non-consenting tenants to cover their share of financing the freehold. These equity loans would rank after any charge to a lender and would be repayable on the sale of a unit. Could this leave units unsaleable?
• Conversion can occur without the consent of mortgage lenders.

Could leasehold interests be converted to commonhold without lender’s consent?

The Law Commission recommends that lender’s consent should not be required, and states that Government should work with lenders to ensure that lenders will accept the automatic transfer of their mortgages. The Law Commission’s view is that ‘commonhold will offer lenders improved security compared to that available over leasehold interests. In exchange for security over a time-limited leasehold interest, the lender would receive security over a permanent freehold interest, which is not susceptible to forfeiture.’

The Law Commission has sought to make the reformed commonhold system acceptable to lenders. For example, new tools for lenders are proposed, such as the right for lenders to apply for the appointment of a professional director where existing directors are failing to comply with obligations in the CCS, such as keeping the building in repair.

Further details of the Law Commission’s views on the impact of commonhold on lenders is set out in the open letter to lenders, available on the Law Commission website.

Is it all positive for lenders?

In order to ensure that the common parts are kept in good repair, unit holders would be obliged to make payments to the commonhold association. Such payments would be similar to current service charge arrangements. However, as there would not be a landlord enforcing payment of the service charge, with the sanction of forfeiture to hand, non-payment of charges due to the commonhold association needs to be dealt with differently. The idea of the commonhold association having a first charge over units to secure payment of contributions was overwhelmingly opposed by lenders during the consultation period. The Law Commission has, therefore, proposed a different solution and is recommending a new power for the commonhold association to apply to court for the sale of a defaulting owner’s unit in order to recover arrears.

Whilst this will be more attractive to lenders than a first charge to the commonhold association, it is not without problems. In cases where the loan to value ratio was high, and the level of arrears significant, the costs of sale and payment of the arrears could reduce the lender’s security.

In a leasehold scenario there is a clear systematic route for recovery of service charge that ensures, in the main, that buildings are maintained and therefore property values do not diminish as a result of poor maintenance.  The Law Commission has identified this as a flaw of the current commonhold system and whilst his has made proposals to bring it into line with the leasehold system, it remains to be seen whether the proposals would be as robust.

What happens if the commonhold association becomes insolvent?

This is a big issue for lenders because it would affect the value of their security. The Law Commission’s primary solution is to avoid commonhold associations becoming insolvent, but that clearly is not something that can be universally avoided. In the event that they do, the Law Commission recommends that the structure remain in place by the appointment of a successor association, so that individual units are not rendered ‘flying freeholds’. How this would work in practice is unclear.  In a leasehold scenario if the freeholder or management company becomes insolvent the leasehold interest remains intact and the lender’s security remains in place. In the leasehold system there are existing procedures available to create replacement management companies and/or for the tenants to acquire the freehold interest if desired.  There would need to be an equivalent level of certainty in the commonhold regime for this concern to be alleviated. 

What happens if the commonhold is brought to an end?

If a lender’s existing mortgages over leasehold interests are to be automatically converted to commonhold units, will they convert back if the commonhold is broken up and reverts to a freehold/leasehold structure? The report details what would happen to a lender’s security in the case of dissolution of the commonhold, including that lenders should have an automatic right to make applications to the court during the termination process so that they can protect their interests, and a requirement that commonhold associations must notify mortgage lenders on passing a termination resolution.

Having a right to apply to the court may provide some comfort to lenders, but they are still going to be concerned about the time and cost that will be involved in protecting their security. 

Why the ‘reinvigoration’ of commonhold?

The Law Commission report states that commonhold was introduced ‘as a way of enabling the freehold ownership of flats which avoids the shortcomings of leasehold ownership’.  The press on these shortcomings has centred around the instances of doubling ground rents and leasehold houses.  There is universal acceptance that doubling ground rents and leasehold houses should be phased out and the industry has already done so. The Leasehold and Freehold Reform Bill is certainly a massive step forward in enabling this.

Whilst the leasehold system is not without its shortcomings and is by no means perfect, lenders are comfortable with it and have taken security on leasehold properties for decades.  The leasehold system has established landlord and tenant legislation and case law, which gives an element of certainty as to the marketability of the leasehold security lenders are taking.  Lenders also have clear acceptability criteria for leasehold properties and defined enforcement routes should that step be necessary. 

It may therefore be that a more palatable option for lenders would be to tweak the leasehold system to reduce the ‘shortcomings’ rather than seek a wholesale shift to commonhold, which remains an unfamiliar system for most despite having been originally introduced nearly 20 years ago. Its omission from the Leasehold and Freehold Reform Bill highlights that commonhold is not there as yet and the concerns raised still require resolution, but it certainly remains on the agenda.

The report (Reinvigorating Commonhold: the alternative to leasehold ownership) stretches to 640 pages and contains a lot of detail. It remains to be seen if and when the recommendations will be implemented. As always, the devil will be in the detail. However, it is certain that such a wholesale reform of our leasehold system will need the support of lenders to have any hope of success and the current proposals do raise legitimate concerns for lenders, which are already adequately dealt with in the leasehold system. 

Contributor: Alexandra Holsgrove Jones

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at January 2024. Specific advice should be sought for specific cases. For more information see our terms & conditions.