UK property law is amongst the most complex in the world.
Amongst its many instruments is the ground lease.
Ground leases are granted by the freeholder of land and buildings to a leaseholder, usually with a long lease.
This is a semi-permanent arrangement as the lease typically lasts for 125 years or longer and will usually remain in place until the leaseholder decides to terminate the lease, sell up and move out.
If the lease runs out, then the land and building(s) are transferred back to the freeholder, unless an extension is granted.
The leaseholder will pay both an upfront payment to the freeholder and ground rent, which is usually paid monthly or annually.
The leaseholder usually holds absolute control of the property within restricted covenants and easements specified in the lease agreement.
Ground rent is charged applied to the land itself, which remains under freehold ownership throughout the long lease.
Essentially then, commercial property ownership through leasehold involves both an upfront payment in-line with the property’s market value in combination with yearly or monthly ground rent.
A Brief History of Ground Leases
Ground leases are an age-old feature of UK property and land law and though they’ve been subject to several reforms in the Landlord and Tenant Act 1954 and Housing and Urban Development Act 1993, they remain fundamentally similar to their medieval origins.
Ground leases came about when much of the UK was owned by ‘Landed Estates’. Feudal land barons, knights, earls, viscounts and other members of the British aristocracy owned the vast majority – or all – of the land. The Crown Estate, City of London, Church Commissioners and other major institutions, for example, still own significant portions of London including Regent Street and significant portions of the financial district. These areas will all be subject to ground leases.
But, any freeholder of land or property can enter into a leasehold relationship with tenants and this is a very common form of property ownership.
Ground leasing enables the freeholder to permit development and use on their land without transferring ownership of the land totally.
There is significant leverage in commercial ground leasing investment, where freehold land is purchased and sold on a leasehold basis with payable ground rent, and the current market is burgeoning.
What is a Ground Lease?
There are 3 types of generic property ownership and occupation in the UK; freehold, longer-term leasehold agreements or shorter-term rental agreements.
A ground lease is a long lease granted to a leaseholder. They are usually 125 years or longer in commercial property but longer in residential.
The ground lease is granted by whoever owns the land a building or buildings are placed upon, i.e. the freeholder.
The lease is granted on the buildings and land – it provides the right for the leaseholder to use and manage the building and charge rent on any occupiers, etc.
The leaseholder will usually pay an upfront payment for the ground lease, much like a normal property sale but at a discount (as they are not purchasing the freehold) and will have to pay ground rent to the freeholder also.
The advantage for the leaseholder is that they’ll be able to access a commercially viable asset that is often fully equipped, a ‘turn-key’ investment that they can immediately manage and make a profit on.
Because they are only purchasing a long lease, the upfront payment is considerably less than if they were to buy the freehold of the property.
Also, a lot of freehold land simply isn’t for sale, i.e. in cities like London, the land may be owned by the Crown Estate. Leasehold is often the only option for operating a business out of these areas and freehold buildings can be astronomically priced – not viable for most businesses that prefer a more temporary relationship.
What is Ground Rent?
Ground rent is charged to the leaseholder, by the freeholder, on the land that their leasehold property is built on.
In the UK, commercial ground rent will usually range between 5 and 10 percent of the income generated from the land and buildings for the leaseholder. The rent can be reviewed periodically, usually every 5 to 21 years. Increasing the rent in-line with CPI and RPI would be reasonable when the local market rental prices are increasing.
If local market rental prices decrease then the rent will typically remain the same.
The Rights of Commercial Tenants
Business tenants that are leaseholding commercial properties are granted various rights through the Landlord and Tenant Act 1954.
These rights are known as ‘security of tenure’. The headline right here is the right to renew the lease when it expires. Leases are typically very long, though, so this situation is fairly rare.
It’ll first be down to the freeholder and tenant to agree on the terms of the lease extension. But, if this fails then the court can mediate the process and ensure that a new lease is granted on fair terms.
In reality, many freehold:leasehold relationships are relatively short-lived and ownership can change regularly, especially in commercial settings. Of course, some are long-term relationships, e.g. some family businesses have been operating out of Regent Street and other Crown Estate-owned land for hundreds of years.
When The Act Does Not Apply
Some leaseholds are not covered by the act and the tenants won’t have the right to lease extension. These are as follows:
- Farming and agricultural services
- Mining
- When a licence is granted rather than a lease (e.g. franchising)
- Short leases (typically under 6 months)
- When the tenants opt out of the Act in writing
- Subletting leaseholders that do not occupy the premises
- Where enfranchisement applies under the Leasehold Reform Act 1967
The law regarding commercial lease agreements is advanced and solicitor or lawyer negotiation is inevitable in the event of disputes.
In general, less government protection is available for commercial property deals in general, including ground leases. Deals are liable to caveat emptor – let the buyer beware – in many cases. Of course, commercial leaseholders and tenants still have rights, but the discretion and due diligence is firmly encouraged for anyone considering leasing or freeholding commercial property.
Enfranchisement In Commercial Property
The Leasehold Reform Act 1967 provided a foundation for residential leaseholders to choose to buy the freehold that their home is built on, or a portion of the freehold, rather than extend their lease or have to move out when their lease expires.
The motive here was to enable the leaseholders in properties approaching the end of their long lease to purchase that property as freehold rather than simply renewing the lease at considerable expense. This would unlock long-term homeowners in leasehold properties from ground rent, restricted covenants and other rules set by the freeholder.
For houses, this is a relatively straightforward process. In flats, leaseholders can club together and buy a portion of the freehold.
Again, this relinquishes leasehold owners from ground rent and other charges, and means they have increased rights over the modification and maintenance of their properties.
But what about in commercial real estate?
This question was debated in the House of Lords back in 2001. In the Act, the premises that tenants have a right to enfranchise are defined specifically as a ‘house’ or ‘home’. The law is intended to protect homeownership, not commercial property ownership.
Two law cases Hosebay and Lexgorge argued that a commercial leasehold property should, in some situations, fall under the definition of ‘house’, therefore entitling the leaseholder to enfranchisement.
In both cases, the buildings in question were being used for commercial purposes but had originally been designed as residential properties. After a lengthy series of appeals, enfranchisement was initially granted to the leaseholders – they would be allowed to force the freeholder to sell them the land.
“I reach my conclusion with no particular enthusiasm. The 1967 Act was originally intended to assist residential tenants occupying their houses as their only or main residence to acquire their freeholds.” And again “I rather doubt that the amendments made to s.1 in 2002 … were intended by the legislature to have this sort of effect” – Lord Neuberger (Judge)
These cases were appealed all the way to the Supreme Court, who overturned the appeal for enfranchisement, thus denying the leaseholders right to enfranchise the buildings in question and forcing a sale from the freeholder.
The Supreme Court questioned these lines in the Act; “designed or adapted for living in” ruling that the buildings in the case were not a “house reasonably so-called”.
It’s worth noting that the properties in question really blurred the lines between ‘house’ and ‘commercial property’. Commercial properties that are blatantly commercial properties, e.g. warehouses or office blocks, would never be contestable in this way.
The relative immunity of commercial real estate to enfranchisement further increases its leverage as an investment and is one factor that has increased their appeal for those looking for long-income investments.
Essentially, this ensures that ground leases are a no-lose investment strategy for those looking for a steady 5% to 10% income from ground rents, with the added leverage of owning the land.
The freeholder is protected from enfranchisement and the burden of liability is on the leaseholder to ensure they pay ground rent to prevent the building from reverting to the freeholder at likely massive capital gain.
Ground Leases as Investment Opportunities
Commercial ground rents have attracted significant attention in recent years due to their bond-like qualities, leverage and security.
We can see how owning a property freehold, selling the ground lease and simultaneously collecting ground rent has potential as a high-leverage asset.
The freeholder will retain the land after the lease expires and since enfranchisement does not apply, the leaseholder will have to extend the lease if they want to remain in the property.
It’s a slow-and-steady investment route, not an alpha-investment route that can provide massive gains, but for niche acquirers of land where ground rent can be charged on long-leases, they provide a solid avenue to safe, long-term returns.
What is a Ground Lease Investment?
A basic ground lease investment is fairly simple.
It involves a relationship between an investor, who owns the land and any buildings on it – the freeholder, and a leaseholder, who owns a long lease on the property only.
Long Leaseholder
- Owns the building itself until the long lease expires (normally 125 years+)
- Pays ground rent to the freeholder
- May receive rent from commercial occupiers (or profits from other building classes like shopping centres)
- Is responsible for property management and upkeep
Freeholder (investor)
- Owns the land the building is built on outright
- Receives ground rent from leaseholder
- Gets the building back at the end of the lease (if no extension is requested or granted)
The ground rent will usually range between 5 and 10% of the total income made from land and buildings. The leaseholder is contractually obliged to pay this and if they fail to do so, the freeholder can force the leaseholder to forfeit the lease whilst leaving any occupiers unaffected, so would then receive 100% of any income generated from the land and buildings.
This adds security to the investment, as the leaseholder defaulting on ground rent payments would result in a huge capital gain as the property reverses back to them. Of course, this would be rare, but long-term payment of the 5 to 10% ground rent is therefore highly secure and also protected against falling rental values, as the ground rent is only increased and never reduced.
In London, between 2007 and 2009, rental values for commercial buildings dropped hugely – by as much as a third. Ground rent, however, would not be affected, and the aforementioned risk aversion of the leaseholder adds security that ground rent payments will continue to roll in, even despite volatile market forces.
For these reasons, ground rent investments with their steady incomes of some 5 to 10% have become an interesting investment choice for those looking for long-income, including pension and insurance companies.
Summary
Ground leases in the UK are granted by the freeholder of land and any properties built on it and the leaseholder, who will usually pay an upfront payment to own that property on a long lease as well as ground rent.
Leasehold ownership is advantageous for both parties. The landowner retains the land after the lease expires, and can charge ground rent. This makes ground lease investment an attractive proposition as a long-income investment strategy. This is further enhanced by the relative immunity of commercial leasehold to enfranchisement
For the leaseholder, this relationship enables them to stay adaptable and agile with a semi-permanent commercial property relationship.