Mainly for students
Einar Roberts is a partner in the residential consultancy division of Cluttons LLP and Kerry Glanville is head of property litigation at Pemberton Greenish LLP
The deferment rate is a central component of the enfranchisement price calculation. Einar Roberts and Kerry Glanville explain current guidance on how it should be calculated
To enfranchise, a tenant must pay a sum that represents the value of the landlord’s interest plus one half of any marriage value arising as a result of the “marriage” of the freehold and any leasehold interests. The value of the landlord’s interest (excluding marriage value) is made up of two components. The first is the right to receive the rent due under the lease over the remainder of the term. The second is the value of the right to vacant possession at the end of the term. This is determined by applying the deferment rate over the unexpired term of the lease to the freehold vacant possession value of the property (assessed at current prices).
Over the past few years the Upper Tribunal has endeavoured to lay down general guidance as to how the deferment rate should be calculated. The latest part of this process is now in place with the decision, given in October, in Trustees of the Sloane Stanley Estate v Charles Carey-Morgan [2011] UKUT 415 (LC), (referred to as Vale Court), which deals with deferment rates for leases with reversions of less than five years. It departs from the methodology set out in Earl Cadogan v Sportelli [2007] 1 EGLR 153 (Lands Tribunal); [2008] 1 WLR (Court of Appeal).
The Sportelli formula
In Gallagher Estates Limited v Walker (1973) 28 P&CR 113, the Court of Appeal confirmed that in the absence of dependable open-market transactions concerning the subject matter to be valued, resort should be made to other markets, including the financial or money markets, for guidance. However, until Sportelli, it was the norm for expert evidence in enfranchisement cases to be given by valuers. In Cadogan Holdings Ltd v Pockney [2004] LRA/27/03 came the recognition that a static yield theory was without theoretical precedent. In Arbib v Earl Cadogan 2005] 3 EGLR 139, Judge Rich expressed disappointment at the quality and analysis of the evidence before the tribunal. Accordingly, financial evidence was given on behalf of the parties in Sportelli.
The Lands Tribunal determined generic deferment rates (DR) of 4.75% for flats and 5% for houses subject to leases with unexpired terms of more than 20 years. It adopted the formula DR=RFR+RP-RGR, where the components are:
- A risk-free rate (RFR) derived from index-linked gilts
- A real growth rate (RGR) reflecting the long-term growth in house prices
- A risk premium (RP) reflecting the risks which are specific to investments in long reversions, such as volatility, illiquidity, deterioration and obsolescence.
Attempts at departing from the guidance
Arguably the most controversial aspect of the tribunal’s decision in Sportelli was its application of a universal deferment rate irrespective of location. Acknowledging this, the Court of Appeal expressly left open the possibility of further evidence being called in cases concerning areas other than prime central London (PCL) while confirming that the Sportelli rates would still be the starting point.
Not surprisingly, early attempts at persuading the tribunal to depart from these guideline rates failed. Notable examples are Hildron Finance Ltd v Greenhill Hampstead Ltd [2008] EGLR 179, concerning a property in Hampstead, and 22 conjoined appeals concerning various properties in the West Midlands reported as Re Mansal Securities Limited and Others’ appeals [2009] 20 EG 104.
It was not until Zuckerman v Trustees of the Calthorpe Estate [2009] UKUT 235 (LC), which also concerned properties in the Midlands, that the tribunal was prepared to sanction a deferment rate of 6%. It was persuaded that for the subject properties there was a greater risk of deterioration and significantly lower prospects for long term growth compared to properties in PCL.
Different rates for different reversions
In reaching its decision in Sportelli the tribunal acknowledged the possibility that, at a given valuation date, house prices might be either above or below projected long-term average growth rates, leading to an increase or education in the deferment rate but, over time, it was a “reasonable working assumption” that these effects would counterbalance. For reversions of less than 20 years, however, it considered it would be necessary to have regard to the property cycle at the date of the claim.
It was not until July 2010 that the tribunal was provided with the opportunity to examine deferment rates for reversions of less than 20 years. In Cadogan Square Properties Ltd v Earl Cadogan [2010] UKUT 427 (LC) the subject premises concerned flats with unexpired reversions of between 15.6 and 17.8 years. The parties again relied upon the evidence of financial experts, but that evidence was, at least in part, rejected. The tribunal instead adopted an approach based on conventional valuation principles and which reflected both the freehold vacant possession value in relation to trend at the valuation date and the length of the unexpired term.
The question it asked was whether, on the evidence, the position of the property cycle at the valuation dates should lead to a change in one or more of the components of the Sportelli formula. It concluded that the real growth rate should be adjusted to reflect what hypothetical parties in the open market would arrive at as a result of a negotiation. It determined that the deferment rates should be 5.25% and 5.5% respectively for the reversions under consideration, having adjusted the Sportelli real growth rate of 2% down to 1.75% based on the market at valuation dates between June and December 2005 and to 1.5% for valuation dates of February and August 2007. This approach is advisory for reversions of between 10 and 20 years.
Vale Court
The appeal concerned a collective claim in respect of a block containing 25 flats, six of which were subject to leases with 4.74 years unexpired at the valuation date. Determining the appropriate deferment rate was one of several issues under appeal. The tribunal characterised long-term reversions as being in the nature of financial interests owing to the lack of an early prospect of the purchaser being able to enjoy possession. Short-term reversions, by contrast, were considered more akin to freehold interests in possession. The growth and risk profiles identified in Sportelli for long PCL reversions were demonstrated not to work at very short terms. The tribunal concluded that the correct approach for determining a value for short-term reversions is to value the freehold interest and then make two adjustments to reflect the fact that the right to possession is deferred:
- The application of a net rental yield as the appropriate discount rate to reflect the value of possession that is lost during the currency of the lease
- An end allowance adjustment to reflect the lack of control that the owner of an interest with a future right to possession has as compared with the owner of an interest in possession.
The tribunal had considered real growth as a potential adjustment and concluded that no allowance would be appropriate on the basis that there was no evidence that a purchaser of a short-term reversion would take any different view regarding growth and future price movements than a purchaser of the freehold in possession. It noted that the investment horizon of the freehold interest potentially extends well beyond the term date of the current lease.
Still to come…
There is an obvious gap in the guidance regarding reversions of 5-10 years. There is no neat theory that unites the precedent either side of this period of unexpired term. One might speculate that some form of arbitrage might be put forward whereby different investors take stances closer to one theory or the other, but the matter will likely be tested on a case-by-case basis.
Challenges on foot
There are challenges on foot within PCL contesting the universal findings from Sportelli, it remains to be seen to what extent these challenges will succeed.