James White from Fanshawe White comments on the recent decision in Kelton Court….

A recent decision in the Lands Tribunal has reopened the debate on deferment rates and given the initiative back to leaseholders and their valuers to argue for higher deferment rates to reduce the premium payable for a lease extension or the freehold interest.

The generic rate of 5% for flats set by Sportelli no longer applies automatically and each case should be judged on its individual merits.

In areas outside Prime Central London (PCL) there is scope to argue a higher deferment rate to reflect the greater risk of deterioration and obsolescence (+0.25%) and the prospect of lower capital growth (+0.5%) compared to PCL.

In all areas, including PCL, there is scope to argue a higher deferment rate to reflect the increasingly onerous management burden and liability associated with flats compared to houses (+0.25%).

Background

The Sportelli case was an aggregated number of appeals to the Lands Tribunal concerning Prime Central London (PCL) Leasehold Valuation Tribunal decisions where the deferment rate was an issue.

For the first time evidence from financial experts, in addition to valuers, was relied upon in determining the deferment rate. Their decision was based on the following formula:

Risk free rate 2.25% – based on a 5 year rolling average for index linked gilts

Less

Real growth 2.00% – based on growth of property above inflation

0.25%

Plus

Risk premium 4.50% – based on risk of property as an asset class distinct from gilts

Extra risk for flats 0.25% – based on additional management compared to houses

Deferment rate 5.00%

Although all the properties were in PCL the Tribunal stated that they saw no reason, based on the evidence before them why this decision should not apply outside of PCL. The financial evidence was of the opinion that over a long period (say 50 years) property growth was the same across all regions, both prime and secondary, and as such there should be no distinction for location. Accordingly a precedent was set which has been applied by LVT’s throughout England and Wales with little exception.

This decision was appealed to the Court of Appeal who upheld the Lands Tribunal’s decision but left the door ajar by suggesting that further evidence could be presented, in particular regarding the risk premium, for different areas.

The Kelton Court decision

This was an appeal to the Lands Tribunal of an LVT decision which had applied the Sportelli precedent of 5% to multiple lease extension claims in a 1930’s purpose built block in Edgbaston, Birmingham.

The basis of the risk free rate (2.25%) less real growth (2%) remains the same but the leaseholders’ valuer successfully argued the additional risk premium (4.5%) and allowance for flats (0.25%) applied in Sportelli did not fully reflect the circumstances of this case;

Deterioration and Obsolescence – it was held that the comparatively low value of property in Birmingham compared to PCL, coupled with not dissimilar costs of repair, made it less economically viable to keep property in good repair leading to a greater risk of deterioration not reflected in vacant possession values. Accordingly an extra 0.25% was added to the risk premium.

Prospect of future growth – it was held that the real growth rate of 2% determined in Sportelli for PCL might not be achievable in Birmingham based on a comparison of the statistical date presented. The evidence presented was the Nationwide Regional Index for the West Midlands and the corresponding Halifax Regional Index compared to the Knight Frank Index for Kensington & Chelsea (part of PCL where the Sportelli cases were situated) which showed a considerable difference in growth between the areas. Accordingly an extra 0.5% was added to the risk premium.

Allowance for flats – Sportelli established the principle that the management of flats compared to houses was more complex and warranted a 0.25% addition to the deferment rate. Sportelli did not consider it justified to differentiate between flats that are subject to head leases, nor between small and large blocks of flats. In Kelton Court the leaseholder’s valuer successfully argued that the introduction of The Service Charges (Consultation Requirements) (England) Regulations 2003 made the management and risk associated with flats much greater. Accordingly an extra 0.25% was added to the 0.25% adjusted made by Sportelli. The point was made that had there been a head lease, thereby placing the management risk and burden on the head lessee rather than the freeholder, an extra 0.25% on the deferment rate would not have been appropriate.

The overall result of these additions was to increase the deferment rate in the Kelton Court case from 5% to 6%.

Our Conclusions

This decision has proved that it is possible to achieve a higher deferment rate but only subject to producing new evidence.  We do not consider it reasonable to simply rely on this decision as a precedent, unlike Sportelli, and so the onus must be on the leaseholder to produce and successfully argue new evidence.

It does raise the possibility of the RICS being asked to commission research into regional variations in growth to see how they compare to PCL.

Where there is a head lease the freeholder’s deferment rate should not be affected on the grounds of complex management.

We further believe that in small buildings such as converted houses with only 2 or 3 flats the extra 0.25% should not apply irrespective of whether there is a head lease or not. We consider the lack of communal areas and lack of shared services results in either no annual service charges or very often a simple apportionment of the buildings insurance premium.  In such cases we consider the additional 0.25% is not appropriate.

The possibility of a future Right to Manage (RTM) company could be used as an argument to mitigate the freeholder’s management risk as a counter to the threat of an extra 0.25% being added to the deferment rate.

James White

31/03/2010

An interesting point arising from the discussions in the Kelton Court seminar group at the ALEP Conference on Wednesday was that the question of the ‘management risk’ associated with flats might also be abated not only in a situation where there is a head lease, but also if the flats are subject to ‘maisonette’ style leases.

These are effectively fully repairing and insuring residential leases typically found in small blocks of not more than 2 or 3 flats where all the maintenance responsibility and the obligation to insure rests with the individual flat owner.

In these leases the structure of the covenants is such that the property is divided into ‘layers’ with each owner fully responsible for the structure and interior at their ‘level.’

This is certianly a good point and one no doubt that will be taken in practice against anyone trying to argue for a 0.5% enhanced management risk factor in such a situation.

I would be interested to hear if anyone has encountered such an argument.

Mark Chick

12.3.2010

The decision of the Lands Tribunal in Kelton Court (Zuckerman and others v Trustees of the Calthorpe Estates [2009] LRA/97/2008) is clearly of importance to those acting for tenants outside PCL (Prime Central London).

Being the first post-Sportelli case to depart from the 5% deferment rate for flats was clearly going to be seized upon by valuers acting for flat owners everywhere. Achieving a 6% deferment rate is clearly ‘news’ although it has to be borne in mind that the decision to depart from the Sportelli 5% rate was based on 3 key factors in that decision, two of which were very specific to the property and its location.

Firstly, the Tribunal accepted that there was a higher risk of obsolescence in the properties at Kelton Court – effectively because of the economic viability of repairing them being likely to be for a shorter time. This led the Tribunal to conclude that a 0.25% increase in the ‘risk premium’ from 4.5% to 4.75% would be appropriate.

Secondly, the Tribunal accepted that there would be a lesser rate of growth in the capital value of properties in the West Midlands. As such it was appropriate to make an allowance that would have the effect of reducing the growth rate. An appropriate measure in this case according to the tribunal was to increase the risk premium by a further 0.5%, making the total risk premium 5.25%.

Thirdly, and finally, the Tribunal concluded that because of the enhanced ‘management risk’ associated with flats – effectively the difficulty in collecting the service charge and the risk that the landlord might incur some irrecoverable costs in doing this, or might have to meet some of the costs himself – that it would be appropriate to increase the percentage allowed for this in the Sportelli decision of 0.25% to 0.5%.

When applying these factors to the calculation of the deferment rate at Kelton Court, the result was a deferment rate of 6%.

Comment

Whilst the first two factors (obsolescence and growth rate) are more likely to be confined to geographical areas outside Prime Central London (‘PCL’) the third would seem to apply ‘anywhere’.

Indeed in deciding that an investor would require an additional 0.5% rather than 0.25% risk premium to deal with the management risk associated with flats the Tribunal heard (and appears to have accepted) statistical evidence adduced by the tenants’ representatives from the Residential Property Tribunal Service (‘RPTS’) relating to London that the number of service charge disputes had increased greatly – 411 cases in 2007 compared with 232 in 2005 and 27 in 2004.

The number of service charge dispute cases looks set only to increase and whilst this may to some extent (now) be a function of the economy, looking back to 2007 this argument would seem to be less applicable. Greater awareness of flat owners’ rights under the service charge legislation and increased requirements for consultation certainly seem to have given rise to more challenges in the LVT on service charge.

In Kelton Court we therefore appear to have the Lands Tribunal not only giving a clear indication that it is possible (in case specific circumstances) to argue for a departure from the 5% deferment rate outside PCL (on grounds of obsolescence and growth) if applicable, but also that the ‘management headache’ associated with flats was perhaps also under accounted for in Sportelli.

It is worth sounding one note of caution at this point – as the Tribunal did also say that if the flats were subject to a headlease (and the properties in Kelton Court had once been but this had been surrendered) that the Tribunal would not have seen fit to depart from the Sportelli uplift of 0.25% for flats.

Notwithstanding the general importance of this decision for property outside PCL, this third point is more likely to be of general importance and I cannot see any reason why it should not be possible to argue that the tribunal’s comments that the impact of the Commonhold and Leasehold Reform Act 2002 on service charges generally should not apply to properties anywhere – where there is no headlease to buffer the landlord from the ‘problems’ of management – whether in PCL or otherwise. Indeed, the Tribunal’s comments at paragraph 16 of the decision are fairly clear on this: –

“I am satisfied that by 2007, the first date with which I am currently concerned, the market was more aware of the dangers posed by the regulations than was the case in Sportelli, where the properties fell to be valued between 2 ½ and 3 ¾ years earlier.” [NJ Rose FRICS at Para 16]

As such Kelton Court is likely to be of assistance to tenants’ valuers in seeking to argue an enhanced risk premium for flats and hence an overall deferment rate of 5.25%.

How this plays out in practice remains to be seen, but early indications appear to be that the point is being taken in the LVT. So in summary, Kelton Court is good news for the tenant’s valuer and not just outside Central London.

Mark Chick

9.3.2010

When is a house not a house?

The answer appears to be when it is on the Grosvenor Estate, used 88.5% as offices and has a lease clause that restricts the property to such use under the terms of the lease.

The latest case on what constitutes a house for the purposes of enfranchisement under the Leasehold Reform Act 1967 takes the question of ‘what is a house?’ a step further although, as the tenant has abandoned their proposed appeal to the House of Lords, we will not be treated to further judicial consideration of the question in this case.

The case in question is Grosvenor Estates Limited v Prospect Estates Limited [2008] EWCA Civ 1281.

In Prospect, the facts were that the building constructed in or around 1850 as a house. Since construction two floors had been added and at the date of the notice of claim in early 2007, the property was held under the terms of a lease for use as offices, with only the topmost floor being set aside for residential purposes.

The terms of the lease stated that the top floor was to be used for residential purposes only by a director, partner, officer or senior employee of the company person or firm in occupation of the remainder of the building.

On the facts 88.5% of the building was used for non-residential purposes under the terms of the lease. The building had been used in this way for the last 50 years.

At first instance the court had determined that the building was a house within the meaning of the 1967 Act. The landlord appealed.

The Court of Appeal reviewed the relevant authorities on this point and considered the applicable tests to be as follows:-

1. If a mixed-use building can reasonably be called a house, it remains a house within the meaning of the 1967 Act even if it could reasonably be called something else.

2. Whether it is reasonable to call something a house is a question of law.

3. If a building is adapted or designed for living in only in exceptional circumstances can it not reasonably be called a ‘house.’

The Court of Appeal (Mummery, LJ) considered that the above principles had been applied without taking into account the full factual circumstances. The requirement in the lease that the building should be used pretty much wholly as offices was persuasive. A consideration of the internal and external features was not enough.

Accordingly, at the relevant date the building was not a house within the 1967 Act and the tenant’s claim failed.

Mark Chick

9 March 2009