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