Statement following the Cadogan appeal decision Leasehold Advisory Service

For several years controversy has been raging amongst valuers as to the appropriate way in which landlords' interests should be valued in purchases under the Leasehold Reform Act. The arguments have centred on hope value1 and deferment rates2.

After years of uncertainty and inconsistent decisions by Leasehold Valuation Tribunals and the Lands Tribunal (the appeal body), the Lands Tribunal arranged that five similar cases relating to properties on the Cadogan Estate and one in South Kensington would be heard together in anticipation that the decision would provide guidance to valuers and LVTs for the future, particularly in relation to prices in central London. judgmentsfiles/j319/LRA-23-2004.doc'

The decision itself can be found here and runs to 53 pages. The headline decision was to reduce the deferment rate on the Cadogan Estate (from 6%) to 4.5% for houses and to 4.75% for flats. The effect of reducing the deferment rate is to increase the value of the landlord's interest and, with it, the price payable.

However the headline masks a number of other matters:

  1. The Tribunal's determination was only in relation to the deferment rate. They made no comments on capitalisation rates and invited valuers to consider whether it was appropriate to continue to value the rent separately from the reversion.

  2. The Tribunal said that the deferment rate should include all elements of hope value. In the past, hope value has sometimes been identified separately.

  3. They said that the deferment rate would be based on a risk free rate which, in these cases would be 2%. They then added 1% because there are costs and delays in selling property as compared with sales of gilt-edged investments and a further 1.5% for the additional risk attaching to ownership of freehold investments in houses. They said that the management issues relating to flats were greater than for houses and that justified a further 0.25% increase to 4.75%.

  4. The Tribunal suggested that the disadvantages of investing in parts of London that were less well regarded than the Cadogan Estate, would be reflected in the capital values but also said that, there might be additional risks to be reflected in the addition to the risk-free rate. In respect of the property in Rosary Gardens SW7, they hinted that a rate of 6.25%3 was probably too high and that, if they had a chance to make a determination on it, it would have been at a lower rate.

  5. The Tribunal expressed surprise that no evidence had been presented to them to the effect that the deferment rate should vary with the unexpired lease term. This is because it should reflect hope value, which increases as the lease shortens. They said they felt that the rate they had determined was 'safe' in respect of the unexpired term of three of the properties, which lay in the range of 19-34 years.

  6. No rate should be adopted because it is conventional and everyone else uses it. Valuers will have to produce evidence to LVTs to support their chosen rates. LVT decisions should not be given much weight as evidence for a deferment rate.

  7. All transactions take place in the real world and not in the 'no-Act' world and so they are affected by factors that must be excluded. That may make them of little or no importance as evidence.

A decision by a Tribunal is not binding, either on future decisions by the Lands Tribunal or on the LVTs. It can only be authoritative if it is accepted and followed by the majority of valuers and tribunals.

The application of the recent decision is very limited. It applies to properties on the Cadogan Estate and in similarly highly regarded areas, where the unexpired term of the lease is no longer than about 35 years. The Lands Tribunal specifically made reference to the fact that the basic deferment rate they determined (4.5% and 4.75% for a flat) might not be relevant where the investment carried additional risks and possibly also not at longer unexpired lease lengths.

In most cases outside the central London area, the unexpired lease is much longer than 30 years. In those cases, in the 'no-Act' world in which the valuations takes place, the landlords' hope of realising an early profit is both less certain and has a smaller value. The deferment rate should reflect that, but valuers will have to work out how the rate should be varied. The cost of lease extensions and enfranchisements will only increase where the deferment rate is reduced as compared with the rate which used to be adopted.

It is understood that the central London landlords may seek even lower rates. Further afield, valuers will need to explore the unresolved matters of additional risks and unexpired lease terms and to question the conventional basis of valuation, the risk free rate and the additions for risk.

1The landlord of a leasehold flat or house has the opportunity to do a deal with his tenant to reduce the rent payable, to extend the term of the lease or both. That deal can only be done with the tenant, not with a third party. There is no certainty when such a deal will be done, if at all. The element of the price that a third-party investor would pay for that possibility, as part of the price for the freehold investment as a whole, is known as 'hope value'.

2A landlord's interest comprises, basically, the right to receive the rent and the right to have the property back at the end of the lease (this is known as the reversion, because the property reverts to the landlord's ownership). The value of the interest the landlord will receive at the reversion is known as the 'reversionary value'. No one would pay the full value of the reversion that can only be received in several years' time. The present value of the reversion is a discount on the reversionary value. The discount rate is the interest that the investor requires during the period until the reversion. The rate used in this context is known as the 'deferment rate'.

3This rate had been agreed between the parties and therefore was not a matter for them to decide.