Leasehold is fleecehold. Why we always buy freehold property

Leasehold property is everywhere. If you look through a few property listings on one of the major portals, you'll see that a large number of properties are being sold leasehold - unsurprisingly nearly all of the apartments but also many of the houses. If you buy leasehold property not only do you not own the land on which the property sits, but you also open yourself up to many other costs and administrative headaches.

Most of the glossy brochures and online adverts targeted at prospective residential property investors are for shiny new apartment buildings in city centre locations. These marketing materials often highlight the possibility of high investment yields that appear attractive to a prospective investor. But publicised yields are nearly always very misleading. They exclude applicable service charges and ground rents which are often extremely expensive and over which the prospective investor has almost no control.

Take the following example:

A two bedroom apartment advertised for sale at £345,000 in the desirable Castlefield neighbourhood of Manchester, just on the western fringe of the city centre.

https://www.rightmove.co.uk/properties/118809866#/?channel=RES_NEW

This property would rent for about £1,350 per month based on comparable properties nearby (including a two bed unit in the same development currently advertised at £1,300). This produces a gross yield of 4.7% - fairly typical for a new build property of this spec, in this particular location. Gross yields on new build property in the city centre are typically in the 4-6% range depending on size, spec and the individual sub-market.

But a close look at the listing reveals some additional charges as follows:

£2,068 service charge per year (£172 pcm)

£240 ground rent per year

If we deduct these expenses we see that the yield drops from 4.7% to just 4%. It is important to remember that the service charge does not cover costs relating to any internal areas of the apartment itself which would have to be met by the landlord directly. Neither is the service charge fixed and it could easily go much higher in the future if unexpected costs arise or the managing agent does a poor job of keeping routine maintenance and servicing costs under control.

Indeed there are many other reasons to avoid investing in leasehold property wherever possible:

1. Escalating ground rents: Some leasehold properties are sold with escalating ground rents where the amount payable doubles every ten years (equivalent to a 7.2% increase every year) which can quickly become prohibitive and make properties difficult to resell.

2. No control over costs: There are many costs over which a leaseholder will have no control as to the amount payable or the timing of payments due. These include maintenance costs (especially costly bigger ticket items like heating & ventilation or mechanical & lifts as well as roofing) but may also include innocuous things like routine repairs or landscaping.

3. Onerous covenants: Leasehold property is often sold with onerous covenants preventing the homeowner from carrying out renovations, extensions, general improvements or even changing the colour of their front door without permission from the freeholder which usually involves some kind of fee. I've even seen covenants preventing homeowners from putting sheds in their gardens, prohibiting the installation of TV satellite dishes and prohibiting certain types of vehicle from being parked in car parking spaces.

4. Freeholder charges: Freeholders will often charge leaseholders for providing information in the context of the sale of leasehold property leading to further expense on exiting an investment.

5. Estate management fees: With some new build housing developments even where the houses themselves are sold freehold, there is an increased prevalence of onerous "estate charges". These often encompass management of estate roads and sewers which are not adopted by the local authority. As a result, the local authority will not be on hand during the development to insist that they be built to the proper standard. Councils are obviously incentivised not to adopt vital infrastructure on new developments whilst still demanding full council tax from homeowners.

6. Cladding: The much publicised cladding scandal in the United Kingdom has left many leaseholders powerless in the face of ruinous charges for remediating their properties and has left many trapped in their homes - unable to sell or remortgage. Leaseholders in such buildings have almost no control over the cost to remove and replace flammable cladding or in some cases the extortionate cost of so called "waking watch" fire wardens.

Quite rightly, the government plans to ban the sale of leasehold houses and there are plans for all leasehold ground rents on new build flats to be set at "one peppercorn" in the future.

For all of these reasons and many others, we do not buy leasehold property. We own the land on which our buildings sit and we retain control over the timing and nature of all costs relating to routine maintenance, significant repairs, property management & buildings insurance. We retain full control in choosing our own preferred contractors. Moreover, without paying ruinous service charges and escalating ground rents, our gross to net yield conversion is also much higher producing superior returns.

Follow the Smart Money

Technology investment in the UK reached its highest level ever in 2021. Total investment in UK technology companies reached £29.4 billion last year, up by 230% from 2020.

In what was a record global year for technology investment, it is promising to note that UK investment amounted to over a third of the European total and was more than double Germany (£14.7bn) and three times the level seen in France (£9.7bn).

Technology investment and the growth in high paying jobs that accompany it are often a pre-cursor to a rise in real estate asset values. Blackstone is famed for pursuing technology adjacent real estate investment strategies including last mile logistics warehouses (e-commerce), film studios (streaming platforms such a Netflix) and prime Grade A office space in major tech hubs such as San Francisco and New York.

Sometimes, advanced data science based on enormous and disparate data sets can provide fascinating and prescient insights into the best locations for future real estate investment. But other times it's easier just to follow the smart money - if the world's most sophisticated venture capitalists and mega-cap private equity funds are putting their capital to work in a particular location, its prospects are almost certainly very good.

One could have bought almost any real estate asset in the San Francisco Bay Area 20 years ago and seen extraordinary growth in capital value over the following two decades. It seems that we can sooner train more engineers, start more companies and write more lines of code than we can find more land, entitle that land and build tomorrow's houses, offices and warehouses upon it.

It's interesting to note that the UK government's Department for Digital, Culture, Media & Sport recently unveiled a "levelling up power league" to rank regional cities based on venture capital funding, advertised tech salaries and unicorn companies. The top three were Cambridge, Manchester & Oxford. The average house price in Manchester is a fraction over £200k. In Cambridge and Oxford it's nearer to £450k.

If you can marry tech investment with a high quality of life, low cost of living and low real estate values you might just be onto a real winner. Which brings me to the following tweet from Stripe's Patrick Collison back in January of this year:

Major tech hubs including San Francisco, New York and London have to some extent become a victim of their own success. By pulling in record amounts of VC funding, startups and the workers associated with them, they have become somewhat unaffordable with a lower quality of life and stratospheric cost of living.

San Francisco's loss however may be Manchester's gain. We like the city and we are long the real estate.

Energy Performance Certificates - uncertainty, folly, opportunity

Following the end of a public consultation on the subject in January of this year, the UK government looks likely to introduce new legislation raising the minimum permissible EPC threshold for rented properties in England from "E" to "C". Whilst the specific requirements of the legislation have not been brought forward as of yet, it is likely to have very significant ramifications for the private rented sector and those who operate within it.

In total there are 4.6 million privately rented homes in England & Wales of which over 2.1 million have an EPC rating below a "C". This equates to 47 per cent of all privately rented homes in existence. These properties may all, in the relatively near future, need to undergo significant and costly energy efficiency improvements if they are to continue to be rented out.

At this stage it's hard to know the specific ramifications of such a change and what carve outs or exemptions there may be.

It's highly likely that the changes will be phased in over a number of years and quite possible that the total amount private sector landlords will have to spend on their properties may be capped. None the less - this is a significant policy change, with the potential to meaningfully alter the medium term economics of the UK private rented sector.

It has already been reported that the proportion of new purchases of buy-to-let properties attracting an EPC rating of "C" or higher has risen significantly - rising from approximately 30 per cent to over 50 per cent in the last three years alone.

The costs of upgrading much of the Victorian housing stock commonly found in the UK's major towns and cities are likely to be substantial. Most of these properties were built with solid brick walls and therefore provide no possibility to retrofit cavity wall insulation. Whilst upgrading loft insulation and adding floor insulation may be a relatively cost effective way to improve the EPC rating, these measures are unlikely to bring most properties up to the required "C" rating in isolation.

Adding external or internal wall insulation is exorbitant (in the region of £10k + for a small two bedroom terrace) leaving landlords and investors with the option of fitting solar PV panels to the roofs of their properties in an attempt to make the grade. The cost of fitting such a system would be approximately £4000 - £5000: a substantial sum even for those who may own only a single property. Not all properties are likely to be suitable depending on the orientation and surface area of their roofs.

"Show me the incentive and I'll show you the outcome"

Given that the focus on ESG initiatives has been with us for a number of years, upgrading the minimum EPC requirement for PRS property was somewhat foreseeable.

We are fortunate enough to have largely factored in the changing legislative environment for all of our investments in the last few years. We have bought properties which already met the new energy efficiency requirements, or those that can easily (and cost effectively) be upgraded in order to do so.

None the less, recent personal experience shows how narrow the margins can be between meeting the threshold and falling a fraction below.

The minimum threshold for a "C" rating is 69 points out of 100. The difference between a 68 and 69 is tiny: on one property the threshold was crossed by insulating an area of just one square metre above a kitchen extension. I can assure you that this token task is not practical to implement (think cutting holes in ceilings, diverting wiring and re-plastering). Neither is this small change something that will make any difference to an occupant's energy bills or carbon footprint.

Indeed, I foresee some strange outcomes arising from the new incentives, if and when the new rules are introduced.

Opportunity

There are 2.1 million privately rented homes in England & Wales that do not currently meet the minimum energy efficiency requirements likely to come into force in 2028. If you assume that the average required spend in order to upgrade these properties to reach a "C" grade is approximately £5000 this equates to a £10.5 billion market opportunity over the next 5-6 years.

Moreover, this ignores the likelihood of significant price rises in the future. The enormous rise in demand as we approach the deadline for implementing such measures is likely to overwhelm the restricted supply of skilled labour and contractors to fulfil it.

This is an extremely fragmented market, dominated by small contractors who largely confine their work to operating in a specific local geography. In addition, there are few one-stop-shops offering the full range of services required to sufficiently upgrade much of the UK's ageing housing stock (think cavity wall & loft insulation, internal & external wall insulation, photovoltaic panels).

The ballooning size of the market and urgency of the solution provide an interesting opportunity to roll-up a number of firms in order to provide an all-in-one solution - at scale - for the many operators in the private rented sector.