Oct

Long-dated reversions

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A reversion is when the full (market) value of the property reverts to the interest of the superior landlord. An example of a long-dated reversion is a freehold ground rent. A ground rent is usually associated with a long-lease, the rent of the ‘ground’ – the land upon which the property is built, as distinct from the built-structure itself. Whether how the amount of ground rent has been arrived at is necessarily of the land alone, the amount would be low compared to the rental value of the property as a whole. On reversion, expiry of the lease, the rental would revert to the full value of the property (including the built-structure), depending upon legislation and case-law.

In the commercial property market, ground rents, including long-dated reversions, used to be sought after by higher-rate taxpayers desirous not of income, but capital growth. The tax advantage has been largely eroded but the investment case remains, particularly for pension funds where subject to availability it is possible to time the reversion date with the pension withdrawal. In buying a low rent, the purchase price is akin to a percentage of the full capital value of the property, virtually guaranteeing that the closer the reversion the more the property will go up in value. Theoretical valuation is to calculate the net present rental income for the duration and add the estimated rental on reversion deferred by the duration. The rate of interest for each calculation is a variable. Together with the theoretical, the practical approach would include but not limited to what else can be bought for the same money to produce the same sort of yield but with more scope for investment angles and capital appreciation.

With low interest rates, long-dated reversions are attractive investment propositions. Given the choice for the same price between (1) a rack-rented or foreseeable rent review property whose capital appreciation depends upon an increase in that rent, and (2) a low rented property whose capital appreciation depends upon the number of years remaining until reversion, the latter would be less risky, particularly since any prospect of the tenant going broke would be welcomed.

The rent of long-dated reversions can be fixed throughout the term, or with preset fixed increases at specified intervals, or subject to rent review, either formulaic or geared to market rent. With a geared rent review, at each review the rent payable after the market rent is agreed or ascertained would be some percentage of the market rent (as defined by the lease). Long-term leases are rapidly becoming an instrument of the past and even where they continue to be granted the wording of the lease is more sophisticated than before. It is very easy to overpay, a consequence of investment market (auction) sentiment, and, as one might expect, long-dated reversions are not all plain-sailing. The obvious downside is that anything can happen over a long time. Whether that matters depends upon the yield, the relationship between the purchase price and the reversion date.

Long leases at fixed or rising ground rents offer possibilities for the patient. There might be investment angles and scope for different interpretations that can result in substantial windfalls. A superb example is Brockhall Village, Lancashire: cited as the archetypal dream for every ground rent investor, this was a ground rent in a 999 year lease of a former mental hospital where the tenant, the NHS, having closed the hospital would have been able to sell the site for redevelopment had it not been for a restricted user clause and the freeholder, (Gerald Hitman was a school-friend of mine), refusing change of use. Instead, the freeholder took the lease back and developed Brockhall Village, a gated community including some 400 homes, hotel and training ground for Blackburn Rovers football team.

Commercial property geared rent review introduces inexperience to the subtly of rent review. To the inexperienced, a geared review might be thought a dead cert. but it is not. Inexperience might reason that long-dated review intervals should result in an overage (addition) in comparison with the norm, for example 21 yearly reviews compared to 5 yearly, the 16 years advantage of value to the tenant. Where inexperience goes wrong is in ignoring the possibility that in the market at the valuation date a long-term might not be in demand. Regardless of the long-dated review frequency, the term of the lease might not only cancel any overage but also reduce the rent.

Another factor enters the experienced way of thinking. The comparison between the review in question and the market at the valuation date including any evidence. With reviews to market rent, amongst the assumptions for the hypothetical lease is the notional term. Whether the notional term should be the unexpired residue or the original term at the review date, the specific nature of the premises and the locality are factors to take into account. Whether for the hypothetical tenant it would more advantageous or disadvantageous for a term to be more or less than the ‘norm’ is not something to be decided upon in isolation.

The case law concerns the date from which the notional term is calculated. To defeat any interpretation that the residue is more advantageous than the original term, or vice versa, some leases require the valuation to be based on either possibility. With geared rent review, where the duration of contractual term might be an issue, another possibility, provided the wording of lease allows, is the ‘market-led’ approach. A ‘market led’ approach goes beyond the original term or residue into the best of all, namely that a rent on a lease of any duration can be considered.

With long-dated reversions, anything can happen which is why it is so important for investors to appreciate that the direction that the market for the type of property and its locality is taking must remain in sync with the direction of the demand. To overcome resistance to rent increases, the theoretical aspects of rent review can be used to defeat the all-too-often casually-relied upon presumption in favour of reality, but the impact of success might not necessarily assist long-term capital appreciation.

Michael Lever
The Rent Review Specialist
Established 1975

… LandlordZONE.

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