Managing The Risks of Short-Term Leases?

The rising popularity of serviced apartments attracts guests seeking hotel-like comforts while maintaining their privacy. To stand out among the competition and increase profitability, it’s crucial to enhance your marketing strategies for your multiple properties in town.

Short-lease properties are becoming increasingly rare, catching many buyers off guard as they navigate the purchasing process. Among the most affected property types are flats, often leaving buyers unaware of the implications until well into negotiations.

If you’re considering purchasing a flat with a short-term lease, it’s crucial to understand the implications fully. Take the time to delve into the specifics and consider seeking expert advice to navigate the complexities of this property type effectively.

What is a short-term lease?

A freehold property grants the buyer complete ownership and control over the property, with no restrictions unless they decide to sell it.

In contrast, a leasehold property only grants ownership for the duration of the lease. Once the lease expires, ownership reverts to the landlord or freeholder.

Leasehold properties typically start with a lease term of 99 years or more, though newer leases for purpose-built flats can extend to 125 years or even 999 years.

A lease with 80 years or less remaining is generally considered short, potentially posing challenges for buyers and impacting property value.

A leasehold property’s value

As the lease term diminishes, so does the value of a leasehold flat. Typically, a flat with 99 or more years on its lease would fetch a price similar to that of a freehold property.

However, as the lease term decreases, the property’s value diminishes accordingly. A flat with 70 or more years left might retain about 85% to 90% of its full value, while one with 50 years remaining could drop to around 70%.

When purchasing a leasehold property, it’s crucial to ensure that its value aligns accurately with the remaining lease term.

A right to extend

In response to the challenges posed by short lease properties, reforms were introduced in the early 1990s. The Leasehold Reform Housing & Urban Development Act 1993 granted leasehold property owners the legal right to request a lease extension, with certain conditions in place to prevent freeholders from refusing such requests.

Under this Act, leaseholders who have resided in a property for two years or more possess a statutory right to extend their lease by 90 years. However, the waiting period before being eligible to apply for an extension may not be ideal, particularly for properties with short leases.

In some cases, buyers of properties with short leases may request the current owners to serve a statutory notice for lease extension as a condition of purchase, provided the current owners have lived in the property for at least two years.

Does it cost money to extend the lease?

The Act clearly defines the process that must be followed when calculating how much the leaseholder must pay to the freeholder for extending the lease. The cost for extending a lease is called the ‘premium.’ Ultimately, the final premium cost will be determined via negotiation between the parties, but the calculations taken into account are:

The amount by which the freeholder’s market value interest in the property will reduce due to the lease extension.
Any other losses the freeholder may incur due to the extension of the lease.
The ‘marriage value’ – this relates to the property value increase resulting from the Extension of the lease. Under the Act, when a property with 80 years or less remaining on the lease is extended, the freeholder is legally entitled to 50% of the value increase. For this reason, leaseholders are generally advised to begin the lease extension process while 85 or more years still remain.

What are the benefits of buying a short-lease flat?

Short-lease properties hold appeal for retirees and those without dependents, offering an affordable living option without concerns about property value preservation for future beneficiaries. Additionally, buy-to-let investors find short-lease properties attractive, leveraging rental income for substantial returns before relinquishing ownership to the freeholder at lease expiry.

What are the risks associated with buying a flat with a short lease?

The main drawback of purchasing a short-lease property lies in its resale difficulty. As the lease term diminishes, so does the property’s value, making it less appealing to potential buyers and lenders alike. Short leases often stem from owners unable to afford lease extensions, commonly found in less affluent areas, or due to significant property repair needs.

Additionally, buyers should factor in maintenance and ground rent expenses stipulated in the lease agreement. These costs can be substantial, even if the intention is to let the property deteriorate until the lease expiration, potentially resulting in additional financial burdens.

What is ground rent?

Ground rent is an annual fee paid by the leaseholder to the landlord, typically ranging from £10 to £100-£200. It’s crucial to review the ground rent amount and any potential changes outlined in the lease agreement. Some ground rents may increase over time, either by a fixed percentage or linked to inflation metrics like the Consumer Price Index (CPI), highlighting the importance of thorough examination before finalizing the purchase.

What does ‘demised premises’ mean?

The term ‘demised premises’ encompasses the property components under the leaseholder’s ownership during the lease term, typically including the flat’s interior from floor joists to ceiling and internal wall surfaces. However, ownership usually excludes external or structural walls and the roof.

This limitation on ownership often restricts leaseholders’ renovation options, necessitating freeholder approval for significant alterations. While less restrictive for flats, it may still hinder plans like creating open-plan layouts or combining rooms.

What is a ‘sinking fund?’

A ‘sinking fund’ or ‘reserve fund’ is a portion of the service charges you might need to pay. It’s set aside to cover major maintenance, like structural repairs or external redecoration, ensuring funds are available when needed.

The contribution to this fund may be outlined in your lease agreement, but if not, you’ll need to discuss it with the landlord to determine your share.

What about a mortgage on a flat with a short lease?

Buying a flat with a short lease is often smoother with cash, as mortgages for such properties can be challenging to secure and come with higher interest rates. Most UK lenders define a ‘short lease’ as less than 75-85 years, but criteria vary, so consulting a mortgage expert is wise.

One workaround for a short lease is asking the current owners to extend it, if eligible. Even if you cover the extension cost in your offer, you sidestep the mortgage approval hurdles for short-lease properties.

Other considerations

Ensure you inquire about any upcoming major works planned for the leasehold flat you intend to buy. Understand the scope of the work and confirm if funds are allocated for it.

Review the lease agreement carefully, preferably with your conveyancer, to identify any property-use restrictions or covenants. These may include limitations on business use or pet ownership within the property.

Current and future leasehold reforms

The Leasehold Reforms, beginning on June 30, 2022, mark a significant shift. Phase one eliminates ground rents on new properties, adhering to the pledge of zero future ground rents. However, this applies solely to new lease agreements, with reforms for new retirement property leases on the horizon.

The subsequent phase pledges to abolish marriage values, allow leaseholders to buy out ground rents without extending lease terms, and establish a statutory calculation for premium payments. These changes, prioritizing leaseholder protection, are slated for implementation by 2024.

Thinking of buying, selling, or renting?

For cash buyers or those securing a suitable mortgage, purchasing a flat with a short lease boils down to practicalities. Factor in the costs of extending the lease and consider the property’s future saleability. While prioritising long-term value may not be essential, a short-lease flat can still offer a solid investment if it meets your criteria.