15.4 Capitalisation Rates on Doubling Ground Rent

In the context of lease extensions

Edited by Ashley Connell

Leasehold Enfranchisement Solicitor at Hetts

Doubling ground rents, where the rent increases at fixed intervals (e.g., doubles every 10, 20, or 33 years), require a nuanced valuation approach under the Leasehold Reform, Housing and Urban Development Act 1993. Unlike fixed rents, the income stream is not uniform, so valuers must segment the calculation into "tranches" corresponding to each period between rent reviews, with each tranche discounted to reflect its timing.

Methodology

1. Calculate PV for each period: Compute the present value (PV) for each rent level over its duration using the Years' Purchase (YP) factor for that period.
2. Defer future tranches: For periods after the first, apply a deferral factor (PV of £1 deferred) to account for the time until that rent level begins.
3. Sum the PVs: Combine the discounted values to obtain the total compensation.

Example: Consider a lease with 80 years remaining, a current ground rent of £250, doubling every 20 years, capitalised at 6%.

• Period 1 (Years 1–20, £250):
  YP (20 years @ 6%) ≈ 11.47
  PV = £250 × 11.47 = £2,868
• Period 2 (Years 21–40, £500):
  YP (20 years @ 6%) ≈ 11.47
  PV of £1 (20 years deferred @ 6%) ≈ 0.312
  PV = £500 × 11.47 × 0.312 ≈ £1,790
• Period 3 (Years 41–60, £1,000):
  YP (20 years @ 6%) ≈ 11.47
  PV of £1 (40 years deferred @ 6%) ≈ 0.097
  PV = £1,000 × 11.47 × 0.097 ≈ £1,113
• Period 4 (Years 61–80, £2,000):
  YP (20 years @ 6%) ≈ 11.47
  PV of £1 (60 years deferred @ 6%) ≈ 0.030
  PV = £2,000 × 11.47 × 0.030 ≈ £689
• Total PV ≈ £2,868 + £1,790 + £1,113 + £689 = £6,460

This layered approach accurately captures the escalating income and the time value of money, ensuring the freeholder is compensated for the actual income profile.

Capitalisation Rate: Why Equated Yield is Preferred for Doubling Rents

A common question is whether the capitalisation rate should differ between fixed and doubling ground rents. In standard UK leasehold valuation practice, the same rate is applied across the entire income stream, whether fixed or escalating, when using an equated yield approach. This is critical for doubling rents or any ground rents reviewed on a fixed, knowable basis (e.g., doubling every 20 years).

Equated Yield Approach

The equated yield reflects the total expected return, incorporating growth (e.g., doubling rents) by explicitly modelling the cash flow through sectional PVs, as shown above. It treats the income as a geared or growing annuity, with escalations handled by deferral factors rather than an adjusted rate. Mathematically, it aligns with the internal rate of return (IRR) that equates discounted cash flows to the asset’s market value. This ensures precision for predictable, stepped increases.

Why the same rate?

• Market Evidence: Capitalisation rates are derived from comparable sales of ground rent investments (e.g., auction data). Investors bid based on the overall return profile, not by assigning different yields to fixed vs. escalating portions. A single rate (typically 5–7%, with 6% as a benchmark for modest rents) is supported by tribunal decisions, such as Earl Cadogan v. Cadogan Square Ltd (2011).
• Security of Income: Ground rents, whether fixed or doubling, are secure (backed by the lease and enforceable), justifying a consistent risk profile and a single rate.
• Practicality: Applying multiple rates for each tranche requires specific market evidence, which is rarely available. Tribunals favour a single rate for consistency and simplicity.

Why Equivalent Yield Should Not Be Used

The equivalent yield, common in commercial valuations, is a single “blended” yield applied to the entire income stream, often for reversionary interests. For doubling ground rents or fixed-review rents, it is less suitable because it does not explicitly model the stepped changes in income. Applying a single equivalent yield without segmenting the cash flow into tranches risks undervaluing or overvaluing the growth component, as it assumes a uniform income profile. While valuers can adapt the equivalent yield by layering PV calculations (mimicking equated yield), this is unnecessary and prone to error, as the equated yield already handles the predictable escalations of doubling rents with precision. Using equivalent yield for fixed-review rents may also lack the granularity required to satisfy tribunal scrutiny, especially in disputed cases.

Exceptions: RPI-Linked Ground Rents

RPI-linked ground rents, where increases are tied to inflation (e.g., RPI adjustments every 5 years), differ fundamentally. Unlike doubling rents with predictable, fixed escalations, RPI-linked rents are uncertain, as future inflation is unknown. Here, an equivalent yield approach is more appropriate, as it incorporates an assumed growth rate (often based on long-term inflation expectations, e.g., 2–3%) into a single yield. This reflects investor pricing for inflation-hedged income, often commanding a slightly lower yield (e.g., 4.5–5.5%) due to perceived stability. Market evidence from ground rent sales supports this distinction, and valuers must use equivalent yield to align with investor expectations for such variable, non-fixed escalations.