15.3 Capitalisation Rates on Lost Fixed Ground Rent
In the context of lease extensions
Understanding Ground Rent Compensation
Ground rent compensation is a core part of the premium for lease extensions under the Leasehold Reform, Housing and Urban Development Act 1993, reflecting the present value of the fixed ground rent the freeholder loses when the lease is extended to a peppercorn rent. The Nicholson v Goff [2007] case confirmed that such compensation is required, stating: "The factors relevant to capitalisation rate: the length of the lease term, the security of recovery, the size of the ground rent (a larger ground rent being more attractive), whether there were provisions for review of the ground rent and, if there was such provision, the nature of it." For fixed ground rents, valuers focus on term length and income security, typically using 6-7% rates, with 6.5% common, though recent tribunals have applied higher rates (e.g., 7.5-8%) due to leasehold reform uncertainties.
The Role of the Capitalisation Rate
The capitalisation rate discounts fixed ground rent payments to their present value, directly impacting compensation. A lower rate increases the premium, while a higher rate reduces it, reflecting the investor’s expected return. Per Nicholson v Goff, fixed ground rents, being stable, often warrant lower rates (e.g., 6.5%), but recent tribunal shifts to 7.5-8% account for risks like potential ground rent caps. The rate must balance statutory fairness with market evidence, using comparables adjusted for property-specific factors.
Methodologies for Determining the Capitalisation Rate
Selecting the capitalisation rate for fixed ground rents involves market analysis, comparable evidence, and professional judgement. Key methodologies include:
- Market Evidence Approach: Valuers analyse freehold sales with similar fixed ground rents to derive yields, adjusting for lease terms or location. A prime urban freehold might yield 6%, while a less desirable one could be 7%.
- Yield Comparison: Rates are benchmarked against low-risk investments like gilts, with adjustments for illiquidity. Nicholson v Goff guides these comparisons, though recent tribunals have applied higher rates (e.g., 7.5%) due to market shifts.
- Risk Adjustments: Fixed ground rents are low-risk, but longer terms or legislative risks may justify slight increases. A 2025 tribunal used 7.5% for a fixed rent case, citing reform uncertainties.
Worked Example 1: Fixed Ground Rent with Standard Rate
Consider a flat with a 60-year lease term and a fixed annual ground rent of £150, using a 6.5% capitalisation rate. The present value (PV) is calculated as:
PV = GR × (1 - (1 + r)-n) / r
Where:
- GR = £150 (ground rent),
- r = 0.065 (capitalisation rate),
- n = 60 (years).
PV = 150 × (1 - (1.065)-60) / 0.065 ≈ 150 × (1 - 0.0237) / 0.065 ≈ 150 × 15.026 ≈ £2,253.90
This is the compensation payable.
Worked Example 2: Fixed Ground Rent with Higher Recent Rate
For the same flat (£150 fixed ground rent, 60 years), using a 7.5% rate:
PV = 150 × (1 - (1.075)-60) / 0.075 ≈ 150 × (1 - 0.0134) / 0.075 ≈ 150 × 13.154 ≈ £1,973.10
The higher rate reduces compensation by about £280.80.