17.3 Negative Interest Issues on the Head Lease
In the context of lease extensions
Dispelling the Myth of Negative Interests in Intermediate Headleases under the Leasehold Reform, Housing and Urban Development Act 1993
Overview of Lease Extensions
In setups with a freehold, intermediate headlease, and flat sub-lease, the competent landlord is the freeholder if the headlease lacks sufficient term for the extension (sections 40 and 56, Schedule 11). Professionals should verify terms early to identify the correct party and avoid tribunal disputes (sections 48, 91).
Premium Apportionment and Compensation
The extension premium compensates for the diminution in landlords' interests under Schedule 13. This includes capitalised ground rent loss, using a 6-7% rate for fixed rents (Schedule 13, paragraphs 6-7). In multi-tier structures, the premium splits proportionally between freeholder and headleaseholder (paragraph 10). The headleaseholder receives a lump sum for lost flat rent, while continuing payments to the freeholder. A deemed surrender and regrant aligns the headlease (Schedule 11, paragraph 10).
Why Negative Interests Do Not Exist
Claims of negative interests for headleaseholders, where outgoing rents exceed lost incoming ones, hold no merit under LRHUDA 1993. The lump-sum compensation equals the discounted value of foregone rents at 6-7%, allowing investment to cover obligations fully. No true imbalance arises, as tribunal oversight ensures fair apportionment (section 48). For multi-flat headleases, per-extension payments offset losses incrementally. Headleaseholders can pursue enfranchisement to eliminate rents.
To illustrate mathematically, consider a simple example of perpetual ground rent loss. Suppose the headleaseholder loses an annual ground rent of £100 from the extended flat. Using a 6% capitalisation rate, the lump-sum compensation (present value, PV) is calculated as:
PV = Annual Rent / Capitalisation Rate = £100 / 0.06 = £1,666.67
Investing this £1,666.67 at the same 6% market rate yields an annual return of:
Annual Return = PV × Capitalisation Rate = £1,666.67 × 0.06 = £100
This exactly replaces the lost £100 income stream, enabling the headleaseholder to meet ongoing payments to the freeholder without net loss. The formula assumes a perpetuity (ongoing rent), aligning with the Act's valuation principles, and demonstrates why no negative interest occurs.
If the rent paid to the freeholder by the headleaseholder is more than the rent received from the flat before the lease extension, that is irrelevant to the flat leaseholder and not their concern. Such discrepancies are not factored into the calculations for the extension premium, which focus solely on the diminution in value attributable to the specific flat's extension.
The key point
The investment value of the ground rent compensation payable to the intermediate headleaseholder is exactly equal to the ongoing obligations of paying the rent to the freeholder, ensuring financial neutrality.