15.1 Schedule 13 LRHUDA 1993: Valuation Framework

In the context of lease extensions

Edited by Ashley Connell

Leasehold Enfranchisement Solicitor at Hetts

Overview of the Premium Calculation

The premium payable by the leaseholder is the sum of three main elements under Schedule 13:

1. Diminution in the value of the landlord's interest (Paragraph 2): This represents the reduction in the landlord's asset value due to the lease extension. It primarily comprises the capitalised loss of ground rent and the deferred loss of the freehold reversion.
2. Landlord's share of the marriage value (Paragraph 4): This is 50% of the "marriage value" created by combining the leasehold and freehold interests through the extension, but only if it results in a positive figure (nil if negative).
3. Compensation for other losses (Paragraph 5): Any additional compensation for injury to the landlord's other interests (e.g., if the extension affects a superior lease or adjoining property). This is often zero in straightforward cases.

The total premium is thus:

Premium = Diminution in Landlord's Interest + Landlord's Share of Marriage Value + Compensation

Each component is calculated using market-based assumptions, including yields and discounts derived from comparable evidence. The process involves estimating the "existing" values (before extension) and "proposed" values (after extension) of the interests involved.

Below, each component is broken down in detail, including the methodologies, formulas, and relevant rates.

Component 1: Diminution in the Value of the Landlord's Interest

This is the core of the premium and reflects what the landlord loses financially. It is calculated as:

Diminution = Value of Landlord's Interest (Existing) - Value of Landlord's Interest (Proposed)

The "existing" interest includes the right to receive ground rent for the remaining lease term plus the reversion to the freehold at the end of that term. The "proposed" interest is typically negligible: a peppercorn rent and a reversion deferred by an additional 90 years (making it almost worthless in present value terms).

This diminution breaks down into two sub-components:

1a: Loss of Ground Rent (Capitalised Value)

The landlord loses the future stream of ground rent income, as the new lease is at peppercorn rent. This loss is capitalised into a present value using a capitalisation rate.

• Methodology:
  • Identify the current ground rent (e.g., £100 per annum).
  • If the rent is fixed, capitalise it over the remaining lease term.
  • If the rent reviews upwards (e.g., doubling every 25 years), calculate in "tranches" for each period at different rent levels.
  • The present value is calculated using the formula for the capitalised value of an income stream.
• Formula (for a fixed ground rent):
  Capitalised Ground Rent = Ground Rent × (1 - (1 + r)^(-n)) / r
  Where:
  • Ground Rent = Annual ground rent payable.
  • r = Capitalisation rate (as a decimal).
  • n = Remaining years on the existing lease.
  This is the present value of an annuity. For escalating rents, sum the present values of each tranche.
• Capitalisation Rate: This is the yield rate applied to convert the income stream into a capital sum. It reflects the risk and return expected by investors in ground rents. Rates are derived from market evidence (e.g., sales of similar investments). Typical rates range from 6% to 8% for low-risk, fixed rents, but can be lower (e.g., 4-6%) for secure investments or higher for riskier ones (e.g., with frequent reviews). Case law like Arbib v Cadogan (2005) provides guidance on appropriate rates.
• Example: For a £200 annual ground rent, 50 years remaining, at 6% capitalisation rate:
  PV = 200 × (1 - (1.06)^(-50)) / 0.06 ≈ 200 × 15.76 = £3,152
  This £3,152 is added to the diminution.

1b: Loss of Freehold Reversion

The landlord loses the value of regaining full possession at the end of the original lease, as the reversion is now deferred by 90 years.

• Methodology:
  • Estimate the freehold vacant possession (FHVP) value of the flat (i.e., its open market value if sold freehold with vacant possession).
  • Discount this value back to the present day over the remaining lease term (existing reversion) and compare to the much further deferred proposed reversion (which is often valued at near zero due to the long deferment).
• Formula:
  Value of Existing Reversion = FHVP × (1 + d)^(-n)
  Where:
  • FHVP = Freehold vacant possession value.
  • d = Deferment rate (as a decimal).
  • n = Remaining years on the existing lease.
  The proposed reversion is FHVP × (1 + d)^(-(n+90)), which is typically negligible (e.g., less than 0.1% of FHVP for long deferments).
  Thus, Loss of Reversion ≈ Value of Existing Reversion (since proposed is ≈0).
• Deferment Rate: This is the rate used to discount the future reversion value, reflecting the risk-free rate plus a risk premium for property investment. The landmark case Sportelli v Cadogan (2007), upheld by the House of Lords, set a generic deferment rate of 5% for flats (4.75% for houses) where the unexpired term exceeds 20 years, absent special circumstances. This rate assumes a 2% risk-free rate (based on gilts) plus 4.5% for property growth minus 1.5% for management/volatility, but it's now a benchmark. Tribunals may adjust for location or property type (e.g., lower for prime central London).
• Example: For a £500,000 FHVP, 50 years remaining, at 5% deferment:
  Existing Reversion = 500,000 × (1.05)^(-50) ≈ 500,000 × 0.087 = £43,500
  This £43,500 is added to the diminution.

The total diminution is the sum of 1a and 1b (ground rent loss + reversion loss).

Component 2: Landlord's Share of Marriage Value

Marriage value arises from the "marriage" of the leasehold and freehold interests, creating additional value through the longer lease. It is only relevant if the existing lease has less than 80 years unexpired (per Paragraph 4(2A), inserted by the Commonhold and Leasehold Reform Act 2002), but technically calculable anytime—though often zero for longer leases.

• Methodology:
  • Calculate the total value of all interests before and after the extension.
  • Marriage value = (Sum of values after) - (Sum of values before).
  • The landlord receives 50% of this (tenant gets the other 50%), or nil if negative.
• Formula:
  Marriage Value = [Value of Extended Leasehold + Value of Landlord's Proposed Interest] - [Value of Existing Leasehold + Value of Landlord's Existing Interest]
  Typically:
  • Value of Extended Leasehold ≈ FHVP (since 90+ years lease is near-freehold equivalent).
  • Value of Landlord's Proposed Interest ≈ 0 (peppercorn and long-deferred reversion).
  • Value of Existing Leasehold = FHVP × Relativity.
  • Value of Landlord's Existing Interest = Diminution (as calculated above).
  Thus, Marriage Value ≈ FHVP - (Existing Leasehold Value + Landlord's Existing Interest)
• Relativity: This is the percentage ratio of the existing leasehold value (with its remaining term) to the FHVP value, assuming no Act rights. Relativity tables are used to determine these values, our page on Relativity for Lease Extensions gives the relevant relativity rate. For example:
  • 70 years: 84.66% relativity.
  • 60 years: 78.26% relativity.
  • 50 years: 70.7% relativity.
  Relativity is evidenced by market data, settlement graphs (e.g., Savills or Gerald Eve graphs), or tribunal decisions. The Parthenia model or RICS research provides benchmarks, but it's contentious and often negotiated.
• Example: FHVP = £500,000; Existing lease 50 years; Relativity = 70.7% → Existing Leasehold = £353,500; Landlord's Existing Interest = £50,000 (say, from earlier calculations).
  Before Sum = 353,500 + 50,000 = £403,500
  After Sum ≈ 500,000 + 0 = £500,000
  Marriage Value = 500,000 - 403,500 = £96,500
  Landlord's Share = 50% × 96,500 = £48,250

Component 3: Compensation for Other Losses

This is payable if the extension causes loss to the landlord's other property interests (e.g., reduced value of an intermediate lease or development potential). It is calculated as the diminution in those interests' value.

• Formula: Similar to Component 1, but applied to affected interests.
• Often zero, but could include lost rents or reversions from superior leases.

Aggregation of Components

The total premium is simply the arithmetic sum:

Total Premium = (Loss of Ground Rent + Loss of Reversion) + (50% × Marriage Value) + Compensation

In the example above:

• Ground Rent Loss: £3,152
• Reversion Loss: £43,500
• Diminution: £46,652
• Landlord's Share of Marriage: £48,250
• Compensation: £0
• Total Premium: £94,902

Key Rates and Assumptions

• Capitalisation Rate: 6-8%, market-derived for income yield.
• Deferment Rate: 5% benchmark for flats (Sportelli).
• Relativity: Table-based, e.g., 70.7% at 50 years; critical for marriage value.
• Other Assumptions: FHVP from comparables; no-Act world for lease values; inflation/growth implicitly in rates; tax ignored unless specified.