Ground Lease Blog - Turner Southern

November 25, 2016 In Commercial Ground Rent Investments, Commercial Ground Rents, Ground Lease Investment, Ground Leases, Ground Rent Creation

Ground Rent Investments & Creating Value

Over the years we’ve all heard about marriage value and it’s always taught in the valuation modules on RICS accredited courses. And its perhaps because of this that there’s a neagtive attitude Ground Rents and Long Leasehold interests. I finished my Postgradute University Course in 2002 and at that time interest rates were at 4.00% and not only that they were also at a 35 year low, so it is perhaps unsurprising that the concept of “divorce value” didn’t really exist as a valuation method. In fact, during the last half century, it is only within the last 8 years that rates have remained below 5%.

UK Interest Rates over the last 50 years

Looking at the graph above, which charts interest rates over the last 50 years, it is quite clear to see the seismic change in interest rates brought about by the recession and the Bank of England’s moves to avert an economic meltdown.

So what has all this got to do with Ground Rent Investments and creating value? With UK interest rates at 0.25%, yields on RPI indexed ground rents, in fact all ground rents for that matter, have fallen significantly. There is of course an exponential correlation between yield movement and YP, which once below 5% really starts to drive up pricing, as demonstrated in the chart below.

Yield ~ Years Purchase – Correlation Chart

Commercial Ground Rents – Creating Value

By splitting an unencumbered Freehold Interest into a Freehold subject to a Long Leasehold interest you create what I like to call divorce value.

By splitting the income stack in to super senior income (Ground Rent) and standard income you are able to apply different multipliers to each. The Ground Rent income, which is effectively AAA can be valued at significantly lower yield than the majority of standard occupational tenants. Apply the separate yields to each element of the income stack and the sum of the parts is worth more than the sum of the whole…..as I said, Divorce Value.

Here are some numbers

Freehold Office Building

ERV – £1,000,000

Gross Yield 7%

Value £14,285,000

Freehold Office Building Split into Freehold & Long Leasehold Interests

Ground Lease Element

Ground Rent – £100,000

Gross Yield – 3.1%

Value £3,225,000

Long Leasehold Element

Net Rent £900,000

Gross Yield 7.5%

Value £12,000,000

Total Value £15,225,000

Value Added £940,000

November 25, 2016 In Commercial Ground Rent Investments, Commercial Ground Rents, Ground Lease Investment, Ground Leases

The Perfect Ground Lease – Lease Terms, Lease Terms, Lease Terms

The old adage of location, location, location has been uttered many times when discussing commercial property values, and whilst it still has a marginal effect on value for commercial ground rents, what in fact have a far greater impact are the covenants contained within the lease.

Referring back to our article on the Holy Trinity of ground lease creation, what investors are looking for are effective Triple A incomes and Triple Net incomes. Here the lease terms are key to achieving both goals.

Creating the Perfect Ground Lease

Key areas to consider are:-

Triple Net – Ground Lease

Freeholder indemnification
Repair clauses
Insurance clauses

Triple A – Ground Lease

Change of Use – Impact on reversionary value
Repairing obligations
Insurance requirements

The key is creating a lease where by the reversionary value is maintained. In real life scenarios the interests of both the Freeholder and long Leaseholder are aligned however the creation of an AAA interest relies on this also being the case by law.

Creating the Perfect Long Leasehold Investment

Whilst the value of the Freehold can be maximised by drafting overly restrictive clauses within a lease, there is a balance to be had between creating value from the Freehold and maintaining the value of the Long Leasehold Interest. There is a perfect equilibrium where both the value newly created Freehold and the resultant Long Leasehold are maximised.