What is Capitalisation Rate?
The capitalisation rate is a very important factor to be negotiated when calculating how much you'll need to pay your landlord to extend your lease. While it sounds complicated, it's actually based on a simple principle: how much should your landlord be compensated today for the future ground rent payments they will no longer receive once the lease is extended?
This rate is used to calculate the present value of the ground rent income the landlord gives up for the remainder of the original lease term.
A Simple Example
Imagine your landlord expects to receive £200 per year in ground rent from you for the next 50 years under your current lease. When you extend your lease (under the relevant legislation, often to a peppercorn or zero ground rent), the landlord loses that future £200/year income stream.
The big question is: How much are those 50 years of £200 payments worth as a single lump sum today?
A simple answer would be 50 x £200 = £10,000. Whilst that sounds sensible it isn't right – that's because of a simple reason – money in the future is less valuable than money today. Would you rather get £200 tomorrow, or £200 in 10 years?
This is where the capitalisation rate comes in. It allows you to workout how much of a discount to apply to money the landlord expects to get in the future. The technical explanation is that it is how you calculate the present-value.
Why It Matters to You
The capitalisation rate has a direct impact on the portion of the lease extension premium related to buying out the ground rent. Here's the key thing to understand:
- A lower capitalisation rate = The ground rent income is valued MORE highly = You pay MORE
- A higher capitalisation rate = The ground rent income is valued LESS highly = You pay LESS
The reason the capitalisation rate varies is because the "quality" of the income varies. For example a ground rent that pays £5 a year almost isn't worth the hassle of chasing it down whereas a ground rent of £200 is.
What Capitalisation Rate Applies to Me?
Unfortunately there is no definitive answer to capitalisation rate. It is determined by market evidence and negotiation, considering the specific characteristics of your ground rent. The key case of Nicholson v Goff established several factors that influence the appropriate rate:
- The amount of the ground rent: Very low rents might attract higher cap rates (less valuable), while substantial rents might attract lower cap rates (more desirable to investors).
- The remaining length of the original lease: How long would the rent have been paid?
- Rent review provisions: Does the ground rent increase over time? How often? Is it fixed, linked to inflation (e.g., RPI), or does it double? Complex or aggressive review clauses can significantly affect the rate.
- Security of the income: How certain is it that the ground rent will be paid?
Valuers will look at these factors and evidence from the market (sales of ground rent portfolios) to argue for a specific rate. Without reviewing the actual lease and the local market transactions it is hard to give guidelines to what an appropriate capitalisation rate might be. Due to the impact on the premium it is a common area of dispute in negotiations.
Why It's Called "Deferment Rate"
The term comes from the process of "capitalising" an income stream. This means converting a series of future income payments (the ground rent) into a single equivalent capital value today. The rate determines how this conversion is done.
Future Changes
The government's ongoing leasehold reforms primarily target future ground rents on new leases. While these reforms don't directly set capitalisation rates for existing lease extensions, the changing landscape for ground rents could potentially influence market sentiment and negotiations around their value. However, until specific legislative changes affect the valuation methodology for existing leases, the principles derived from case law like Nicholson v Goff remain the basis for determining the capitalisation rate.
