The unintended consequences of high rents in long leases

Claudia Carter, Senior Associate, Fladgate LLP (ccarter@fladgate.com)

When long leases are granted the intentions of the parties are usually to grant a long lease to the leaseholder, for which a high premium is paid, with a ground rent that varies but is generally nominal when viewed in relation to the premium paid for the lease. However, when the ground rent is looked at in isolation (as there is currently no legislation which provides for any other view to be taken) it can have the unintended consequence of the lease being deemed an Assured Shorthold Tenancy (AST) which can impact the leaseholder and any lender with a charge on the leasehold property.

Although ASTs are often viewed as short-term lets, there is no maximum term. Consequently, leases that were never intended to be ASTs are in danger of being deemed an AST. This article will explore the dangers of this unintended consequence, particularly lease termination, and the impact on long leaseholders where the leases have been granted for a significant premium, and often purchased with the aid of a mortgage.

What is an AST?

First we need to establish the criteria for a lease or tenancy to be an AST. A lease of a dwelling will be an AST where it satisfies the following conditions:

1. the tenant is one or more individuals;
2. the tenant (or at least one of the tenants) occupies the dwelling as their only principal home;
3. where the lease is granted after 1 April 1990 the annual ground rent must be between £1,001 and £100,000 (inclusive) in Greater London, or between £251 and £100,000 (inclusive) outside Greater London (prior to 1 April 1990 this condition is based on the rateable value of the property); and
4. the tenancy is not an “excluded tenancy” as set out in Schedule 1 to the Housing Act 1988 (the Act).

Traditionally long leases were granted for a peppercorn rent, which meant they could not qualify as an AST. Today, ground rents can be higher and if you buy a leasehold property with a ground rent over £250 (or over £1,000 in London), then the lease could possibly fall within the Act and be deemed an AST.

What is the problem if a long lease satisfies the above criteria and is deemed an AST?

The problem lies in the landlord’s rights to terminate ASTs under the Act. This right is set out in section 7(6) of the Act where a landlord can terminate an AST during its fixed term if it satisfies the following conditions:

1. the landlord proves one of grounds 2, 7, 7A, 7B, 8, 10 to 15, or 17 of Schedule 2 of the Act; and
2. save in the case of ground 7B, the tenancy provides that it can be brought to an end on the ground in question  (this can take the form of a provision for re-entry, forfeiture or determination).

If these conditions are satisfied, subject to complying with the notice procedure under the Act, the landlord may apply to court for an order to take possession of the property.

One might assume that the court would look to the intention of the parties when granting the lease, realise that the intention was not to create an AST and therefore it would not be reasonable or just to grant possession to the landlord. Unfortunately however, grounds 2, 7, 7A, 7B and 8 are mandatory, meaning that the court must order possession if the landlord can demonstrate the ground. This removes the court’s discretion entirely and the case would turn on the facts and evidence alone. The most notable (and relevant) of these grounds is ground 8, which allows a landlord under an AST to terminate the tenancy where a yearly rent is in arrears for three months. This is an extreme outcome when considering the usually minimal rent and the length of arrears in comparison to the premium paid for the property and the length of the lease.

This enables the landlord to terminate the lease and take possession of the property, without having to compensate either the leaseholder or its mortgagee. Additionally, as this is not forfeiture, there can be no possibility of relief for the leaseholder, nor is it governed by the requirement under the Commonhold and Leasehold Reform Act 2002 that the arrears must have been outstanding for more than three years.

There are discretionary grounds (such as for breach of covenant) which would also allow the landlord to terminate the lease, but as they are discretionary, it is unlikely that the court would consider it reasonable to grant an order for possession on one of these grounds.

Case law

There is limited case law on this subject, with the most relevant case being at County Court level and therefore not binding. In Richardson v Midland Heart Ltd (formerly Focus Homes Options) [2008] L&TR 31 a leaseholder (R) owned 50% of the equity in a leasehold property with a 99 year lease, and paid rent on the remainder. R became unable to remain in the property and tried to sell but fell into rent arrears. The County Court held that the shared ownership lease was an AST and the landlord had been entitled to serve a section 8 notice forcing the district judge to grant an order for possession. R was not able to claim any share in the proceeds of sale or the uplift in value of her share. However the judgment notes that the housing association had offered out of court to refund R’s original premium less any rent arrears and the cost of necessary repairs.

The effect on the value and marketability of the property, and resulting impact on lenders

Although a prudent leaseholder will try to ensure that the rent is paid on time and does not fall into arrears, the payment of the rent will inevitably lie outside the lender’s control, leaving them vulnerable to the lease being determined without compensation. This element of risk may not be acceptable to a mortgagee, which may affect the value and marketability of the lease in the future, especially where the ground rent increases over the term of the lease.

How can the problem be avoided?

The most obvious way to avoid this issue is to prevent the long lease being deemed an AST. If any of the above conditions are not satisfied the lease will not be an AST. The easiest way to achieve this is to keep the ground rent from escalating into the parameters of an AST. Alternatively, if the property is not owned for the purposes of occupying as a principal home, or if it is owned in the name of a company, it will also not be deemed an AST and will not fall into the above trap.

Alternatively, amendments to the lease may be negotiated and could include the following:

1. the inclusion in the lease of a provision that the rent will always be £1 less than the minimum rent specified for an AST under the provisions of the Act;
2. the insertion of a mortgagee protection clause requiring a landlord to give the lender prior notice of its intention to exercise any right to forfeit the lease. This gives the mortgagee the opportunity to remedy the breach before the landlord takes further action in order to preserve its security. This of course is of no assistance to the leaseholder where there is no lender; and
3. the insertion of a landlord covenant into the lease that the landlord will not rely on ground 8 of the Act and seek to terminate the lease during the fixed term. There is however no indication that such a covenant would be enforceable, even if it were to be agreed by a landlord.

If the lease cannot be amended the leaseholder could extend the lease under the Leasehold Reform, Housing and Urban Development Act 1993 where the ground rent will be reduced to a peppercorn.

If none of the above options are available then some indemnity insurance providers offer defective title insurance to cover the risk that the property is repossessed by the landlord under the Act for non-payment of rent. The policy will need to be checked carefully to see if it protects both the leaseholder and the lender, or the lender only.

Are there any other unintended consequences?

Another unintended consequence is the effect on the leaseholder’s right to first refusal on the sale of a freehold. A freeholder of a block of flats who wishes to sell their interest must normally offer first refusal to “qualifying tenants”. However, an AST is not a “qualifying tenancy” and a leaseholder is therefore specifically exempt from being a qualifying tenant. This could mean that the block as a whole becomes exempt from first refusal  (as this will only apply if more than half the flats are held by qualifying tenants). For these leaseholders there is a double whammy of the risk set out above if they fall into arrears of rent coupled with the removal of their right of first refusal.

What does the future hold?

The Government has promised to legislate to remove the risk that long leaseholders could be subject to “unfair possession orders” under the Act, as well as legislating to ban the sale of leasehold houses and abolish ground rents in new long residential flat leases. Neither detailed nor outline proposals have not yet been forthcoming so we must wait with baited breath as the market adjusts to the possible risks while awaiting a solution.