Freehold to Leasehold Title Splitting Remember Shaving Foam Having gone through the sourcing, the financing, the purchasing, the planning, the self-containing and/or refurbishment most people are so stressed and exhausted, they just want to market the flats, sell as quickly as possible and grab a healthy profit. When someone suggests they should get involved in creating leases that add value to the residual freehold they throw up their arms in horror and say my solicitor can handle that. All they want is the money and no more stress. The problem with saying my solicitor can handle that is most solicitors are not investors. They are very good at conveyancing and can complete the sales process efficiently but most have absolutely no idea what creates value in a freehold. Consequently they and their client walk away from 000s through lack of knowledge. Similarly you would stop reading this article if I started writing about lease clauses, reversionary values, yield rates and the like. That s boring paperwork! So in order to get my point across I needed to come up with something interesting and easy to remember. What is that something? Shaving Foam! Yes, this picture of shaving foam will make you remember my point and as a consequence you ll make 000s extra on your next freehold to leasehold title split. You see, taking a big property and splitting it into several flats and selling those flats for a profit is very similar to the owner of a corner shop, going down to the cash and carry, buying a bulk pack of shaving foam, taking it back to his shop, and selling the individual cans of foam for a profit. He buys in bulk; wholesale and sells one by one; retail. The total of his individual sales is greater than his bulk buy so he makes a healthy profit. The question is how much profit?
Let s do the math for a typical large house being split into six flats: Shaving foam multipack 400,000 Shaving foam cans 6x 100,000 Total profit, excluding costs???,000 99% of people reading this article will do the math and say 200,000. It s simple. Buy at 400,000 sell for 600,000 and the profit is 200,000. Wrong! Look at the picture again. What are you missing in our analogy? The cardboard container! In our property world, the cardboard container the freehold is worth money and you can sell it for 000s. What s more, if you create the leases in the right way, you can sell that freehold for many many more 000s. So what makes that extra value? Principally five things. Let s look at them one by one. Ground Rent. Every lease requires the leaseholder to pay rent. After all, they aren t buying the flat they re renting it for an awfully long time. And as a tenant, they pay rent which in the case of a long lease is called ground rent. The added value we can create here, is to have that ground rent as high as possible but not so high that it is off-putting to a potential purchaser. And as the tenant will be renting for an awfully long time, we need to maintain the value of that ground rent throughout the lease term so it s not eroded by inflation over the years. We do that by having rent review clauses as often as possible and linking the rent review amounts to the market value of the property in the future, or some other indexing which protects the real value of the rent being paid. Buildings Insurance. The freeholder will be required, under the terms of the lease, to insure the building. They will recover the costs by way of a service charge, which each leaseholder is required to pay. But that doesn t make a profit, I hear you say. Correct. The total service charge will recover 100% of the costs, but won t produce an income.
What will produce an income is the commission which the insurance broker will pay to the freeholder. That will vary from broker to broker, and freeholder to freeholder, but the principle is the same whoever they are. And that commission is more income for the freeholder in addition to the ground rent. Management. The leases could be drawn up in such a way as to give the leaseholders the obligation to maintain and manage the building through a Residents Management Company. But whilst that is very democratic, it doesn t produce an income for the freeholder. It is therefore better to ensure the responsibility for management remains with the freeholder because he can then charge a management fee. Depending on where the property is geographically and the complexity of the management/building that fee might be three of four hundred pounds per year, per flat in addition to the ground rent. You see, each of those three bits of income ground rent, insurance commission and management fees have a capital value. For example, if they total 3,000 per annum in our example of six flats how much money would you need to put in the bank or building society to produce interest of 3,000 per annum? That sum of money is the capital required and in a similar way, the freehold has a capital value related to the income being produced. But I said there were five things which add value to a freehold. So, what are the other two? Hope Value. When you take your shaving foam multipack and you split it into separate cans, you ll do everything possible within the current planning permission et cetera to make those individual cans as valuable as possible. You ll make your flats as marketable as possible, by making them as big as possible, with the best facilities possible, within the current rules and regulations. But those current rules and regulations might not allow you to do all you could do. You might not, for example, be able to extend up into the loft. In which case in order to make the cardboard container as valuable as possible the leases need to ensure the top flats stop at their ceilings so that the loft remains within the freehold and is not given away with the top floor flats. Similarly, there may be space adjacent to the building, which the planners would not allow you to build on today. But there may be the possibility of building an extension in ten or twenty year s time. And there may be the possibility of a loft extension in ten or twenty year s time. But I m not going to build an extension or loft conversion in ten year s time I hear you say. No you won t. But the there s the possibility the leaseholders will want to. And in order to do so, those leaseholders will have to come to the freeholder and ask for permission as the leases won t allow them to do so without permission. That permission is something the freeholder can charge for. And if the freeholder can charge for it in the future it has a present day hope value. And that present
day hope value enhances the capital value of the freehold it makes the cardboard container more valuable. Possession. As I said earlier, the leaseholders are not buying the flats they re renting them for an awfully long time. But at the end of that time, the tenancy comes to an end and the freeholder gets the flats back and the whole process, in theory, starts again. Possession of those flats at a known date in the future has a present day value. Taking the bank or building society example again what sum of money would you have to deposit now, which would grow to the value of that flat in XXX years where XXX is the length of the tenancy? The sum you d have to deposit, is the present day value of that future vacant possession value. So in creating the leases, we need to ensure those flats are given back as soon as possible. The lease term needs to be as short as possible but not so short as to put off the potential buyers. Commonly, leases are created with 99 year terms or 125 years and sometimes 999 years. So my recommendation is 99 years, if you want to enhance the value of the cardboard container. Having understood what adds value to the cardboard container, let s do the math for our six flats again: Shaving foam multipack 400,000 Shaving foam cans 100,000 x6 with 250pa per flat ground rent Cardboard container??,000 if valued at 10x to 20x ground rent Total profit, excluding costs???,000 If you get your brain or calculator working, you ll see that s 215,000 to 230,000 in total. So our cardboard container is worth 15,000 to 30,000 in our example... from just six flats. Now that s worth having! So next time you re undertaking a freehold to leasehold title split, remember Bernie Wales and his shaving foam. Don t just leave the leases to your solicitor, if he s not a freehold investment expert. Make sure the new leases are written in such as way as to add significant value to the residual freehold value. And make sure you go to someone (like Bernie) who can find you a freehold ground rent investor to buy the freehold at the end of your project ensuring you get a good price for your cardboard container. It may cost you a thousand or two but you ll be getting tens of thousands in return in addition to the 000s you also make from the sale of the individual flats. Now, doesn t that make you smile? Bernie Wales 2013 www.berniewales.co.uk