Capitalisation Rates : The next major battle ground in Enfranchisement?

In April 2012, the Leasehold Valuation Tribunal gave judgment in the 1967 Act case of 23 Pont Street, London*. Although a house for enfranchisement purposes, the property was divided into seven flats, including one occupied by the leaseholder and another by a housekeeper. The other flats were let on rack-rent tenancies.
The lease was unusual. When granted in 1978, with a starting rent of £2,000 per annum, five-yearly reviews were imposed by reference to 2% of the freehold value of the property at the review date. By the time the freehold was claimed in 2010, the rent had risen to £225,000 per annum, and was virtually a rack rent. The use was also restricted, confining (in simple terms) the flat to furnished lettings for terms not exceeding five years. None of the flats would therefore be sold off on long underleases, and the leaseholder’s interest was limited to the profit rents over and above the very high ground rent.

The amount of ground rent meant its capitalisation was a significant component of the overall valuation. The landlord’s expert said that normally a capitalisation rate of 5% would apply, but this rent was so high, and the reviews so in favour of the landlord, it was appropriate to base the rate on a risk-free rate with an uplift, resulting in a rate of 2.25% for the passing rent and 2.5% for the future rent. The tenant’s valuer disagreed, the quantum of the passing rent being irrelevant to the established principles to be applied. Even considering market evidence for net rental yields, he felt the rate should be 4.75% for the passing rent and 5.25% for the review rent.
In its decision, the LVT reminded the parties it was an expert Tribunal, following neither value. The Tribunal separated the issues affecting the capitalisation rate from the deferment rate, and instead based their decision on the net rental yield for flats in the area as set out in the Savills Index (namely 2.4%, with a 2% uplift to reflect the expectation of capital appreciation). The freehold investor was acquiring an income with reviews based on the capital values of the flats, where because of the lease terms, the resultant rent is approaching the rack rent every five years. The flat tenancies themselves were of single properties with annual reviews to market rents, which may periodically increase faster than capital values. With the landlord also having the ability to obtain vacant possession, they were very attractive as an investment.