Leasehold Land Issues: Glasgow renewable lease

11/22/2011
Introduction

Land settlement in New Zealand, commencing in the 1840’s was based on a platform of the NZ Company and Crown selling land as freehold at minimum cost. It was important to provide a mechanism where settlers of limited means could become established. In Otago the use of a long term ground lease was the popular mechanism used; this proved a successful model and became adopted more widely after debate of land tenure issues in the 1880’s. This debate continued for 2 more decades during which the lease format evolved into a form similar to what we currently understand. This format is unique to New Zealand and appears to have received the ‘Glasgow’ name via the Scottish Otago connection.

Lease structure

  • If the lease provisions have been met by the lessee (person in occupation, paying the rent) then the lease provides that the lessee may choose to renew the lease; and that renewal provision continues without constraint of time.
  • The term is usually 21 years without rental review; rental reviews on a 7 yearly basis was introduced for leases established from the mid ‘70’s.
  • Rental on review is usually established by way of a percentage of the leased land value (’rack-rent’). Some leases have that percentage prescribed in the lease. Often the lease calls for the ‘market rent’ to be established and in those cases local practice with identifying the appropriate ‘rack-rent’ is applied. This should vary according to the lease provisions and property characteristics.
  • A short rental period of 7 years will have a lower percentage rental than that for a period of 21 years.A CBD commercial property would be expected to have a higher percentage rental than an out-lying industrial property.
Lessor/Lessee Relationship

  • So we have a situation where a freehold Certificate of title is partitioned via the lease to become 2 properties, each having specific and very different characteristics and usually strong tensions arising from the competing objectives of the lessor/lessee.
  • The lessee owns the improvements, including development work to the land and the rental is therefore based on the value of the land without improvement and in the condition that applied at the commencement of the lease. Work such as filling, drainage, consolidation and retaining structures would usually belong to the lessee and not attract rental.
  • The lessor supplies the land and forever releases this to another party in exchange for rent. The investment nature of this property is low risk, low to moderate income return, easy to administer.
  • The lessee supplies the improvements and business activity on the land that expects to generate a commercial return to those inputs plus meet the rental obligation to the lessor for the use of his/her capital.
  • The lessee accepts much greater business risk than the lessor in terms of the protection of their capital.
Dynamics of Leasehold Interest

  • The lessee has a limited share of the capital growth that applies to a comparable freehold property. The improvements also depreciate or become obsolete and unable to achieve the ‘highest and best use’ revenue outcome from the land. Reinvestment to modernise and expand a business may become an impossible barrier or involve unacceptable risk.
  • The lessee does get some share of the capital growth especially when;-
  • There is a 21 year term without rental review
  • Land values are increasing at a moderate to high rate over that time
  • Capital borrowing cost is significantly greater than the percentage rental basis
  • The market perception is of a low to medium risk business environment
  • The previous points can be summarized as being the advantageous influences of: Time – Inflation – Savings on debt servicing ­– Confident market outlook
  • The above indicates why the market pays significant capital amounts in addition to the improvements value for leasehold property. However the market often seems to poorly reflect the business risk to the lessee and the ingoing payment for the lessee’s interest in those cases will appear high.
  • Changing land use environments where the land value has increased multiple times in response to redevelopment pressure for more profitable land use; this destabilizes the lessees interest by forcing rentals to impossible levels which the original business activity may be unable to meet, the improvements value then becomes eroded.
  • High inflation in the 1980’s, and more recently the influence on seaboard property from the evolving apartment market locally, illustrate the shortcomings of this land tenure where the lessor is faced with a poor return while the lessee also has extreme difficulty when confronted with a huge escalation in rental that bears no relationship to the current land use and renders the improvements incapable of generating the required level of income.
Assessment of Leasehold Interest

  • Components that together make up the saleable lessee’s interest include;-
  •  The improvements component
  • Present Value (PV) of the annual rental difference between the actual rental and what it would be if renewed now; PV of that annual sum for the unexpired period of the current rental term, assessed at a moderate investment return (pre tax), say 8.0% currently.
  • If the lease has a fixed percentage rental (5% is common) that is below the normal rack-rental % applicable for that type of property, then some allowance is required (similar basis to the above) for the beneficial rental saving that difference generates.
  • The preceding largely relates to the dynamics of rent and market over the balance of the current term; value inputs may also be required to account for the lease dynamics on into the future. So in addition to the preceding there is a further component called ‘good will’ or ‘value of right of renewal’. This is a subjective element relating to the perceived use of the lessor’s capital at a favorable rate (rack-rent percentage vs. cost of capital); this applies especially with a 21 year term without rental reviews, and at times of high value growth. The value is established by analysis of leasehold sales and applied as a percentage of the freehold land value. Recent sales in this downturn have indicated 0% to negative, whereas in better times a component of possibly 30% is indicated for standard industrial property.


Conclusion

  • Leasing arrangements work best between the parties when the market remains stable (may still be steadily changing) and allows the lessee’s improvements and business activity to remain relevant as the ‘highest and best use’ activity for a long period.
  • However markets do evolve and force change in land use which is not all bad. Freehold property in that environment has more ability to make transitions in a managed fashion with less time pressure because of not having the rental burden and having access to all of the property equity coupled with better options for financing redevelopment. A leasehold property that is underperforming with the possibility of lessee insolvency, contrasted with an impossible rental burden is a disaster for both parties.
 
SUBSCRIBE NOW
Receive a free subscription to our Morice newsletter
First Name
 
Last Name
 
Email