Introduction
The premium is the price you agree with your freeholder to extend your lease or buy your freehold.
Extending your lease increases the value of your home, so the amount you pay is an investment that will usually be returned to you when you sell.
There are three different components that make up the premium: reversion, ground rent and marriage value.
Premium Components
Reversion
Short Answer
The first component is to compensate the freeholder for the fact they won’t receive your flat back when your current lease ends. The basis of this part of the calculation is the current value of your property and the number of years remaining on your lease.
Long Answer
When your lease ends your freeholders are expecting to receive your valuable flat back. However, when you extend your lease, your freeholder won’t receive it back for another 90 years.
Reversion is the amount you need to compensate your freeholder now, for the loss of your valuable flat in the future. As you are paying the freeholder now rather than in the future, the amount you pay is discounted to take this into account.
For example, imagine you own a flat with 80 years left on it's lease which is worth £200,000. If you deposited £4,000 in the bank today at 5% a interest rate and left it to grow for 80 years it would grow to be about £200,000. For this reason, it is considered that £4,000 today is the equivalent value to £200,000 in 80 years. So, you’d need to pay your freeholder £4,000 now to compensate for the loss of £200,000 in the future as part of your lease extension.
Due to a tribunal ruling in 2007, the figure of 5% is nearly always used for the ‘reversion rate’.
The freehold-owning community would like this rate to be set at a lower level - because it would increase the size of the premiums. If the rate was set at 4% the amount you'd need to deposit in the bank now to be worth £200,000 in 80 years would be more like £8,500 - so this would have a big effect on the premium.
Ground rent
Short Answer
The second component is to compensate your freeholder for loss your ground rent, as extending your lease reduces this to zero. It is worked out in a similar way to the ‘reversion calculation’ and depends on how much your ground rent is and the number of years remaining on your lease.
Long Answer
Extending your lease reduces your ground rent to zero, so you’ll need to compensate your freeholder for the ground rent payments they will no longer receive each year.
This is calculated in a similar way to reversion, where you need to compensate for each missed ground rent payment. However, as you are paying your freeholder now rather than in the future, the amount you pay is discounted to reflect this.
The go to ‘capitalisation rate’ has historically been between 6.0% and 7.0% for ground rents with fixed rises, but at Homehold we routinely compile evidence from auction sales to challenge this.
Marriage Value
Short Answer
The final component is to compensate your freeholder for the added value a lease extension gives to your flat. This only contributes to your premium if your lease is less than 80 years.
If your lease is less than 80 years, you’ll need to pay 50% of the profit made from extending your lease to your freeholder. This calculation is based on how much your flat is worth with a short-lease, in comparison to what it would be with long-lease.
Long Answer
When you extend your lease, you add value to your flat. Whatever it is worth now it will be worth more in the future.
If your lease is below 80 years (even by a day), you have to pay half of the hypothetical profit you make to your freeholder and this is called "Marriage Value".
The way the difference in value between a flat with a short lease and a long lease is calculated is using something called a "Relativity Rate". The relative value of a flat with 70 years on a lease might be 85% of a flat with a 160-year lease.
This Relativity Rate is often calculated using a graph and this is what our Lease Extension Calculator is based on.
However, if there have been sales of flats similar to your own with short leases, your freeholder might want to use these to calculate the Relativity Rate, rather than the graphs. If these flats have sold at low value, this can make your lease extension more expensive. Usually we find that if you live in converted property or on a small development, there is not likely to be any short lease evidence. If you live on a large development with lots of flats similar to your own, it is more likely. We will know more when we do our valuation.
Conclusion
As your lease gets shorter, the premium will increase – so it makes sense to extend it sooner rather than later.
Your lease will suddenly get much more expensive when it drops below 80 years so if you are anywhere near this point, please get started with your lease extension as soon as possible.
