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.
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.
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 worth £265,000 with 100 years left on the lease. If you put £2,000 in the bank today at 5% interest and left it there for 100 years it would grow to be about £265,000. For this reason, it is considered that £2,000 today will be about £265,000 in 100 years. So, you’d pay your freeholder £2,000 now to compensate for the loss of £265,000 in the future.
Due to a tribunal ruling in 2007, the figure of 5% is nearly always used for the ‘reversion rate’.
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.
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.
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.
When you extend your lease, you add value to your flat. The difference between the value of your flat with a short-lease and the value it would be with a long-lease is called the ‘relativity rate’. For example, a flat with 70 years on a lease might be worth 85% of a flat with a 160-year lease.
‘Marriage value’ is the amount you need to compensate your freeholder for the profit you’ll make from your lease extension. This only contributes to your premium if your lease is less than 80 years.
The Leasehold Reform Housing and Urban Development Act 1993 states that the hypothetical profit from a lease extension should be shared equally between the leaseholder and the freeholder. So if you have less than 80 years left on the lease of your flat, you’ll need to pay your freeholder 50% of the profit made from your lease extension.
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.