No one needs any reminder that the housing market is broken. The CPS, a right wing leaning free market think tank put out an article only yesterday which quite rightly pointed out that when people inveigh against evil capitalism and its effect on the housing market, they’re missing the target. The housing market is very far from being a free market. Arguably housing is actually an example of how gerrymandered, broken planning systems eventually turn into rent seeking mafias.

Free market it ain’t.

But we also need to accept that when some capitalists are allowed free rein, they frequently get it wrong, especially in the housing market. Top of any list must be the scandal of the perpetually doubling leaseholds sold on new residential house builds, largely in the North East.

Quite why the builders, with their fat margins, ever thought this was a good idea is entirely beyond me. They make enough money – and sit on enough banks of land – not to need this virtually criminal racket. There’s a damned good reason why we have leasehold regimes, and in the commercial space (student accommodation and office blocks) most leaseholders are entirely voluntary participants. In essence, it’s a form of financial engineering involving all parties.

Leaseholds for residential properties have always been a more questionable activity, especially when vast corporate ground rent investors fail to provide a good service. But over the years, the rules on residential leaseholds have been tightened and in my experience, most resi leaseholders (though not all) are fairly satisfied – and the rents fairly reasonable (most of the time).

And then comes along this bogus implant: 10-year leaseholds on new properties, doubling in value at each valuation point. It’s profiteering and rent seeking behaviour in the extreme and the government is quite rightly going to put a stop to it. Not before time. This is precisely the kind of behaviour that makes Corbynomics so popular with so many. My own personal view is that new leaseholds should be banned for all new residential properties with the exception of large flat complexes where a form of common ownership could be brought in.

Sadly, the whole rumpus about these ridiculous leaseholds has got in the way of the more interesting commercial leasehold story – where ground rents are accepted business practice and make a great deal of financial sense.

I’d thus assumed that most investment funds investing in this space were avoiding the more egregious residential options. Unfortunately, this doesn’t seem to be the case.

A few years ago, I wrote a fairly positive piece about a small UK listed fund called the Ground Rents Income Fund plc, which is a listed real estate investment trust (REIT) investing in UK ground rents – GRIF was launched in 2012 and owns a diversified portfolio of ground rents, valued at £143 million at 31 March 2017. At the time, I noted that it ticked many boxes. It seemed to be providing a stable though low-income return over the very long term – most of which seemed to be index linked. It was never going to be an exciting fund but it seemed dependable.

Over the last few weeks, that logic has been turned upside down. GRIF’s share price has slumped sharply as the leasehold scandal has intensified. Yesterday we found out a little bit more about the impact via a corporate update from the fund’s managers. I had assumed that the fund wasn’t invested in resi leases but now we discover that leasehold houses account for 11% by income of the Company’s portfolio.

The good news is that the fund does NOT have any ground rents which double every 10 years in the resi space. Most of the assets seem to be perfectly straight forward ground rents which increase by a few per cent a year (index linked).

So, what IS in the portfolio?

According to the fund “most of the Company’s portfolio (69.8% by income) is invested in ground rents which increase annually in line with indices, particularly the Retail Prices Index (RPI). Of the remainder, 18% by value and 17% by ground rent income are attributed to doubling ground rents, of which 4% of the ground rent income is derived from three 10-year doubling assets. None of these three assets with 10-year doubling ground rents do so in perpetuity – they double a maximum of three times before reverting to having either no further review or an index-linked review cycle. The rest of the doubling assets in the portfolio are 25, 33, 35 and 50-year doubling assets, which equate to compound increases in rent of 2.8%, 2.1%, 2.0% and 1.4% per annum respectively.”

GRIF’s total portfolio – breakdown of ground rent review pattern

Type of rent review % of income
Index-linked 69.8
Fixed uplift 7.3
Flat (no review) 6.5
Doubling, 25 years 10.0
Doubling, 10 years 4.0
Doubling, 50 years 1.8
Doubling, 33 years 0.4
Doubling, 35 years 0.2

And the residential exposure? According to the managers “of the total number of units in the portfolio, 15% are houses, which generate 11% of total ground rent income. The average ground rent on the leasehold houses is approximately £110 per annum and none are subject to 10-year doubling review patterns.” In the great scheme of things, a ground rent of £100 per annum doesn’t seem too egregious.
In terms of yearly increases in rents “66.7% by income of the leasehold houses adjusts in line with indices, with only 2.7% containing doubling reviews on a 25-year review pattern. The balance of 30.6% is split between leaseholds with fixed adjustments (3.6%) and those which do not increase (27.0%).”

GRIF’s portfolio of houses – breakdown of ground rent review pattern

Type of rent review % of income
Index-linked 66.7
Flat (no review) 27.0
Fixed uplift 3.6
Doubling (25 years) 2.7

What’s the bottom line?

Overall the good news here is that the fund does NOT seem massively impacted by the egregious resi market. Given that low exposure, it does though seem slightly strange that the NAV is going to take a not insubstantial hit – the managers estimate that the portfolio may now be worth approximately £5.5 to £6.0 million less than as at 31 March 2017. This would lead to an NAV per share of approximately 132 pence. Given the small exposure to residential, this seems quite a big number?

The fund has also announced that it “will provide a further update once it has received the next scheduled valuation of the portfolio by Savills, its external valuer, as at 30 September 2017”.
My own hunch would be that the fund might possibly move away from all residential leaseholds – it’s just too toxic in this environment for a public fund. The market for commercial ground rents is much more popular and less likely to be hit by changes in the regulations – it’s also the fund’s core business.

The downside of this is that the valuation of many resi ground rents may decline as bigger outfits sell out, largely for reputational concerns. This might also mean that more long-term capital is redirected into the already saturated and fairly limited commercial ground rents market, pushing up values and pushing down yields. Perhaps, more obviously, because of the uncertainty about any future legislative changes, we could see quite a bit of “uncertainty over the valuation of the portfolio’s assets going forward” as Numis puts it.

But there might also be some upside. The first is that the government will get a grip and crack down on bad practice – in IMHO the big builders should be forced to pay up for their bad practices. My sense is that there won’t be radical changes within the commercial leasehold space which will mean that after a year or so, this very specialised market will bounce back again.
Crucially the contrarian in me spies an opportunity to move into this fund and its shares while they trade at a discount. With the share price at 124.5p it’s at a 5.7% discount to the estimated NAV of 132p according to Numis. Over much of the last few years, the fund has traded at a consistent 5% (but as much as 13%). I doubt the fund will trade at a double-digit premium again anytime soon, but a move back into premium could be a possibility at a later stage. If so, and assuming no other bad news, investors might pick up a valuable 10% turn on the fund and still bank the steady income.