UK: The Ban On Landlords Charging Ground Rent On New Residential Leases Applied To Retirement Homes From 1 April 2023 – What Does This Mean For The Sector?

The abolishment of ground rent in residential long leases comes as part of a package of Government reforms designed to curtail unfair practices in the leasehold market, which we explored in our previous briefing. From 1 April 2023,¹ this applies to all new leases granted with a term of more than 21 years in the senior living sector, though will not impact existing ones. The changes, brought about by the Leasehold Reform (Ground Rent) Act 2022 (the Act), have necessitated developers, investors and owners of retirement housing reforming their existing leasehold structures, which have typically relied upon ground rent as a way to recoup the enlarged capital costs of constructing enhanced communal spaces within retirement schemes. This is despite initial indications from the Government as part of its original consultation that the sector would be spared from the reforms owing to the negative impact this would have on the viability of retirement schemes, and ultimately, their supply.

1. How does the Act work?

The Act does not have retrospective effect. It applies only to newly created long residential leases from 30 June 2022, when it came into force, and from 1 April 2023 in the senior living sector as a result of transitional provisions. The retirement properties to which the provisions apply are those whose residents are 55 years old or over and let for a term of 21 years or more. The Act works by substituting ground rents within long residential leases with a nominal "peppercorn" rent, with no financial value. If ground rent of any real value is charged by landlords and not returned within 28 days of receipt, the landlord has committed a breach under the legislation and is at risk of penalties, including fines of up to £30,000 per lease. Tenants are able to reclaim unlawfully charged ground rents plus interest via the First Tier Tribunal. Landlords are also banned from charging administration fees for collecting peppercorn rent.

2. Why and how does this impact senior living developments?

Senior living developments are unique in offering a level of shared space and services within their communities that require significant up front capital expenditure to build and are innately inefficient to run. This includes the use of residents' lounges, visitor spaces, eating, entertainment, leisure and care facilities, all forming a vital part of the retirement community and taking up a large amount of space – as much as 30% of floor space compared to mainstream residential schemes. If this space were replaced by apartments, assisted living houses or residents' bedrooms in the case of care homes, it would produce a substantial income, but – owing to the design and needs of the scheme and its users – none can be sold or let to recoup the up-front cost.

Ground rent has therefore been used in senior living schemes to generate an income stream for the landlord, either during the term of its residents' leases or from trading in the reversion, to off-set some of the increased cost of providing enhanced communal spaces and also the loss of income from being unable to maximise its lettable space. It has traditionally served a different purpose to the service charge which is operated for communal spaces and designed to deal with the day-to-day cost of their repair, maintenance and upkeep. There is already extensive legislation around the use and operation of service charges in residential schemes which ensures they are not profit-making, that the tenant receives genuine return for value, and that service charges are run in a reasonable and transparent way.

Ground rent came under scrutiny precisely because it is designed to reserve an income which sits outside of the annual rent payable for the tenant's demise and / or is payable in addition to the premium it paid up front on grant, without any protection from legislation equivalent to the rules that apply to service charges. From the Government's perspective, this left ground rent unregulated and open to exploitation in a way that other leasehold income streams were not. The inclusion of senior living housing within the reforms in particular is designed to ensure that purchasers of long leases in retirement accommodation benefit from the same protections against unfair practices as those within the wider residential housing market. As a policy decision, the retirement community is often categorised as 'vulnerable', and it did not make sense to exclude them from legislation which would otherwise have protected them from potential exploitation.

3. What has the impact in fact been?

The market has remained buoyant notwithstanding this seismic change. Market research in the sector indicates that, as a result of an ever-aging population, a nationwide housing shortage, and unprecedented demand on NHS services and beds, demand for senior living space – whether in the form of retirement / sheltered housing, integrated retirement communities or care homes – continues to outstrip supply, creating opportunities for developers and investors. The path to ground rent abolition had also been laid several years prior, so to some extent the sector had (notwithstanding its surprise inclusion) anticipated the change.

Largely speaking, the sector has been pro-active in restructuring its lease models to re-categorise its income streams. The up-front costs of providing enhanced communal spaces may now be recouped through the use of deferred fees, increased management fees, or charging a higher premium for the lease up front. In the planning stages, some investors considered charging an additional premium for the use of communal spaces specifically, though we have not yet seen this used in practice. Certain developers have implemented shared ownership as a model to allow residents to own a portion of their home but pay rent in relation to the balance. Licence arrangements have also been considered as an alternative to leasehold ownership but generally speaking go against the grain of the legislation which is aimed at providing better security for residential tenants. Rights for operators to buy back leases from residents or their families and sell them on (an option better suited to the integrated retirement community or assisted living sectors than to care homes) have also been explored.

The use of deferred fees or "event fees" in particular has received support from leading industry bodies such as ARCO (Associated Retirement Community Operators), following previous scrutiny by the CMA and Law Commission in their 2017 reviews. As we explored in our previous briefing, it is recognised as something which improves the affordability of retirement leases for tenants, makes them sustainable to run, and supports a high level of service provision maintaining quality within the sector (see ARCO's guide on event fees). It is also something the Law Commission, and ultimately the Government, acknowledged the benefits of (see conclusions of Law Commission's review and Government response), though changes in consumer legislation to regulate them and adherence to codes of practice regarding their use are anticipated in future.

The potentially negative impact of increasing premiums to cover off the developer's capital costs has also been well managed. The industry has experience of assisting tenants with the economics of acquiring their lease by providing them with options as to whether to pay more or less up-front costs coupled with ongoing fees. In the context of the abolition of ground rent and the resulting increase in premium (perhaps also coupled with event fees), this has meant providing the option of paying more up front with lower ongoing charges / deferred fees, or paying a lower initial premium with more ongoing charges / a higher deferred fee.

The sector has not experienced significant impact on lending. The Council of Mortgage Lenders, which supported action for leasehold reform, had already set parameters for its members around lending on leases with ground rents. This saw leases accepted as security where ground rent was set to predictable levels (for example, increasing in line with RPI). Major high street lenders already refused more 'onerous' lease terms whereby ground rents escalate at unmarketable rates.

That said, we are still six months shy of the legislation coming into force and the long-term impacts of removing ground rents from senior living lease structures is not yet clear. For schemes which are already generating income, the sector has not had to make any changes as the legislation does not have retrospective effect. For pipeline schemes or those at the pre-planning stage, scheme viability will come into sharp focus; the removal of ground rents means developers are now working with tighter margins, both in terms of re-sale and the longer-term holding of assets. Without the increased costs being passed on to consumers in order to recover margins (which market research will dictate), developers will need to look at other ways to make cost savings, or else alter the consumer profile of their end users and the areas in which they are proposing to build. The inability to sell off the residual income received from ground rent to third party investors also limits the developer's return on investment, and may also de-value the freehold reversion itself, given it can no longer be passively traded in. It remains to be seen if developers will respond by reducing the footprint of their communal spaces to reduce costs (space being something it is coming under pressure to reduce and / or reconfigure elsewhere (see our recent article on bio-diversity net gain requirements, which are limiting development space) and if this will have an impact upon the desirability of the scheme.

4. What should we watch out for?

The legislation abolishing the use of ground rents in residential long leases comes as part of a wider Government initiative to address 'onerous' lease terms and overhaul the leasehold system in a way that provides greater transparency and fairness for tenants. We are seeing the effects of this in other residential real estate spheres with the presentation of the Renters' (Reform) Bill in Parliament on 17 May 2023, which abolishes section 21 rights to evict tenants on 'no fault' grounds, which (as discussed here) will fundamentally alter the economics and risk profile of land ownership in the residential sector. We expect to see continued scrutiny of leases for excess charges, non-traditional costs, or other potentially "unfair" terms, as well as a push towards commonhold ownership as an alternative structure for tenants to own and ultimately control the spaces shared between them in large residential schemes. We explore whether commonhold ownership is a good fit for the senior living sector later in this series.

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