It’s not easy to begin investing in property; there are very high costs involved which have the effect of barring many prospective investors from entering the market. In economic terms, this can be explained by the balancing of supply and demand. If supply remains constant, as demand increases, so does price.
This is not really of much interest to the person who is very keen to begin property investment but is having trouble finding the capital to invest. This is where ground rents can prove to be worthy of some consideration as an alternative. The term is used mainly in England, Wales, and Ireland. The USA has similarities to this system but differs on some points. In Scotland, the term ‘Ground Annual’ is used instead, this system in basically similar to the ground rent one as the interests can be assigned and sold fairly freely.
A Ground Rent is the freehold interest (which is the outright ownership) on a parcel of land where a second party (the Leaseholder) owns a long-leasehold interest. The Leaseholder will be the owner of any building on the land and subsequently will be the recipient of any associated rents generated by the building through a tenancy agreement. He will pay the ground rent on a regular basis to the freeholder for the continued use of the land. A Ground Rent can be on both Residential and Commercial property. As the term suggests, it is rent payable for the use of the ground. The Freeholder will not be the owner of the building that is situated on the land.
Ground Rents are valued in a similar way to most other investment properties. They will have a lease in place of between 21 and 999 years. A period of 99 years is fairly common. When the lease interest is approaching expiry, the Ground Rent value will tend to increase because when a new lease begins, the ground rent might be set at a higher rate (due to inflation) making it more desirable to potential purchasers. The leaseholder is also very likely to have to pay the freeholder a premium to extend or renew the lease. Any likelihood of the leaseholder defaulting on the ground rent payment will have the opposite effect though, so a purchaser will be looking for what is known as a ‘strong covenant’ (meaning the leaseholder is unlikely to default on the payment). If the leasehold interest is not due to expire within the next 150 years, the ground rent value will be quite low in comparison to agreements with less than this to run.
A Ground Rent can be purchased at a property auction (Savills and Cushman & Wakefield in particular, often auction ground rent investments). In common with other property auction lots, a guide price is provided prior to auction. The value of the ground rent investment is likely to be around 10-20 times the value of the annual rent paid. This would be an initial yield of around 5%-10%. So for example if the annual rent payable to the freeholder is £350, then a guide price of £7,000 might be set. This would provide a yield of 5% (yield is calculated by expressing the annual rent as a percentage of the capital value). Often, an investor has the opportunity to purchase a set of ground rent investments, for example on an apartment block with many units. The leaseholder will be obliged to pay ground rents to the freeholder for each individual apartment.
As with almost all investments, a return of between 5% and 10% is typical. Purchasing a Ground Rent investment will not make you rich overnight and is not likely to provide a rate of return that is greater than most other investments. What it will do however is provide a method of property investment that allows the investor to purchase property interests in far smaller ‘units’ than a whole house or flat. A ground rent can also provide an excellent way of diversifying an existing portfolio.
A ground rent can provide a very secure investment. If the leaseholder defaults on the rent, the freeholder has the right to take possession of the land and any buildings upon it (depending upon the agreement terms). However, investors usually simply want a passive rent income, not the hassle of trying to get a new occupant for the property.
Ground rents are not without their shortcomings though. One of the major attractions of property investment is that the freeholder has a tangible investment, the value of which can be increased through improvement. A ground rent does not allow this as it amounts to an interest in property that cannot really be physically observed. Improvement to the ground itself is not particularly possible; the building belongs to the leaseholder so what can the ground rent holder do to increase the value? Nothing really.
Another shortcoming of Ground Rent investment is the scale of administration involved when running a substantial portfolio. The work involved in rent collection and any legal obligations that the freeholder might be obliged to carry out can seem disproportionate to the amount of annual rent collected making ground rents one of the most illiquid investments imaginable. Property investment companies that specialise in ground rents will have rent collection and billing as automated as possible for the purpose of improving cost-effectiveness.