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Taranaki Newsletter - December 2006

13 December 2006

Long Term Ground Leases

In the main, land in New Zealand is held under freehold tenure. There is however a range of leasehold land in most categories including residential, commercial, industrial, and rural, extending from high value coastal to central city commercial and high country pastoral land. In most cases leases are for relatively long periods (ten to twenty one years) and are perpetually renewable, offering the tenant security of occupation as long as the rent is paid and the lease conditions are adhered to.

Generally leasehold land is held under Public Body or 'Glasgow' leases, these are usually for twenty one year periods renewable in perpetuity, with the rental reviewed at the start of each lease term. In Taranaki leasehold land includes leases known as Waitara Harbour and Borough Endowment, Urenui, Onaero, West Coast, Regional Council, and Whiteley, together with a small number of private leases.

The lessee owns the improvements (i.e. buildings, site landscaping, section development) and pays an annual ground rent for the use of the land. The lessor owns the land but gives the right to use and occupy the land to the lessee in return for rent. When purchasing a leasehold property the buyer obtains the right of occupation of the land as long as the rent is paid, and he or she should understand all aspects of the lease including the timing and procedures relating to rent reviews and the use the land can be put to. The value of the lessee's interest will vary during the term of the lease. It is low at the time of rent review when the rent is at market levels, then grows as time goes by and the rent under the lease becomes much lower than the market rent. The value of the lessee's interest decreases towards the end of the lease term, when there is anticipation of a rent increase on review. Often during the mid period of the lease when the rent is below the market, purchasers can be convinced that the lease makes little impact on the value and accordingly pay a price for the lessee's interest which may be too high.

As rent reviews occur infrequently the increase at renewal can be significant and should be planned for. There have always been tensions in this leasehold land system as each rent review brings about competing perspectives, the lessors seeking the maximum rent after a long period of no rent increase and the lessees endeavouring to protect their interest by keeping the rent at the minimum level.

Although there have been some problems in the past, it was not until the 1980's following rapid inflation, that it became apparent that long term leases had disadvantages to both parties, particularly for residential land. The most obvious was that the lessor was receiving a declining return for the ownership of the land with no rent increase over a prolonged period while on the other hand, when the rent was reviewed, the lessee faced a large increase in rent.

So how are ground rents calculated?

Firstly the asset leased must be determined. With most ground leases rents are based on the unimproved land, this being the 'sale value of freehold land as if no improvements of any description had ever been carried out'. The unimproved land is the asset that is leased. This is the land set within the existing environment or neighbourhood but assumed to be devoid of all improvements and therefore in an unimproved state or condition. Therefore rent is assessed on what the land was like when it was first leased and excludes

• improvements on the land, these are structural improvements including houses, other buildings, and fences
• any improvements to the land. These are developmental improvements including excavation, access, and retaining walls.

Having established the asset base being leased, consideration then turns to the appropriate rent comparisons or methodologies. The availability of open market comparisons is restricted but there is a body of case law with legal precedents that establish the principles to be followed.

Assessment Methods

There are two commonly used methods for assessing the ground rent for land excluding any improvements:

A. Classic - this involves comparing the subject property with other properties where rents have been fixed by the market so that the ground rent is arrived at after making relevant adjustments for differences in lease terms, available use, location, size, time and physical attributes.

The direct comparison method is the predominant approach to setting market rentals (i.e. for normal leases or tenancies). Direct comparison has, however, major limitations when applied to ground rents due to the absence of an active. freely negotiated market and consequent lack of robust evidence.

B. Traditional - This involves applying a rental factor rate to the rental value (being in most cases the unimproved value). The rental rate is ideally sourced from other perpetual leased land by direct comparison.

To determine the unimproved value of the land and from that, the annual ground rent, the following steps are necessary:

• Assess the value of the land as it now is in the current market, unencumbered by the lease. This can be equated with land value.
• Assess the value of the land exclusive of tenant improvements which is the unimproved value.

The traditional approach has become dominant in the assessment of ground rent due to the lack of suitable comparables, the classic approach being more commonly utilised as a cross check. A third method - the economic or productive approach - is also utilised as a cross check from time to time, particularly where the highest and best use of the land is commercial.

The ground rent is determined on an objective test that relates to the land rather than to the parties to the lease.

Freeholding of Glasgow Type Leases

Glasgow leases in the main are 'silent' on the issue of freeholding. That is, when the leases were first created it was not anticipated that freeholding would ever occur. In more recent times the increasing difficulties and pressures placed on both lessor and lessee has created an environment where freeholding for all parties is becoming more attractive. In cases lessees have lobbied for some years to achieve freeholding with little success, while lessors have opted to retain the status quo. Particularly with residential land there is now a trend of freeholding being offered, and this is being readily accepted by lessees.

As there is no compunction to freehold on either party, there must be a joint agreement to alter or cancel the lease to enable freeholding to occur. As it is generally the lessee who wishes to freehold, and the lessor who sells their interest in the land, it is the lessor who is in control and makes the freeholding offer, if any. Similarly the freeholding price is set by the lessor, and this can be a wide range from the lessor's interest through to full market land value plus all expenses. There is no right or wrong price. Any freeholding offer is granted by the lessor at their freeholding price; the lessee simply has the option to accept or decline the offer. This is a decision for each lessee to make, dependant on their circumstances.

Summary

In conclusion, when dealing with with leasehold tenure, care should be taken to ensure that rights and responsibilites are understood. The rent fixing process needs consideration as does the impact of rent changes at lease renewal. As always appropriate professional advice should be obtained.

Back issues of the newsletter can be obtained from TelferYoung (Taranaki) Ltd
143 Powderham Street,
P O Box 713,
New Plymouth,
New Zealand.
email: taranaki@telferyoung.com

+ Mike Myers + Ian Baker + Adam Boon + Fintan McGlinchey + Monique Burr + John Larmer