FIT has a 19-year unbroken track record of inflation-beating annual returns, continuous liquidity and low volatility.
Performance of trust vs index over 16 years
Source: FE Analytics
This chart contains information from the start of FE data.
What are the essential mechanics of residential ground rents?
A freeholder who typically owns the land and improvements (normally a house or flats on the land) sells a long leasehold interest (normally 99 to 999 years) to a leaseholder for an initial premium, providing the leaseholder with the right to occupy, subject to terms and conditions outlined in a lease. The leaseholder also has an obligation to pay a nominal annual rent. This ground rent may be in the order of 0.03 per cent to 0.15 per cent of the open market value of the lease.
For example, a 125-year leasehold valued at approximately £350,000 may be subject to an annual ground rent of £100 to £500.
The market value of a long-term ground rent (greater than 100 years) is typically calculated by applying a capitalisation rate of between 5 per cent and 6.5 per cent, being the equivalent of a 20-times to 15-times multiplier (or years purchased) of the ground rent, depending on the remaining lease term and review profile.
How can FIT consistently deliver over a 19-year period when other funds and investment classes have been unable to?
The income from a residential ground rent is highly secure, which in itself is very different to other investment classes.
In the event that a leaseholder defaults on their ground rent, they may forfeit their right to occupy under the lease, thereby having to hand back their very valuable property.
At that point, the freeholder owns the property on an unencumbered basis (with no lease or mortgage).
They are then able to issue a new lease for which they can receive a substantial premium and then receive an ongoing annual ground-rent income.
The freeholder’s rights rank ahead of any leaseholder’s mortgaging bank, which is why a bank with a mortgage on a leasehold interest will always step in and pay an outstanding ground rent, rather than lose its security through leaseholder default.
FIT’s average annual ground rent is only £121. It is this dynamic whereby the leasehold interest is often thousands of times more valuable than the rent (for example, highly over-collateralised) that ensures that the leaseholder is incentivised to pay their ground rent and consequently voids are a rarity.
This means that the income generated by FIT is highly predictable.
What is more, 75 per cent of FIT’s ground rents (by value) have inbuilt rental uplifts linked to RPI, property values or fixed uplifts. This has mitigated the impact of inflation and underpinned capital growth.
Isn’t real estate risky at the moment?
Given the long-term and secure nature of the cash-flows, ground rents on long leases have had no correlation to underlying residential or commercial property values over the last five years.
There are no voids but also no landlord costs for repairs, rates, insurance or taxes as these are paid by the leaseholders either directly or through a service charge.
Additional income can also be derived from tenants such as premiums for granting the extension of leases and license fees to make alterations to their properties.
Landlords may be responsible for arranging the insurance of the buildings and a share of commission earned on insurance premiums provides valuable additional income.
Lofts, roofs, car parking spaces and gardens may also offer value-add opportunities for the freeholder.
Unlike normal real estate investments, residential ground rents do not carry real tenant default risk – remember default on ground rent payments eventually equals forfeiture – and the asset is significantly over-collateralised, which delivers certainty of income.
There is also a high level of diversification due to the small lot sizes.
In a standard property lease structure, the shorter the lease, the less valuable the asset.
However with FIT’s residential ground rents, as the lease shortens the freehold interest becomes more valuable because, upon the expiry of the lease, the freeholder gains the full unencumbered reversionary value of the freehold.
The value of freehold ground rents is influenced by the outstanding term of the lease and both current rental income and future rental growth prospects.
Capital appreciation can be achieved from both rental growth and from shortening lease terms, which in turn increase the prospect of FIT receiving extension payments.
Ground rent values may also benefit from any "marriage value" when tenants seek to acquire their freehold from the fund.
In a climate of economic uncertainty, ground rents are set to become more attractive due to the high yields relative to the level of risk involved, over-collateralisation and their defensive and predictable nature.
In a world where sovereign risk and correlating gilts are valued at relatively low yields, FIT has protected investors’ real wealth far more effectively than gilts over the last decade.
Nigel Ashfield is managing director of TIME Investments and has also been the fund manager of The Freehold Income Trust since 2005. He was previously managing director of Close Brothers’ property division, where he worked for 10 years.