Leasehold Valuation: YP Model Analysis

Overview of the Paper

• The study empirically investigates the extent to which the YP[Dual rate] model for leasehold valuation reflects market agent behavior in England.
• It systematically examines the impact of the YP[Dual rate] model on leasehold valuations.
• The research adopts a qualitative approach, conducting face-to-face and phone interviews with 105 leasehold interest purchasers in Cressington Heath, Liverpool, in 2012.
• QSR NVIVO 10 was used to code the data for analysis.
• Purchasers of leasehold interests do not typically make provision for an annual sinking fund (ASF) in practice.
• Borrowing/debt capital is used to procure property, followed by amortization of the loan.
• Focusing solely on the ASF method is too restrictive, as there are alternative provision approaches.
• Using the model for short leases leads to significant undervaluation, especially when taxation is factored in.
• For very long leases, the specific model (YP[Perpetuity], YP[Single rate], YP[Dual rate], or YP[Dual rate adjusted for tax]) used has little impact on the resultant valuation.
• The research covers statutory and non-statutory valuations like purchase, disposal, rental, insurance, mortgage and company accounts

Traditional Valuation Approaches

• The text outlines five main traditional approaches to valuation
• Comparative approach
• Investment/income approach
• Profits approach
• Cost approach
• Residual approach
• One contemporary approach: hedonic pricing method
• YP[Single rate] and YP[Dual rate] models are often used to value Freehold and Leasehold interests respectively
• A leasehold interest is a wasting asset as it ends at some point in the future

Annual Sinking Fund (ASF)

• The adoption of the YP[Dual Rate] model is on the assumption that leasehold purchaser will set aside an amount from profit rent, which is the an investment for ASF, to recoup the leasehold interest purchase at the end of term
• This would, enable them to purchase another property to remain in the same financial position as a Freehold purchaser

The Debate Surrounding the YP[Dual Rate] Model

• The appropriateness of the YP[Dual Rate] model in leasehold interest valuation is debated.
• Several countries, like Australia and the US have closed the debate and do not use the model
• The UK traditionally values leaseholds using the YP[Dual Rate] model.
• In the UK, there is ongoing disagreement between advocates of the dual rate principle and those of the single rate principle.
• Arguments for and against the model's use in England are often based on personal opinions or theoretical analyses without empirical evidence.

The Paper's Aims

• To investigate if the use of the YP[Dual rate] model reflects real-world conditions
• To determine whether the choice of model (YP[Dual rate] or YP[Single rate]) significantly affects leasehold valuation outcomes

Research Methodology Details

• Qualitative research methodology was used
• A case study approach was used to study Cressington Heath in Liverpool
• 105 leasehold purchasers were selected to be interviewed in 2012

Analysis of the Models

• Cox (1853) stated the most important factor to consider in leasehold valuation was the duration
• Freehold would be more valuable with gradual return to the purchaser over the duration
• Mackmin (2008) notes that the use of YP [Single rate] seemed well established in the C19th which rolled into the C20th
• Webb (1909) argued that when a leasehold interest is bought, it may be desirable to provide for the continuance of the income from the interest after the expiry of the lease term
• Webb observed that it will be necessary to form a sinking fund by putting aside a certain amount each year to accumulate with interest till the end of the term.
• Smith (1926a) stated leaseholds are terminable interests and purchasers need to recoup the purchase price when the lease expires by setting aside a portion of the income to create a sinking fund

On calculation of premiums

• The YP[Dual rate] model was being advocated as tool to calculate premiums
• The calculation should allow for 6 percent interest on capital and also provide for redemption of capital at (say) 3 per cent

Computing Leasehold Interests

• Allowance has to be made for the fact that the investor pays tax on capital and income

Shapiro stated that

• When an investor buys a leasehold interest there is one factor that will not be met in a freehold interest, namely that one day the buyer’s interest must cease and the buyer will have no further interest in the property; if the buyer obtains a further lease in the property at market rent to follow the expired lease, that will be a new lease with no market value

Survey findings

• 28.6% was sole ownership, where the title was in the name of one person
• 71.4% was joint ownership, where the title was in the names of two persons.
• Most participants purchased their properties by mortgages from banks and the mortgage period ranged from 25-30 yrs
• LTV ratio ranged from 70-90% implying that the equity contribution or deposit of mortgagors ranged from 10-30%.
• 81% of the respondents participated in this market

The HomeBuy Direct Scheme

• The government through HCA and participating UK house-builders like Redrow and Bellway offer financial help to first time-buyers to purchase new homes
• The scheme is called HomeBuy Direct and its primary objective is to make new homes affordable to potential purchasers
• The criteria include; annual income should be below £60,000 and applicants should not already own or have owned a property
• Both HCA and a house-builder provide equal equity loans up to 30% of the full purchase price which is paid to the mortgagee.
• The Purchaser deposits 5% of the remaining amount
• The equity loans from HCA and the house-builder are interest free for the first five years, after which an interest of 1.75%, rising annually by the Retail Price Index plus 1 is expected to be paid.
• With effect from April 2013, house-builders no more contribute equity under the scheme and so the equity loan is provided by only the government.
• Ground rent for the leases purchased ranged from £200 – £750 per annum
• Term of all the leases was 999 years with a commencement date of 1st January 2006
• Purchase prices ranged from £124,995 to £252,995

Future considerations

• 9.5% of the purchasers responded that they did not need to be concerned about it now since the future will take care of itself, with the saying “I will cross that bridge when I come to it”.
• Some intimated their plans on using debt capital in the future
• 98.1% of the respondents were unaware of the ASF method

The PV£1 concept

• One can make provision for an amount of £100,000 that is to be spent in 10 years' time by discounting £100,000 at an appropriate interest rate and then investing that discounted lump sum to accumulate to £100,000 in 10 years' time
• The amount to be invested today at 6% to accumulate to £100,000 in 10 years time is £55,840. The impact of inflation can be incorporated
• A leasehold purchaser could hold a portfolio of investment vehicles
• Supporters arguments are for the replacement of the original capital but such a replacement deals with historic values
• The theory does not factor in inflation

Table 3 analysis, YP Factors

• Short leases will have different values depending on the model used
• Longer leases, values become similar regardless of the model

Conclusion

• Bidders in practice, do not use the ASF theory
• There are other techniques that can be used but the focus in the literature is on only the ASF
• The ASF theory totally ignores the impact of inflation even though it is a reality
• For very long leaseholds, it does not actually matter which model is used as the resultant valuation will be the same
• Taxed dual rate leads to undervaluation for short leases
• The YP[Dual rate] model should be declared defunct