Ch.16 - Freehold vs Leasehold

HI

My question relates to the second last paragraph on p.8 of Ch.16.

Why does leasehold have a higher initial rental yield than freehold?

Thank you!

 

I am guessing that: rental yield= rent/ price. Since in a leasehold you dont have to pay the price of a property (which you would under a freehold) the rental yield should increase. Under a leasehold however you do have to pay ground rent to the original owner. this coupled with the fact that there's capital loss when held to the expiry of the lease( as opposed to chance of capital gain) should mean that running yield should be higher than under a freehold

 

Would you happen to have a formula for calculation of rental yield in leasehold? I'm struggling in putting this into context myself since there is no initial price paid for leasehold property except the ground rent.

 

Actually no. But I have been searching around and it seems that in most situations under a lease, an upfront lump sum has to be paid to the owner and a rent(which is quite low) needs to be paid every year. The lump sum amount is the price for the lease and this amount is obviously going to be lower than the price under a freehold. So by the same formula, yield= rent(net of that paid to the owner)/ price for lease, the rental yield would be higher under a leasehold because of the lower price.

The core reading hasnt given much details about this though, so I can't be sure.

 

I'd simply consider that for a leasehold asset you're the lessee of the asset only for a limited amount of time (leasing period) after which the asset goes back to the original owner (lessor). On the contrary, in case of a freehold you are the owner of the freehold asset in perpetuity (as it holds for equity shares). E.g. if you buy as a investor two properties in London at the same price, one leasehold and the other freehold, you will ask an higher rent for the leasehold property because you have less time to make up for your investment before the property goes back to its true owners.

 

Thank you for your insights guys!

I have thought about this a bit, and I am now wondering why does it say higher initial rental yield? Does this imply that the level of rental yield will change over the course of the contract? Is it because there will be no capital gain at the end of the leasehold contract?

Also, in terms of a formula for rental yield I have thought about it this way (not sure if its correct!!)

• Leasehold = Rent received from renting out the property to third party / Price of leasehold (i.e. Rent payable to the freeholder + any other fees/costs paid for the lease of the property)
• Freeholder = Rent received from leaseholder / Purchase price of property

So considering the above "formulae", could it maybe help to explain a change in rental yield over time.

Eg. For the freeholder the total rent received at the start of the contract is small relative to the purchase price of the property. While closer to the end of the contract, the total rent has increased compared to the fixed purchase price. So rental yield should increase over time for the freeholder?

But for the leaseholder, both the rent received and the rent payable is expected to increase over time (roughly in line with inflation). So the rental yield is initially high (compared to freehold), but could be expected to remain at the same level other over time (while rental yield on freehold increases).

Your thoughts on this would be great!

Thank you!

 

I like your formulas. I'd think about the "initial" in this way. A leasehold property close to its lease term (when goes back to the lessor) will be very difficult to market. E.g. take your London property: a leasehold property for 500 years lease term. You will get an higher rent yield for the first 450 years than a freehold property bought for the same price. However, the rent you will be able to get in the last 50 years of lease term will be lower. Because whoever sign the rent needs to consider that he or she can stay only for the next 50 years.

I've exaggerated the lease term here (where "initial" is 450 years) since we are dealing with London property. With shorter lease term (let's say 10 years), we'd be able to see the "initial" higher rent and then the "lower" rent at the end of the lease term.

 

But in this case, you will have to pay ground rent too. So the net income will be the difference between rent received and rent paid (and net maintenance etc). This may not be as high...