The growth in leasehold ownership within the UK retail mortgage market is resulting in lease-related issues increasingly affecting lender clients. Walker Morris’ Karl Anders and Louise Power provide some practical insight for lenders.
Diversity in Low Cost Home Ownership options, coupled with economic pressures facing borrowers of all ages and across all socio-economic groups today, is resulting in mortgages increasingly being offered on leasehold flats, retirement housing, shared ownership arrangements, and so on. While leasehold has traditionally been the appropriate form of land ownership for properties within communal buildings and estates, a trend has emerged whereby housebuilders have sold new-build houses as leasehold properties.
The overall growth in leasehold ownership is resulting in lenders increasingly finding themselves having to grapple with issues affecting their leasehold securities – both in connection with shared ownership and conventional long leasehold properties.
Risk of forfeiture
Where a borrower defaults on monies due under the lease (usually service charges and ground rent), the first a lender hears about this is often when the landlord takes steps to forfeit the lease. Forfeiture can have catastrophic consequences for a lender’s security, in that it will extinguish it, leaving the lender with only an unsecured debt to enforce (unless it can apply to the courts for, and be granted, relief from forfeiture).
Faced with a threat of forfeiture lenders can be on the ‘back foot’ and are frequently left in the position of paying such charges (including substantial legal fees to the landlord’s lawyers), so as to ensure that the lease/security is not lost. However, this approach creates multiple risks for the lender:
- The customer may decide to rely upon the lender to repeatedly pay the landlord on its behalf, instead of making payments itself.
- There is an erosion of equity (and this is likely to be at a higher rate for interest-only mortgages).
- A lender can ‘sleep walk’ into a negative equity situation, as a result of multiple debits to the mortgage account.
- A landlord of a shared ownership lease (most likely a Housing Association) may refuse to accept continued payments from a lender and may bring its own possession proceedings to recover possession (for fear of erosion of equity and of being out-of-pocket if the lender takes possession and relies on the Mortgagee Protection Clause in the lease allowing it to staircase up to 100%). A vitally important point to note here is that such action by a Housing Association will ultimately result in loss of the security. This is because these possession proceedings are for statutory termination of an assured tenancy under the Housing Act 1988 and a lender does not have any right to apply for relief from forfeiture in these circumstances.
- Ongoing payment by the lender of customer’s lease sums can mask wider affordability issues. It will often result in the mortgage debt increasing and the customer’s financial situation worsening overall. This raises the question whether the lender is acting responsibly and treating the customer fairly.
- Another key issue is that payment of customers’ outstanding lease sums can (albeit somewhat paradoxically) lead to serious customer relationship issues. Through our own research we have discovered that, in the last four years numerous customer complaints have been upheld by the Financial Ombudsman Service following the payment by lenders of ground rent and service charges on behalf of their customers. Whenever a complaint is made, and whatever the outcome, significant management time and costs are wasted, and customer relationships and lenders’ reputations are adversely affected.
Currently, in many cases a lender’s options when faced with a potential lease forfeiture will depend on the approach taken by the particular landlord.
Some landlords (and their legal advisors) are aware of a lender’s need to contact its customer and to take legal advice on the options open to it. Such landlords/legal advisors may take into account the timescales involved in the lender doing this; others do not and instead use this delay to increase the level of legal costs incurred. Some law firms acting for landlords are fully aware of the propensity for lenders to pay up to protect their security and they use this as a viable business model. They operate by incurring legal costs and make payment of those costs a condition of agreeing settlement to avoid forfeiture. Some landlords/legal advisors also do not contact lenders until after proceedings have been issued (it is only at this stage that landlords have to make contact, under the requirements of the Civil Procedure Rules).
There may be an alternative option for lenders, which could preclude action by landlords in any event. In the usual course the mortgage lender receives a payment demand from the landlord and the lender then makes payment, so that its security is not left vulnerable to forfeiture or possession. The lender then adds any such payments to the mortgage debt. In due course, the mortgage account might fall into arrears as the customer’s repeated failure to pay sums due under the lease masks wider affordability issues. The lender will then pursue possession proceedings on the basis of mortgage arrears and a suspended order is very often likely to be made .
However, in many cases where a lender has been asked to make payments under a lease where forfeiture is threatened (or where a shared ownership Housing Association is threatening to commence Possession proceedings), lenders may be better served by following an alternative course. This involves seeking possession on the basis of breach of mortgage condition (the breach being the customer’s failure to comply with the terms of its lease), rather than/or even in conjunction with, action on the basis of mortgage arrears. It is likely that, on the facts of many of these cases, a lender should be able to prove that its security is at risk and that it should thereby be entitled to an outright possession order.
We already act for a number of retail lenders who have adopted an enforcement policy which involves seeking possession of leasehold properties on the basis of repeated breach of mortgage conditions where the customer fails to meet their leasehold obligations. These lenders have taken this ‘alternative approach’ in over 200 cases in which the security was at risk due to lease non-compliance. In a significant number of those cases the matter was settled on the basis of lease arrears being cleared by the customer. That not only resolved the immediate security risk, but also ensured that the customer fully understood, and took responsibility for, their liability to make lease sum payments going forwards. This approach has been a “wake up call” for customers resulting in them properly addressing lease and mortgage compliance, and affordability issues generally, where they may previously have been unwilling to do so. As well as resolving the security risk for the lenders, this has enabled customers to continue living in their homes.
The remaining cases were resolved by way of mortgage possession proceedings and the vast majority of those – some 86.14% – resulted in an outright possession order for the lender.
Risk of disclaimer
Another potentially quite worrying emerging trend over recent months is that of liquidators disclaiming headleases.
In a typical residential lease scenario, the ultimate landlord of a block of flats, is the freeholder; a management company holds a headlease; and then residents occupy individual units pursuant to a sublease, which is mortgaged to a bank. The bank’s security is therefore over the sublease interest. If the management company runs into financial difficulties and is placed into liquidation, it is possible that the liquidator might decide that the headlease is onerous property, in which case the lease can be disclaimed.
The effect of a disclaimer of a headlease is that the headlease effectively falls away, leaving the landlord and the subtenant with no rights against the head tenant (the management company). However the subtenant’s interest and obligations continue (and therefore so do the bank’s), just as if the headlease still remains in place. This is also particularly unsatisfactory because there is no direct contractual relationship between the subtenant and the freeholder.
From the lender’s perspective, the practical consequences are that it still has a legally valid security over the sublease, but there is no one directly responsible for the overall maintenance and upkeep of the block of flats and the value of the security can be significantly decreased. In addition, the borrower will only be entitled to remain in possession of its flat so long as obligations under the (now disclaimed) headlease are being met, yet the individual borrower has little or no control over that situation. Perhaps worse still, even then the freeholder/landlord may be entitled to forfeit at any time on the basis that its head tenant (the management company) is insolvent. In those circumstances, the borrower’s sublease (and therefore the bank’s security) is at risk.
This is clearly an undesirable situation to say the least.
Advice for lenders
Often the first that a lender will learn of this problem will be when it receives notice (either directly from the liquidator or via a borrower) that a headlease is being disclaimed. If and when that happens, a good practical tip will be for the lender to ensure that, as soon as possible, it finds out as much as it can about:
- The property in question (including over how many subleases in that building it has security).
- The head tenancy company (including in respect of how many other properties it has headleases and what they are; whether any of those have also been disclaimed; and whether/over how many of those the lender also has security).
When a headlease is disclaimed, affected parties can apply to the court to obtain a vesting order (and/or freeholders can prompt the process by applying to the court to invite affected parties to take vesting orders). Where a vesting order is granted, the subtenants effectively become the direct tenants of the freeholder/landlord – albeit that will be on the terms of the now-disclaimed headlease. It is important to note that there is a 3-month time limit for such applications.
So that the lender can be as well-informed as possible when it comes to considering its options, it should also:
- Obtain expert advice to determine the impact of the disclaimer on the value of the property and security and to ascertain whether the sublease has become ‘unmortgageable’. Valuation advice can also be helpful for demonstrating to the borrower that taking a vesting lease protects his/her investment and/or it can support any vesting lease application which may have to be made on behalf of the lender itself.
- Ascertain the terms of the now-disclaimed headlease.
From our experience, subtenants and lenders have, when served with notices of disclaimer, failed to appreciate that, while their legal interest in the sublease remains, the real impact relates to the value of that interest. The valuation advice we have received has been that sublease flats without a superior headlease interest would be unmortgageable and of little investment value. In addition, there are real practical difficulties as there would usually be no party responsible for the management, maintenance or insurance of the building, such interests typically being the responsibility of the head tenant.
On this basis, an early approach to borrowers to explain that their investment is already significantly diminished and the freeholder could seek to terminate their sublease by forfeiting the headlease or making his own application for a vesting order can pay dividends. This can help to ensure that borrowers quickly take the necessary specialist advice and/or allow lenders to make vesting order applications on their behalf (adding the costs of doing so to the mortgage account).
Overall, the key is to deal with matters quickly upon receipt of any notice of disclaimer in light of the potentially significant consequences and tight vesting order-application deadline.
 because reliance on mortgage arrears engages the court’s discretion under section 36 of the Administration of Justice Act 1970 to adjourn proceedings; stay or suspend execution; or postpone the date for possession, where the court considers that the customer is likely to be able within a reasonable period of time to pay any sums due under the mortgage