Fixed or geared ground rent, a wasting head lease and a minimum unexpired term: how a lender turns a leasehold into a loan amount.
A lender sizes a loan on a leasehold property from the income left after the ground rent, valued as a wasting interest, and then refuses it outright if too few years of the head lease remain at maturity. On an illustrative office earning £2,000,000 of rent, the maximum loan falls from £20,000,000 freehold to £17,750,915 with a £150,000 fixed ground rent, 11.2 per cent less, and to £17,271,161 with a ground rent geared at 10 per cent of rents.
Worked in full in The Real Estate Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Long leasehold commercial property is common in city centres, on estates owned by institutions and landed families, and wherever a local authority kept the freehold. The building looks the same to a tenant; to a lender it is a different security. The ground rent ranks ahead of debt service, a geared ground rent moves with the property's own income, and the head lease is a wasting asset whose remaining term sets a hard limit on what any lender will accept.
| Input | Value |
|---|---|
| Occupational rent, net of irrecoverable costs | £2,000,000 |
| Freehold capitalisation yield | 6.00% |
| Long leasehold yield, freehold plus a margin | 6.25% |
| Unexpired term of the head lease | 125 years |
| Fixed ground rent (option A) | £150,000 |
| Geared ground rent (option B), share of rents received | 10% |
| Maximum loan to value | 60% |
| Minimum debt yield, on net income | 9.0% |
| Loan term / minimum unexpired term at maturity | 5 years / 60 years |
Every test starts from net income after the ground rent, because a head landlord who is not paid can forfeit the lease and with it the lender's security. Most lenders require the ground rent to be paid from the rent account before debt service, and the facility treats non-payment as an event of default.
Net income = occupational rent − ground rent
Fixed: 2,000,000 − 150,000 = £1,850,000 (the ground rent is 7.5 per cent of rent)
Geared: 2,000,000 × (1 − 10%) = £1,800,000
The freehold is valued in perpetuity, rent divided by yield. A leasehold interest has a finite life, so the net income is capitalised with a years' purchase for the unexpired term, at a yield a little above the freehold one to reflect the weaker title and the narrower buyer pool.
YP = (1 − (1 + y)−n) / y; in Excel =PV(6.25%,125,-1) = 15.99, against 16.67 in perpetuity at 6.00%
Leasehold value = net income × YP
Fixed: 1,850,000 × 15.99 = £29,584,858. Geared: 1,800,000 × 15.99 = £28,785,268
| Tenure | Net income, £ | Value, £ | Loan at 60% LTV, £ | Loan at 9.0% debt yield, £ | Maximum loan, £ |
|---|---|---|---|---|---|
| Freehold | 2,000,000 | 33,333,333 | 20,000,000 | 22,222,222 | 20,000,000 |
| Leasehold, fixed ground rent | 1,850,000 | 29,584,858 | 17,750,915 | 20,555,556 | 17,750,915 |
| Leasehold, geared ground rent | 1,800,000 | 28,785,268 | 17,271,161 | 20,000,000 | 17,271,161 |
Loan to value binds in all three cases. The fixed ground rent costs £2,249,085 of debt, which splits into two pieces. The leasehold yield and finite term alone, on the full £2,000,000 of rent, would cut the loan to £19,190,178, a loss of £809,822. Deducting the ground rent removes a further £1,439,263, about 9.6 times the annual ground rent: 60 per cent of a 15.99 years' purchase. The geared ground rent is larger today, £200,000 against £150,000, so it costs more debt at the outset, £2,728,839.
Take 20 per cent off the occupational rent and recompute the debt yield on each loan as originally sized.
| Tenure | Ground rent after the fall, £ | Net income, £ | Change in net income | Debt yield, before | Debt yield, after |
|---|---|---|---|---|---|
| Freehold | 0 | 1,600,000 | −20.0% | 10.00% | 8.00% |
| Fixed ground rent | 150,000 | 1,450,000 | −21.6% | 10.42% | 8.17% |
| Geared ground rent | 160,000 | 1,440,000 | −20.0% | 10.42% | 8.34% |
A fixed ground rent is senior leverage that nobody calls debt: it stays at £150,000 while the rent falls, so the lender's net income drops faster than the building's. A geared ground rent shares the fall, which is why both leasehold loans start at the same 10.42 per cent debt yield but the one sized on the geared ground rent ends with the stronger one. In a rising market the logic reverses, and a geared ground rent quietly takes a share of every rent review.
| Unexpired term today, years | YP at 6.25% | Value, £ | Loan at 60% LTV, £ | Unexpired at maturity | Lender policy |
|---|---|---|---|---|---|
| 125 | 15.99 | 29,584,858 | 17,750,915 | 120 | Meets it |
| 99 | 15.96 | 29,526,764 | 17,716,058 | 94 | Meets it |
| 80 | 15.87 | 29,368,273 | 17,620,964 | 75 | Meets it |
| 65 | 15.69 | 29,024,678 | 17,414,807 | 60 | Just meets it |
| 60 | 15.58 | 28,820,968 | 17,292,581 | 55 | Fails: no loan |
The capitalisation barely notices the difference between 125 and 60 years; the lender's policy does. The constraint on a shortening head lease is a cliff, not a slope, and it arrives when the term remaining at loan maturity drops below the lender's floor. The practical consequence is that a lease extension or regear with the freeholder is often worth more to the owner as financeability than as value. In practice the market also applies a wider yield to short leaseholds than this single-rate sketch, so the real value curve falls faster below about 80 years.
Sizing the leasehold as if it were freehold: debt yield on the occupational rent, value at the freehold yield. That produces the £20,000,000 loan, £2,249,085 too much. On the true figures that loan runs at 67.6 per cent loan to value and a 9.25 per cent debt yield, not the 60 and 10.00 the credit paper shows. The second mistake is to read the ground rent as fixed when the head lease has its own review, often upward only or to a share of market rent. Read the head lease before the occupational leases; the general sizing logic is set out in how to calculate the maximum loan on a commercial property, and the freeholder's side of the same income in how to value a commercial ground rent.
Deduct the ground rent, value what is left as a wasting interest, and check the unexpired term at maturity before anything else. Here a 7.5 per cent ground rent removes 11.2 per cent of the loan, a geared one behaves better in a downturn, and below the lender's term floor there is no loan at all. The sizing and exit-test model for your own loans is with the free workbook for this case.
Yes. The ground rent is paid before debt service, because non-payment can lead to forfeiture of the head lease and loss of the security. On an illustrative £2,000,000 rent with a £150,000 fixed ground rent, the debt yield is tested on £1,850,000, and the freehold-style figure of 10.00% on a £20,000,000 loan is really 9.25%.
Lender policies vary, but most set a minimum unexpired term at loan maturity. With an illustrative 60-year floor and a five-year loan, a head lease with 65 years left just qualifies and one with 60 years left gets no loan, even though its value is only about 2.6 per cent lower than at 125 years on a single-rate capitalisation.
It costs more debt today if it is larger, but it shares a fall in rents. After a 20 per cent rent fall in the illustrative case, net income falls 21.6 per cent under a £150,000 fixed ground rent and exactly 20.0 per cent under a 10 per cent geared one, leaving debt yields of 8.17% and 8.34%.
This article is one calculation from The Real Estate Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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