For landlords who own leasehold flats, rising service charges have traditionally been viewed as a profitability problem. Increasingly, however, they could become a mortgageability and property value problem too.
Every additional pound in costs ultimately reduces a landlord’s net return. But if service charges become sufficiently high to concern mortgage lenders, the consequences could extend considerably further.
Why Are Service Charges Increasing?
There isn’t one explanation. The make-up of charges varies significantly between buildings, but several areas have experienced particular pressure.
Buildings Insurance and Fire Safety
Buildings insurance is one.
Following Grenfell, insurers became considerably more concerned about the potential severity of fires in multi-occupancy buildings with combustible cladding and other fire-safety defects. Some insurers withdrew from parts of the market, while others reduced their appetite for high-rise risks.
The Financial Conduct Authority found that average premiums for multi-occupancy residential buildings increased by 125% between 2016 and 2021. Government guidance subsequently reported an average increase of 187% for buildings with identified fire-safety issues.
There were separate concerns around broker payments to managing agents and freeholders. The FCA subsequently introduced greater protections around fair value, remuneration and transparency.
So, while remuneration practices contributed to concerns about value, the underlying change in insurers’ perception of fire risk and the reduced availability of insurance were also fundamental factors behind rising premiums.
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Major Works Are Becoming More Expensive
Maintaining a block of flats inevitably involves periodic major expenditure. This might include:
- roofs and external structures;
- lifts;
- windows and balconies;
- fire-safety improvements;
- external decoration;
- drainage and communal areas; and
- heating and other shared plant.
Those works have themselves become considerably more expensive due to persistently high inflation in the construction and contractor sector over recent years. A healthy reserve or sinking fund can help spread major expenditure over time. Without sufficient reserves, leaseholders can face significant one-off demands. Importantly, there is generally no fixed cap on how much leaseholders can be asked to contribute towards reasonable major works where those costs are recoverable under the lease.
Communal Heating Can Add Another Layer of Cost
Many blocks of flats use heat networks, where heating or hot water is provided from a central source through shared infrastructure including pipes, heat exchangers, substations and Heat Interface Units.
These systems shouldn’t automatically be regarded as more expensive than individual boilers. But they do create shared infrastructure that needs to be operated, maintained and eventually repaired or replaced.
Heat networks are also now regulated by Ofgem, with new consumer-protection, billing and registration requirements being introduced.
For landlords buying into developments with communal heating, it is therefore worth understanding not simply the current heating charge, but the age, condition and management of the underlying system.
When Does a Service Charge Become a Mortgage Problem?
This is where rising costs become particularly significant. Mark Harris, chief executive of SPF Private Clients, recently told The Negotiator that lender criteria vary, but an annual service charge equivalent to around 1% of a property’s value can be a useful “red line” rule of thumb, beyond which a lender may decide not to lend.
It isn’t a universal lending rule. Nevertheless, it illustrates the problem. A £300,000 flat with a £3,000 annual service charge is already at 1%.
For landlords, the potential chain of consequences is uncomfortable:
higher service charges → lower profitability → affordability concerns → fewer mortgage options → fewer potential purchasers
A cost originally regarded as a relatively routine expense could therefore begin to influence the liquidity and potentially the value of the investment. In the context of the above example of a £300,000 propertye, some lenders, when considering affordability, may regard a recurring monthly outgoing of £250 as making a significant dent on a potential purchasers disposal income.
What Can Landlords Do?
Leaseholders do have options where they are concerned about costs. They can:
- check the lease to establish what can legitimately be recovered;
- request supporting information behind substantial increases;
- scrutinise major works proposals and participate in Section 20 consultations;
- investigate reserve funds and anticipated expenditure;
- examine buildings insurance costs, cover and remuneration arrangements;
- seek a determination from the First-tier Tribunal where charges are disputed and specialist advice suggests this is appropriate; or
- collectively explore Right to Manage if there are wider concerns about the management of the block.
Section 20 consultation is specifically intended to give leaseholders notice and an opportunity to comment on qualifying major expenditure.
However, landlords should not simply withhold disputed charges without appropriate advice.
Could the Building’s Insurance Cost Less?
Where buildings insurance represents a material proportion of the service charge, it is worth establishing whether the insurance has recently been tested against the wider market.
Individual leaseholders may not control the placement, but the freeholder, residents’ management company or managing agent may be able to review the arrangements.
Plan Insurance Brokers can provide quotations for blocks of flats and multi-occupancy residential buildings. If insurance costs have risen significantly, there is little downside in establishing whether competitive alternative cover is available.
Service Charges Are Becoming an Investment Issue
For landlords buying leasehold flats, service-charge due diligence should increasingly sit alongside rental yield, mortgage costs, location and lease length.
Don’t just establish what the service charge is today. Look at its history, reserve funds, anticipated major works, insurance costs and the condition of major communal infrastructure.
For an existing landlord, a rising service charge can steadily erode profit. But if it reaches a level that concerns mortgage lenders, the consequences could be more serious. It could affect refinancing, reduce the pool of potential buyers and ultimately influence what somebody is prepared to pay for the property.
Service charges are no longer simply a property-management expense. They are increasingly an investment issue.