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Enforced switches from cost rent to notional rent

For practices still receiving cost rent, an enforced move to notional rent may result in a shortfall, writes Lynne Abbess

Cost rent projects mostly originated in the 1980s when interest rates were at an all-time high (image: iStock)
Cost rent projects mostly originated in the 1980s when interest rates were at an all-time high (image: iStock)

For many years ‘cost rent’ was used as the generic term to refer either to notional rent (paid to owner occupiers) or to current market rent (CMR - paid to tenants).  In fact, while cost rent covers either the ownership or lease scenario, it is calculated on an entirely different basis from either of these, with very little relevance to market values.

Sky high interest rates
Although, in theory, it is still possible to apply for cost rent (now known as ‘cost of borrowing’) it does not seem to be used in practice. But there remain a considerable number of projects around the country which remain ‘on the books’.

These largely originated in the late 1980s when interest rates were at an all-time high, and it was therefore impossible to fund a new surgery development on a conventional basis, as the basic rent was simply inadequate to service the loan costs. As cost rent includes the cost of the interest payments on the loan, it provided a mechanism to overcome the problem. 

The constituent parts of the cost rent calculation are as follows:

  • The site value (as approved by the district valuer – the only ‘market’ constituent of the allowance
  • Build costs
  • Rolled up investment, i.e the accumulated interest throughout the build period and before the cost rent reimbursement kicks in
  • Professional fees

The extent of the permitted building was subject to specific requirements both in terms of the number and type of rooms and their size – all to be approved by the district valuer. It was common practice for 100% funding to be available and, in theory, (assuming neither the site value nor the dimensions were exceeded), the cost rent reimbursement should have been adequate to meet the interest on the whole of the funding, leaving the capital repayments to be met by the borrower.  

Fixed or variable rate
Cost rent could be taken on either a fixed or variable basis – but the only cost rent funded schemes which are now likely to remain on the books of NHS Estates are those that were fixed - at interest rates which were running as high as 15%.  It is perfectly understandable therefore that in those parts of the country where property inflation has not been as rampant as in others (outside London and the south east) the level of cost rent reimbursement can, to this day, remain at a level which is considerably higher than notional rent /CMR.

However, the fact the headline rent may appear to be higher does not mean the recipient GPs are ‘in clover’ for the following reasons:

  • The cost of the project – and therefore the size of the loan – bore no resemblance to the resulting value upon completion, resulting in the project being in negative equity from day one.  
  • It is not uncommon for GPs to have suffered a shortfall in their outgoings from the outset as the scheme may well have exceeded the strict limits imposed – particularly in circumstances where GPs were (sensibly) planning ahead and adding rooms which fell outside those limits.
  • The fact cost rent (as opposed to notional rent/CMR) is still being paid demonstrates there have been no upward reviews since the set up of the scheme in question i.e. the rent has remained static (presenting no opportunity to reduce the monthly shortfall).
  • By the same token, there is unlikely to have been any capital growth – and invariably, the property has remained in ‘negative equity’.
  • It is impossible to surrender the loan early (in order to take advantage of the more attractive rates on offer now) without suffering the payment of an early redemption penalty, which often amounts to a six figure sum.
  • If the case of endowment loans, there is almost always an additional shortfall to be met upon the expiry of the mortgage as a result of the poor performance of the collateral endowment policies.

Notwithstanding all the disadvantages listed above, the one reassurance a GP has been able to take is the guarantee of knowing he or she would be able to continue to service his loan on an ongoing basis.

This reinsurance was further enhanced by the fact that it is only the GP who can elect to switch from cost rent to notional rent/ CMR.  

In fact, because it is recognised there is a risk that notional rent can go down at the tri-annual review, some prudent GPs have taken the view it was preferable to retain their cost rent to safeguard against an unfavourable review next time around, which would leave them with a shortfall in the future.  

Ripples of concern
Against this background, it will be understood that ripples of concern are beginning to spread around the country upon news that NHS Estates now appear to be taking a different stance – and we are now seeing evidence that NHSE itself is purporting to trigger the switch from cost rent to notional rent/CMR – even without prior consultation with the GPs, let alone with their approval!  

None of us can fail to have noticed the need for every opportunity to be seized to make savings – particularly where (on the face of it) those savings do not appear to have an immediate impact upon the service delivery to patients. On that basis, it has no doubt been regarded as an easy win to make the apparently simple ‘switch’ from cost rent to notional rent/CMR – and to substitute a considerably lower figure in the balance sheet as a result.  

However, not only is this unlawful, but its impact can have very far reaching consequences.  
A GP who has consistent in making the repayments due under their mortgage for some 20 plus years may suddenly find they are faced with a shortfall. What are they to do in such circumstances?  

It is unlikely he or she will be able to re-arrange funding to take up one of the lower rates now on offer because of their exposure to a very considerable early redemption penalty.  

And he or she is hardly likely to want to risk the mortgagee disclaiming the mortgage and repossessing with the end of the mortgage term tantalisingly close in sight, and having faithfully maintained mortgage repayments for the last 20 odd years (quite apart from the effect on his personal credit rating).  

Meeting the shortfall
In practice, therefore, there will, no doubt, be an increasing number of GPs who feel they have little alternative other than to seek to stump up the difference and to meet the shortfall themselves.  

In an extreme example, of course, the shortfall may simply be too great for the owning partners to meet and we have already seen a situation arise where a perfectly good and functional surgery has been forced to close, notwithstanding an outcry from the local population, vigorously supported by the local MP.  

But what is there to be done? It might be assumed that it is considered unacceptable to expose a well-meaning GP to the risk of taking on a huge loan (placing him in a position of negative equity) for the purpose of supporting his local community with a much needed surgery – but it would appear not to be the case.

Is there a remedy? Yes of course. But when faced with the prospect of bankruptcy, how many GPs are likely to issue proceedings against their paymaster?

Lynne Abbess is a partner at specialist healthcare solicitors Hempsons

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