of a fall in property values
The Bank of England has been putting up interest rates
to try and slow down the increase in property prices. There
has been a lot of speculation recently about the property
market being on the verge of crashing. One of our clients
was concerned how a fall in their surgery value would affect
them given that one partner is planning to leave in a year's
Their property was built for a total cost of £1.2m
and this was financed by a loan for the same amount. The
practice receives cost rent based on £1.2m and the
current open market value of the property is £800,000.
There are four partners in the practice who own the property
The value of the property in the accounts will either be
shown at cost or based on a valuation which could be the
open market value or the cost rent value.
The value of the property in our client's accounts is shown
at the cost rent value of £1.2m rather than the open
market value of £800,000. If the value in the accounts
were at £800,000 then the accounts would show negative
equity of £400,000 with corresponding overdrawn partners
capital accounts. If property prices fall this practices
negative equity would be increased. Equity in a property
is the open market value less the balance outstanding on
the mortgage. Negative equity occurs when the balance on
the mortgage is more than value of the property.
Practices that are funded under the cost rent scheme would
normally have a clause in their partnership agreement to
say that the value of the property would not be less than
the cost rent value. The reason for this is if, as in our
client's case, they valued the property at open market value
the accounts would show negative equity of £400,000
and each partner would have an overdrawn capital account
of £100,000. If a partner left then they would be
required to repay this debt. However an outgoing partner
should not have to suffer this loss as the practice receives
cost rent income based on the value of £1.2m which
covers the cost of financing the loan.
Interest on a business loan is allowable for tax relief
and GP's can benefit up to 40%. If a loan for a property
is more than its open market value then there is an element
of the loan which is not secured on an asset. The Inland
Revenue could argue that the interest on the excess amount
be disallowed for tax purposes. In our example, the client's
loan amount is £1.2m, but the property is only worth
£800,000 therefore the interest on the excess of £400,000
could be disallowed. If property prices fall then the excess
will be higher.
Practices can receive notional rent which is based on the
open market value of the property. Most practices move from
cost rent to notional rent when the income becomes more
beneficial. Normally notional rent is reviewed every three
years by the district valuer.
Many practices have gained in the past from their notional
rent being greater than the amount of mortgage interest
charged on their outstanding loans. This has been due to
low interest rates and high property prices. Practices will
need to consider the impact of a fall in property prices
on the rent they will receive. With the increase in interest
rates and potential fall in property prices, practices who
receive notional rent may find that their notional rent
does not cover the cost of the mortgage interest.
A fall in property prices will not affect the amount a
practice receives for cost rent.
Practices may also need to review their current mortgage
arrangements if interest rates continue to increase. Practices
may want to look at fixed rate mortgages where the rate
of interest can be fixed for a period of time. This can
protect practices from high interest rates. However practices
also need to be aware of early redemption penalties, which
will be charged if the mortgage is redeemed early. For example
if you fix your mortgage for 10 years and the interest rates
go down then you may want to switch to a variable rate which
could mean you incur large redemption penalties.