Blocks of flats can mean high income

You may well feel that being a landlord, or worse still a freeholder with leaseholders at your mercy, is lower down the ethical scale than buying shares in BAT or British Energy. But you could get an income of up to 12 per cent a year if you invest in the freeholds attached to blocks of flats.

Freeholds aren't hard to buy. There are several million leasehold flats in England and Wales and all have a freeholder. An informal market has existed for years, with desirable groups of freeholds being bought and sold privately among the small group of professional landlords who dominate the market. Some freeholds are also sold at property auctions.

The easiest way for private investors to buy freeholds is through one of the two offshore unit trusts dedicated to ground rents. The trust managers buy up freeholds, then pay another company to maintain the property and deal with the tenants. The unit trust makes most of its money from the ground rents paid by all tenants.

Investors have the security of knowing their money is backed by bricks and mortar: tenants who fail to pay up will lose the right to live in their homes, and the trust will take possession. Athough ground rents are usually fixed at only pounds 50-pounds 100 a year, the freeholds only change hands for around 10 times the annual ground rent. So a freehold on a flat with a ground rent of pounds 50 a year might cost pounds 500 to buy, giving a 10 per cent annual yield.

Venture capitalists Close Brothers back the biggest ground rent fund, the BESSA Income Trust - a smaller one is run by Neill Clark. Close's marketing manager, David Sherman, says: "We say ground rents and gilts should form 5-10 per cent of any portfolio, as a safety-first foundation." They recommend ground rent investments for anyone needing a high income with low risk. And income is paid gross, so non-taxpayers won't have to reclaim income tax.

Around pounds 3.8m has been put into the fund since it was set up three years ago. There's a 6 per cent charge on your initial lump sum - a minimum of pounds 1,000 - but the annual income has been as high as 11.5 per cent a year, although in the last financial year it was 9.4 per cent.

One reason why you probably haven't heard about this type of investment is that the open market in ground rents is very small. More importantly, the two trusts are barred from advertising direct to the public because they don't offer any consumer protection if things go badly wrong. City watchdog rules state that a financial adviser has to approve and sign your investment application, to show that you are aware of the risks you're taking on.

In fact the funds are very safe because they are backed by property investment. But potential investors should be aware that these trusts don't just make money from fixed-rate ground rents. The fund managers will act like all commercial landlords and take advantage of recent changes to the law to make money from selling lease extensions and freeholds to their tenants. Many leaseholders are effectively held to ransom by freeholders once a lease drops below about 50 years. They can't sell their homes because lenders don't like short leases. And at the end of a lease, they will fear eviction.

In both cases, the flat owners will be willing to pay well above the market price to extend their leases or buy the freehold. Extending the lease also means a new contract has to be negotiated, so freeholders can charge more ground rent for the next 90 years.

So far, the changes to the law haven't made any difference to ground rent investments. But both Conservative and Labour party policy is to introduce "commonhold" property ownership. This would bring in a new form of ownership similar to that of American condominiums, where homes are bought outright but with common responsibility for the upkeep of the building. The Government has drafted a Bill due for the next parliament. But investors in freeholds have no need to panic. As the Bill stands at the moment, if landlords don't want to sell up, the law won't force their hand.

BESSA Income Trust: 0171 426 4000.

Neill Clark: 0171 734 4446.