Game-over for UK commercial real estate investment?

It's MIPIM week and whilst colleagues and contacts are wining, dining and networking on the shores of the Meditteranean, I sit here pondering whether we may be witnessing the end of the UK as an attractive place to invest in commercial real estate.  With headlines such as:

"James Dyson calls for looser employment laws and shorter leases"

it is easy to see that the established UK form of investment lease is under threat.  It is a threat from within and without.  The question is whether this threat is such that it could ultimately destroy the attractive nature of the UK as a place to invest in real property?
In order to understand the threat one must first understand some of things that make the UK such an attractive place to invest in commercial real estate assets.  A non-exhaustive list of the attractions are:

• Long lease terms - historically leases have been for long terms certainly in excess of 10 years and often as long as 25 years or more. This creates long term secure income.
• Landlord friendly law - the concepts of privity of contract and very limited tenant protection mean that once a deal has been agreed between the parties it will bind them for the term.  Again security of income.
• Full repairing and insuring terms (FRI) - in the UK the full costs of managing a property can be recovered from the tenants so the annual rent is effectively a net income save for tax.
• Upwards only rent reviews - apart from at the end of a lease term the landlord is always guaranteed its minimum rent level. It may not go up but it can't go down.
• Quarterly rent payable in advance - a beneficial cash flow from the landlord's perspective.

Looking at the list above you might wonder what the challenges now arising are.  Certainly there is no threat of legislation.  In fact, UK landlords probably took a lot of heart from the change of mind by the Irish government not to introduce legislation imposing upwards-downwards rent reviews.  If a country in as dire property straits as Ireland cannot justify such legislation how much more so would a country such as the UK which has probably seen the worst effects pass struggle to justify such a move.  The 2003 report by De Montfort University and the BPF further cautions against such legislation.
However, there have been changes. These have been subtle and occurred over time.  The cumulative effect of the changes is potentially game-changing.  Let's consider some of those changes:

• Loss of privity of contract - this is the only legislative change aimed squarely at landlords.  The removal, in  January 1996,  of the doctrine that once a tenant signed a lease it would be bound by its terms even after an assignment was a major blow to the investment fraternity.  The risk was that the tenant would assign the lease to a lesser covenant and dilute the investment value of the asset.  Various attempts have been made to try and strengthen the landlord's hand but invariably they either have a negative effect at rent review or fall foul of the anti-avoidance measures as most famously occurred in the Good Harvest decision as approved by the Court of Appeal in the House of Fraser case.
• Shorter lease terms - over the past decade lease terms have become shorter. Tenants are less prepared to sign up to long leases form which they cannot easily extricate themselves.  Some of this is as a result of the "tenant's market" with higher levels of voids.  However SDLT has also had an impact with every additional year on the lease costing the tenant tax up-front.  If lease accounting rules do change this may add further weight to the shorter lease term argument.
• Lower recoverability and greater flexibility- landlords have become much more attuned to the needs and expectations of their tenants.  Further, under the threat of legislation a voluntary commercial lease code has been introduced.  This requires landlords to give optionality to tenants.  It requires landlords to comply with the RICS Service Charge Code.  Invariably this increases the likelihood of irrecoverable costs being incurred in respect of a property which fall to be paid by the landlord denting its income.  Gone are the days when tenants could be charged for everything under the sun including rebuilding the property.

The above are the more tangible changes that have occurred.  There are also less tangible, or at least more spontaneous or reactionary events which take place from time to time which change the playing field:

• Monthly rents - during the recent downturn there have been numerous requests and demands that landlords accept monthly rather than quarterly rent payments.  The argument from the tenant's point of view (especially in the retail sector) is that quarterly rents do not reflect the reality of business where cashflow is not quarterly.  Concessions have been given but the pressure remains for a complete change in standard to monthly.  Whether this will happen remains uncertain.
• Use of CVAs and Administration - the number of retailers failing since 2007 has continued to rise and barely a week goes by without another retailer or leisure operator announcing it is in difficulty and needs to restructure.  To date CVAs have not really been used successfully to reduce rental liabilities but it is only a matter of time before this is tried again.  Administrations are very much in vogue and, as I consider in my piece on La Senza and Blacks, the administration is used to renegotiate lease terms (and in particular rent) with landlords.

Therefore, whilst leases may contain upwards only rent reviews the certainty of maintaining that level of income remains threatened.
So, returning to my original question, is the attractiveness of the UK as a top spot for investment in real estate at serious risk?  In my view the answer remains a no despite all the issues highlighted.  There are some very good reasons why not:

• whilst there is an increase in the irrecoverable nature of some costs the fact remains that FRI leases are the norm and the vast majority of costs are recoverable resulting in the rent being a net figure
• many of the threats and issues are more as a result of the current economic climate and my expectation is that once the dark clouds disappear then "normal" market practice and attitudes will return
• part of the attractiveness of the UK is that it provides a stable political and legal framework.  For foreign investors this is a key attraction and the return generated may fluctuate but the risks do not alter much over a long period of time.

No, I think that the UK real estate market is not truly threatened by these small changes and challenges that arise from time to time.  In reality the biggest threat to the UK real estate market continues to be the ever decreasing amount of credit that is available in the market.  When the credit markets return the above will seem like a bad dream!

Redefining the landlord and tenant relationship - back to being radical again

In July 2009 I wrote a blog about how we need to be more radical in relation to Commercial Leases and the Commercial Lease code (see Commercial Lease Code: Let's Be Radical).  Therefore I was most interested to read a Property Week interview with Lawrence Hutchings, Hammerson's managing director UK retail in last week's Property Week in which Lawrence clearly argued for action to be taken "to satisfy both retailers and global investors in the UK retail property arena".

Lawrence specifically makes mention of how landlords negotiate with tenants and expressed a clear belief that "Changes in the landlord and tenant relationship will be structural".  Indeed Hammerson has altered its own internal structure to improve its relationship with tenants by delivering better service performance.

I continue to hold the view that creating an industry standard lease for lower value and/or smaller units would further help improve the landlord and tenant relationship.  It would reduce deal times, deal cost and deliver certainty for both parties.  I may be doing some lawyers out of work but, as I always say to my client, my job is to identify the best way for you to achieve your commercial objectives.  If there is a cheaper and quicker option that is the route my client should take even when the result is little or no work for me.

Anyone else interested?  Please let me know.

Carbon Reduction Commitment: Another victim of the austerity budget

The Spending Review 2010 found some innovative ways to increase the Government's revenue by using the CRC Efficiency Scheme.
One of the tools to be used was a statutory scheme whereby all participants would initially buy their annual Allowance through a bidding process. Initially the number of Allowances was to be unlimited but then it was to be capped thus encouraging participants to reduce the Allowance they require and save them money.
The second part, and what might be called the carrot, of the scheme was that the revenue generated by the auction of Allowances would be recycled to the participants so that, as you might expect, the best performers would receive the reward in the form of cash back.
In the Spending Review 2010 two major decisions were revealed:

1. The first sale of Allowances will be in 2012 rather than 2011.
2. Revenue from the sale of Allowances will be used to support public finances rather than recycled back to Participants.

The second decision is a significant change as it means that the league tables to be produced will now only have a reputational impact as opposed to a financial and reputational impact. Whilst many owners and occupiers will be concerned regarding their reputation and green credentials the cost-benefit of reducing emissions becomes much harder to justify on a reputation only basis unless one is significantly behind ones peers.

A knock on effect for Landlords is that whereas before there was some possibility of recouping some of the costs of compliance by moving up the league tables and receiving the reward of "revenue" from the sale of Allowances; now compliance is a fixed cost with no direct financial return. Depending on the terms of service charge provisions in leases it may not be possible to recover the cost of compliance from tenants. This will create an irrecoverable cost which must be deducted from the "bottom line" meaning values will suffer.

All landlords should instruct their lawyers to review the terms of their service charge drafting to ascertain whether or not the cost is recoverable. If it was before the change announced in the SR2010 then nothing will have changed. If it was not it may be now.

Is the FRI lease manifestly unfair?

I sat in a very interesting meeting the other day which was a general discussion on various points in negotiating an agreement for lease and lease when acting for landlords and tenants. Much of the discussion focused on the inter-relationship between warranties, repairing obligations and service charges and then moved on to insurance and uninsured risks. However, what was most interesting was that the discussion touched on a more general issue about the English institutional fully repairing and insuring (FRI) lease - is the whole proposition of an FRI lease not manifestly unfair and unbalanced.

For the uninitiated, in England and Wales the starting point with a lease which will be acceptable to institutional investors is one in which the investor receives all the rent and the tenant is financially liable for every cost associated with the property (apart from "income" tax on the rent). This works by imposing full repairing obligations on the tenant, requiring the tenant to fully re-imburse the landlord for the cost of insuring the building and requiring the tenant to pay, through the service charge, for the cost of repairing parts of the building outside the tenant's demise.

Now let us examine the relative positions and aims of the parties.

The landlord owns the property for the purposes of investment. It receives income in the form of rent and the potential for capital increases resulting from rent increases and/or yield compression. It is very much interested in the long term existence of the property.

The tenant is renting the property as a place from which to conduct its business. It does not care about the building per se. Its income is generated out of the property but not from the property and it does not, in general terms, specifically have to be located within a specific property. It does not benefit from changes in yields and only sufferes from rent increases.

Now let us consider where the risk in relation to the property should lie. The tenant requires occupation to run his business but has no interest in the long term existence of the property and sees no benefit from any increase in value. The Landlord benefits not only from the existence of the property but also from the continuing ability of the property to meet the tenant's needs. As the tenant's business flourishes so does the value of the property as it is likely to be let to a tenant with greater covenant strength. Therefore you would expect that the landlord would bear the risk of need to repair the property or it being destroyed; he is the owner afterall.

However, the FRI lease is such that the only risk the landlord is taking is that the tenant goes bust. All other risks are placed firmly at the tenant's door. Repairs within the demise the tenant will be required to carry out itself. Repairs outside the demise the landlord will carry out but recover the cost from the tenant. If the building is destroyed by an insured risk there is likely to be a rent cesser but this will only be for the period for which the loss of rent insurance is available and after that the rent restarts even if the building is still unbuilt. Uninsured risks, all things being equal, can fall completely on the tenant with the landlord being able to recover the cost of rebuilding through the service charge. So a tenant who decided against being an owner/occupier could actually find itself in a worse position as a result with higher annual costs and the potential for huge liability when something goes wrong.

Of course, the above is a worst case scenario but it is one which is likely to represent the legal position on a significant number of leases in the market today. The UK is unusual in its total lack of legislation in seeking to prevent landlords from placing the full burden and risk on the tenant. In Germany, for example, it is against the law for landlords to seek to recover the cost of structural repairs through the service charge; this is a risk the landlord took when he bought/developed the building.

Matters have in the last 20 years moved somewhat from the position highlighted above. Tenants have seen much success in toning down liability for things such as uninsured risks and liability to repair latent defects but the the risk is still most firmly with the tenant. So all you tenants out there, a little less criticism of the tenant lawyer who seeks to negotiate a lease and is reprimanded by his client for delaying the deal; the detail could very well matter.

Is this fair? As always it depends on who you ask. In reality it is market forces and perhaps as a result of the current downturn tenants and their lawyers will use the opportunity to further push the pendulum back towards the landlord in terms of carrying the risk. However, I doubt very much that it will swing too far. The fact is that tenants don't appear to care that much - maybe that is because occupiers are businesses who are used to taking larger risks than the institutional property owner funds who tend to be risk averse. Fair it might not be but so what.

Commercial Lease Code - let's be radical

The news that the 2007 Commercial Lease Code has not proved any more well known than its predecessors has been met with dismay by the Government. Larger, institutional landlords did embrace to some degree the Code and did their best to publicise it. However the fact remains that much of the country's commercial estate is owned by small landlords and managed by small agents who have no interest in publicising the code as all it would do is damage their negotiating position and, in the case of agents, raison d'etre. So the prospect of legislation looms closer.
What I am about to say may shock you but . . . bring on the legislation. But not in half measures. Let's not tinker around the edges. Let's be radical.
I propose that for all leases of an area less than a certain minimum and/or a rent below a certain level (eg. £50k per annum) there should be a statutory prescribed form of lease. It could have the following:

• a minimum 2 year and maximum 10 year term
• Index-linked upwards only rent
• Security of tenure
• Repair to standard at date of first lease
• Assignment with consent not to be unreasonably withheld ("ntbuw")
• Underletting of whole with consent ntbuw
• Specific user with change permitted within same use class ntbuw subject to estate management considerations
• No alterations apart from internal non-structural with consent ntbuw
• Service charge drafting would be fixed by reference to the RICS Code

These are just suggestions but you get the idea. It may be that a few variations of the leases would be needed for different types of property and rental structures but all of this is achievable.
Why do this? Well the amount of time and money that is spent in the negotiation of heads of terms and subsequent documentation of those heads is one good reason. All landlords and tenants would need to agree would be the rent and term.
But the benefits go further. When an investor is reviewing a portfolio of properties low value leases would not need to be reviewed for consistency as the terms would be dictated by law. Certificates of Title could be reduced in size. Lawyer review time would be cut leaving more time to do the deal. Disputes would be dealt with more easily since the wording could quickly be interpreted by the courts and the number of disputes would fall. Everyone would benefit to some degree at some point.
The downside? Mainly in reduced flexibility although quite how much flexibility would be lost is questionable. Agents might need to reduce fees to reflect the lack of terms to negotiate but they would still be needed to find the tenants and get them signed up. Lawyers would lose out on fees as our services would not be required for straightforward leases but we would still be needed to negotiate agreements for lease, licences for alterations, etc.
So I say let's legislate, let's be radical, let's create the standard lease.