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!

“Good Harvest” now been tithed?

The Court of Appeal today issued its judgment in K/S Victoria Street v House of Fraser (Stores Management) Ltd & Ors [2011] EWCA Civ 904 (27 July 2011).  Some might call this case “son of Good Harvest” and it was the Court of Appeal’s first chance to consider the decision made by Mr J Newey in Good Harvest Partnership LLP v Centaur Services Ltd.  Those of you who have been reading my blog for a while may remember that I got excited about the first instance decision in House of Fraser as Mr Randall QC opted to follow Good Harvest even though he felt that the reasoning in it was flawed!

I will not bother to go into the detail of Good Harvest and what it means to both landlords and tenants as to do so would simply trod over such well-trodden ground that it is a bit of a quagmire.  I have read the decision of the Court of Appeal and, unsurprisingly bearing in mind the Court in this case was headed by the Master of the Rolls, LJ Neuberger, an exceptionally well respected judge with particular expertise in Real estate, it is a well reasoned decision.  In some ways what is most fulfilling about this judgment is that it has expressly been given to address the uncertainties created by the Newey J decision in Good Harvest.  In fact in one part of the judgment it reads:

“We would hope that those responsible for drafting leases are aware of these conclusions, and that, as a result, the 1995 Act should not lead to many practical difficulties of the sort discussed above.”

The Court is speaking to me and my peers and telling us clearly, “we have told you what the law means now you have no excuses for further screw-ups”!

The decision of the Court of Appeal provides much needed clarity and confirms the following:

1. Any agreement which seeks to require a guarantor of a tenant under a lease to guarantee the obligations of an assignee of the tenant will be void.
2. Even where a landlord merely require a guarantor of a proposed assignee and it is the assignee/assignor who suggests the current guarantor (i.e. the landlord did not require it) as a guarantor of the assignee, that will be void.
3. Any guarantee entered into as a result of an agreement along the lines suggested in points 1 or 2 will not be enforceable.
4. A guarantor can, where reasonable so to do, be required to guarantee the obligations of a tenant as assignor of a lease in an authorised guarantee agreement (the GAGA survives).

Of biggest comfort to landlords (and commercially minded tenants) will be point 4.  It had been suggested in Good Harvest that a guarantor could not be required to enter into an AGA.  If this view had been repeated then it would have resulted in landlords always insisting on the assignee being the most financially sound entity in any group.

The judgment did raise some issues which need to be considered practically so that practitioners seek to ensure that they do not run unnecessary risks with their drafting.  I would highlight the following:

1. Provisions in leases which effectively allow intra-group assignments where the TopCo remains on the hook cannot be made to work.  It seems to me that they simply become unenforceable since the tenant cannot comply with the obligation to provide the guarantee and without it one would revert to the usual consent provisions in the lease. So tread carefully here.
2. The Court has blessed the concept of the current guarantor guaranteeing the outgoing tenant’s covenants in the AGA. However, it did not bless a guarantor guaranteeing the assignee’s obligations directly but less this open.
3. A provision in the original guarantee which seeks to extend the guarantee to a guarantee of any covenants by the tenant in an AGA on an assignment may be vulnerable to challenge.
4. The court cast doubt as to whether a landlord can automatically require on any assignment the outgoing tenant to enter into an authorised guarantee agreement.  This is potentially interesting in the insolvency scenario where landlords often seek to rely on such provisions to refuse consent on the basis that an administrator will not enter into an AGA.

So, Good Harvest has been suitably tithed by the Court of Appeal.   The law has been clarified for the better and the investment community can sleep a little more soundly tonight.  However, a word of warning, there are many existing leases out there which will fall foul of the anti-avoidance provisions of the Landlord and Tenant (Covenants) Act 1995 even after this decision.  The clarity afforded by this decision means a discount in value must be applied to those leases that do.

Good Harvest Take 2

As many of you know on 23 February 2010 Mr Justice Newey shook the foundations of Landlord and Tenant relationships with his first instance decision in Good Harvest Partnership LLP v Centaur Services Ltd. In that decision he held that certain provisions in the lease in question which sought to require the tenant's guarantor to guarantee the obligations of the incoming assignee were in breach of the anti-avoidance provisions of the Landlord and Tenant (Covenants) Act 1995. This limb of the decision was, in the large part, unsurprising.
However, in that decision he also cast significant doubt as to whether any obligation on a guarantor of a tenant to guarantee the obligations of the tenant pursuant to an authorised guarantee agreement (AGA) would be enforceable; this was not expected and has worried landlords and their lawyers.
There was, and is, a large body of opinion that the statements by Newey J were simply wrong and do not stand up to scrutiny. Hopes for a clarification from the Court of Appeal were dashed when, having appealed against the decision, Good Harvest settled just before the appeal was heard leaving the doubts unanswered.
On 1 November 2010 Mr John Randall QC sitting as a deputy High Court judge issued summary judgment in K/S Victoria Street v House of Fraser (Stores Management) Ltd and others ([2010] PLSCS 278) regarding the enforceability of provisions which provided that on an intra-group assignment the current parent company guarantor must stand as guarantor of the assignee. In line with the Good Harvest decision Mr Randall QC held that this requirement was in breach of the anti-avoidance provisions of the LTCA 1995 and should be struck out of the document.
However, interestingly, Mr Randall QC stated that he had come to the decision to follow the ruling in Good Harvest notwithstanding that the reasoning in Good Harvest was flawed.
Once again success for a tenant regarding the unenforceability of a provision seeking to keep a guarantor on the hook post assignment but once again a case which does not reflect the more common situation whereby a guarantor (as part of its original guarantee or as a condition of an assignment) guarantees the tenant (not the assignee's) obligations pursuant to the AGA. The view remains that certainly where the guarantee is contained in the original guarantee and probably where it is entered into at the time of the assignment such an arrangement should not fall foul of the anti-avoidance provisions of the LTCA 1995 and should survive a challenge. Of course the devil is in the detail.
Any ruling to the contrary would have a significant detrimental effect on the ability to rely on guarantors to prop up weaker covenant tenants.

Setting the Landlord Free

English land law has a lot of idiosyncrasies; mainly as a result of how it has developed over many centuries. Two of these are the idea of privity of contract and privity of estate. In very simple terms these ideas mean that once you sign up to a lease (whether as landlord or tenant) you remain bound to comply with the terms of the lease even after you have disposed of your interest (either selling the reversion or assigning the lease) and that in order to ensure any new tenant would be directly liable to a landlord direct covenants with the landlord are advisable.
Now any slightly bright spark might notice that this could create a bit of a problem. For example, imagine you (A) take a new lease for 20 years of an office. After 10 years you have outgrown your offices and so you take some new offices and assign your lease to someone else (B). Seven years later that someone else goes bust. You remain liable for the rent in respect of your old premises and whilst you will have, if properly advised, received an indemnity from B since B is now bust this is of little value.
In recognition of this fact an act was passed in 1995 called the Landlord and Tenant (Covenants) Act. The first thing to note about this Act is that it only applies to leases created on or after 1 January 1996. The main effect of this Act was to make it so that Tenants were automatically released from their covenants on assignment of the lease. As a sop to the Landlord lobby a mechanism was inserted so that the landlord could keep the outgoing tenant on the hook as a guarantor of the incoming tenant but this could last for one assignment only.
In terms of Landlords being automatically released the Act did not provide for this - the logic being that leases rarely (if ever) give a tenant any control over a landlord disposing of its reversionary interest and so a tenant could find itself with a straw-man landlord failing to perform significant obligations. However the Act does provide for an ability for an outgoing Landlord to seek a release which must be given if reasonable.
Whilst at one point it was considered that as a result of the Act it was now impossible for Landlords to avoid continuing liability in advance a case in which went to the House of Lords in 2005 confirmed this was not so. In London Diocesan Fund v Avonridge Property Co. Ltd [2005] 1 WLR 3956 the House of Lords confirmed that with the correct drafting there was nothing to stop the Landlord and Tenant agreeing (as was the case before the Act) that once the Landlord has disposed of his reversion to the Lease he would not longer have liability for breaches of the landlord covenants.
Surprisingly, use of this mechanism is not automatic in the market. The most likely reason for this is that very few leases contain particularly onerous landlord covenants so the risk to the landlord of a lease coming back to haunt it is relatively remote. However where a landlord is granting a lease which does contain more onerous landlord covenants consideration should quite probably be had to including such a clause. Lawyers acting for tenants should pick up on the clause and advise their clients of its effect. I suspect most will not be bothered as many might be surprised to have learnt that without this clause they did have a claim.
Another example where this clause may be considered is where an Insolvency Practitioner is granting a lease and wants to ensure that the liability is limited to the period that the reversion remains vested in the insolvent entity.