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!

On-line precedents: Help or hindrance?

The  internet has brought many benefits to lawyers and particularly to firms who wish to avoid (or cannot justify) the employment of a Knowledge Development Lawyer (aka a Professional Support Lawyer). Whereas previously in order to keep up with the latest legal developments one had to subscribe to countless hard copy journals; constantly receive updates from publishers; then spend time updating the loose leaf guides (often a job for the unsuspecting summer student) now this all happens on-line saving significant time (and paper for the more environmentally conscious of us). None of this is a bad thing and is of great benefit to large and small firm alike. This is further enhanced by the availability of automatic updates notifying you of changes to law, recent case updates and similar.  Keeping up to date has never been easier and, frankly, I wonder how we ever managed without - perhaps we were blissful in our ignorance?!?

Courtesy of Rev Dan Catt via Flickr

However there is another development which is in my experience is less than helpful - the emergence of the on-line precedent. On the surface what could possibly be wrong with on-line precedents? Apart from anything else, I hear you say, they result in much more standardisation; who needs 10 different forms for the same transaction. Surely this is a good thing and will help save time and reduce costs?  I even suggested something similar myself in respect of standardising leases, did I not?
Well having recently run a transaction involving a significant number of properties across a portfolio with multiple other small firms involved I can say that this is not the case. Part of the transaction involved obtaining licences from landlords and due to the nature of the properties most often the landlords were represented by small firms. What we noticed was that the same clauses were appearing on almost all the licences we were receiving and the same problem clauses at that.

Why were these clauses a problem?  Let me outline the two most major issues the "standard" precedents caused:

1. In some cases the clauses were not commercially acceptable. Whilst in the context of a simple transaction involving two individuals or a company owned by its directors they were probably okay, on anything more complicated they became onerous and unworkable. The clauses were not something we as a firm or the other large firms involved have in our standard institutionally accepted forms of documentation. However by including it in their on-line resource the resource provider has created the impression that it is standard in the market. I lost count of the number of times we were greeted with a, "This is a standard requirement of our client and is standard in the market" response. If your client's precedent is an on-line resource I suspect your client is pretty oblivious to most of its terms and just because it is in a precedent does not make it market standard!
2. The guidance provided by the on-line resource can be unhelpful and, at worst, obstructive. Suggesting a clause is necessary because without it your client's insurance is at risk when in reality the clause is asking a tenant to take on a risk it cannot mitigate with no obligation on the landlord to assist when it could easily do so is hardly a recipe for productive negotiation. Whilst some firms adopt an aggressive first draft and look then to compromise that only works when the draftsman understands what is necessary and what is unnecessary. We spend a significant amount of time going through our precedents with new joiners explaining the purpose of each and every clause.  The purpose of this training is to ensure that they understand why the clause is there and, by extension, if and how it can be amended or, in certain circumstances deleted.  On-line precedents do not come with this level of training.  Therefore, when an amendment is sought, fear sets in because the lawyer does not have the confidence that they fully understand why a clause has been put into a document.  Whilst the argument we put forward may sound convincing what if we are ignoring another reason for the clause's existence?  Conceding the point might result in their client being exposed and the lawyer being negligent.  Therefore, better to resist and rely on the "it is a standard clause" defence.

There is no point complaining unless you propose a solution.  The first solution would be to get rid of on-line precedents but I accept this would be a step backwards and not particularly helpful to the legal fraternity.  If I am honest I think the issue really lies with the draftsmen of these precedents.  In some cases it is my suspicion that the draftsmen are not transactional lawyers but rather professional KDLs.  Whilst this works within a transactional firm this is because the KDLs have the benefit of engaging daily with the transactional lawyers.  This creates a necessary and mutually beneficial exchange of thoughts and ideas.  Draft clauses which show themselves to be commercially unviable fall on the lawyers' equivalent of the cutting room floor.
However, some of the on-line precedent providers loudly and proudly claim that there precedents have been drafted for them by lawyers and law firms so lack of transactional experience cannot along explain the issue.  The problem with this source of precedent is that, whereas within the law firm there exists a peer group within which a proposed amendment can be discussed, evaluated and agreed/amended/rejected with the benefit of the collective hive mind, for the smaller practitioner such support simply does not exist.  Therefore firms providing these drafts must ensure that their drafts are commercially and legally unbiased.  If the starting point is a reasonable one then the fact that a lawyer is less willing/confident to concede a point is not likely to be such an impediment.

Don't get me wrong.  This blog is not intended to be a criticism of my peers who work in smaller firms.  Frankly I think that they do an incredible job.  It is easy to forget how much I rely on the support I have from KDLs, peers and, indeed, as much on-line resource as I could possibly ask for.  Lawyers in smaller firms simply do not have that level of support and yet provide as excellent advice and client service as many a large firm.

No, my criticism is of the providers of supposed tools aimed at reducing the burden of the small firm lawyer.  As I have mentioned previously the role of the transactional lawyer (and by extension his drafting as his tool) is not to seek to screw the opposition.  Those who provide resources to enable the lawyer to do this need to ensure that those resources truly assist the lawyer in furthering his goals and do not, instead, become an unnecessary and unwelcome hurdle to be overcome.

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.

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.

Rent is an administration expense - but at what cost?

A recent decision in the High Court (Goldacre (Offices) Limited -v- Nortel Networks UK Limited (in administration) [2009] EWHC 3389 (Ch.)) has confirmed that where an administrator makes use of a leasehold property the rent reserved by that lease will be an administration expense. This is in accordance with most practitioners' prior views.

However, the case did decide some other related points which are, in some ways, surprising as follows:

1. the amount of rent which becomes an expense of the administration does not relate to the area occupied. Use of a small part of the premises demised will make the whole rent reserved an expense of the administration;


2. if the administrator is using the premises on the rent payment date then the whole period's (e.g. quarter's) rent will be payable as an administration expense even if the administrators' use ceases during the relevant period.

These two points could have interesting implications. The corollary of (1) might be that where the premises are part sub-let and the administrators continue to use the other part then it may be that the administrators are exposed to the credit risk of the sub-tenant default. The corollary of (b) might be that where the administrator is not using the premises on the rent payment date then there is no liability for the rent as an expense even if the premises are used for the remainder of the relevant period.

Neither of the above points were directly addressed in the judgment.

It should be noted that the fact that it is now confirmed that rent will be an expense of the administration if the administrators are using the premises does not mean that the administrators have to pay it on the due date and in full. This is still dependent on there being sufficient realisable assets out of which the rent can be paid. This was expressly confirmed in the judgement.

So whilst the case confirms a generally held belief it has muddied the waters for both landlords and administrators in some regards and altered the balance of power slightly but with the administrators arguably still holding the upperhand through the benefit of the moratorium.

FRI Leases in a recession - not always the protection you expect

The Financial Times reported today that "Maintenance Cuts threaten property values". For those who cannot be bothered the article what it says it that whilst UK property is generally let on full repairing and insuring tenant covenants landlords are cutting back on repair and maintaining those parts of the properties for which they have responsibility and for which they recover the cost through the service charge due to fears over whether the costs are recoverable arising from tenant default and increasing voids. Meanwhile, landlords are facing an increasing number of void units in disrepair due to tenants failing to repair and then becoming insolvent.

The failure by landlords to carry out anything but the most urgent of repairs is, of course, a double edged sword for a landlord. It exposes the landlord to the risk of tenants seeking to enforce landlords' repairing obligations (although this might be unlikely save where the disrepair is likely to damage the tenant's business). More importantly, it makes reletting the unit at the best rent very difficult since the centre in which the unit is quickly becomes dilapidated and less attractive to potential tenants. Hence, one could argue that failing to repair is only prolonging the pain for the landlord. In truth, however, landlords will probably wait until real signs that the market is picking up before deciding to carry out repairs. The timing does need to be right since if a competing location is in better repair and condition it may prove more attractive and take away potential new tenants.

Repair of individual units is even more tricky for landlords. Is there any point in carrying works of repair to a vacant unit with little chance of letting. On the other hand what chance is there of letting a unit in disrepair and what effect will this have on rent. Some landlords may opt to wait until a potential tenant is found and then agree to put the property in repair (or pay a reverse premium to the tenant to do this). This means that the level of rent should not be affected. However, a tenant looking to move in quickly (especially in the run-up to Christmas to make the most of the holiday trade) is more likely to opt for a unit ready to go.

Finally, all landlords (and tenants when landlords are carrying out works) would be well advised to check carefully the terms of service charge provisions in the various leases to check what works are recoverable and what are not. How are voids treated? What are the obligations in terms of repair?

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.