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!

Real Estate investors and the VAT increase: a non event?

The great thing about value added tax (VAT) is that, unlike other taxes, for many involved in business the tax represents a cash flow issue as opposed to a hard cost.  The ability to offset input tax against output tax and recover your VAT means that for those providing B-2-B services the impact of the VAT rise on them and their customers is significantly more limited.
On the face of it the commercial real estate market should be similarly protected.  After all, once a property has been opted to tax the owner can charge VAT to its tenants and recover its VAT that it incurs from its suppliers.
But, as always with tax, the position is not quite so simple.
First of all it is not always possible to opt to tax and, in some cases, an option to tax can be disapplied.  Where this happens the owner of the property may not be able to recover its VAT costs relating to the building and where it has claimed it may be forced to pay the monies back to HMRC.
Secondly, there are certain classes of business that cannot recover VAT.  From the city perspective the one encountered most often is financial institutions.  This is a significant issue since for these class of tenants any VAT on the rent is a hard cost and not a mere cash flow issue.  Therefore before deciding whether to opt to tax a property (if the choice exists) it is important to consider what sort of tenant you are targeting.  In a mixed use scenario this can be quite complicated and you need to balance all the drivers before making a decision.
Another reason the VAT position will affect property is because stamp duty land tax is calculated on the VAT inclusive consideration.  So where a property is being acquired and it is not a transfer of a going concern (TOGC) SDLT will be calculated on the price plus VAT.  In that scenario the effect of the 2.5% increase in VAT is an additional SDLT liability.  In the lease context the effect is larger since you are considering the NPV of all future rental payments including the VAT element.  In both cases it does not matter that the buyer/tenant can recover the VAT.
So whilst the increase in the VAT rate on the face of it might not seem that important in the real estate context when you look at it in a bit more detail you realise that getting your VAT decisions right at the outset could have a significant effect on the financial performance of your real estate assets over the long term.