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!

Peacocks sold: Seduction again?

Those familiar with my blog will remember my relatively recent blog entitled Blacks and La Senza: Agression v Seduction.  Today we are met with the news that Peacocks has finally been sold out of administratio to Edinburgh Woollen Mill.  This is good news, especially for the 6,000 people whose jobs have been saved and the 338 landlords whose stores will remain open.  It is less positive for the 3100 people who will lose their jobs and the 224 stores that have ceased trading with immediate effect.

A quick note to landlords of those stores - the oft-quoted decision in Goldacre may not assist you in getting your rent paid up to the next rent payment date.  This is because the decision left it woefully unclear what the position was where a company went into administration after a rent payment date - is the rent or any part of it an expense of the administration or can the company in administration effectively trade rent free?
But do not despair completely for it appears that Edinburgh Woollen Mill has adopted the "seductive" approach to its acquisition vis-a-vis landlords.  Philip Day, chairman and chief executive of the Edinburgh Woollen Mill Group, based in Langholm in Scotland, is quoted as saying that he hoped there would be scope to save more jobs and stores from those being forced to close due to performance issues and overhead pressures.
This is a clear statement of intent that once they have had the chance to review all the numbers they will identify further sites they wish to re-open and dangle in front of landlords the carrot of some rent.
Does this mean that seductive approach is now preferred over the aggressive approach or is this just a hangover from Valentine's day?  No doubt there will be a few more insolvencies in 2012 that will reveal more.

OSCRE: Just for the geeks or time for the lawyers to get involved?

On 24 January 2012 I attended a symposium in London to discuss trying to push forward at a greater rate the implementation of the OSCRE standard and its adoption in the Real Estate community.  This is not a new path and many will remember the unsuccessful attempts at doing this no more than 10 years ago with PISCES.  In fact OSCRE is a sort of successor to PISCES.  It is the US version of PISCES and has now been adopted by the UK commercial real estate market following an amalagamation of the two standards boards.  So why does anyone think that OSCRE will succeed where PISCES disappeared into obscurity?
In my view the world is now significantly more advanced than it was 10 years ago making OSCRE a necessity.
1   What is OSCRE?
OSCRE stands for Open Standards Consortium for Real Estate but this does not describe what it is.  It is a universal language intended to allow real estate systems to "speak" to each other.  The ultimate goal is to enable the inputting of data only once and for that data then to be able to be re-used in different systems in the real estate world.

2   What happens currently?

Let's consider a simple property leasing transaction.  The steps are as follows:

a)  The agents agree heads of terms and send a hard copy to the relevant solicitor

b)  The solicitors draft the various documentation and following some negotiation it is finalised

c)  Both solicitors will produce word based reports to their clients setting out the final agreed terms and seeking execution

d)  The documents are executed and then completion occurs

e)  Various SDLT (tax) and Land Registry forms are prepared and sent to the relevant authorities

f)  Both solicitors will prepare a report for the asset management teams at landlord and tenant providing detailed information on the lease

g)  The asset manager will input the information received from the solicitors onto their systems

3   What could happen?

Taking the same transaction:

a)  The heads of terms are sent as data (a wordy version can be created as well)

b)  The initial draft lease is created automatically from that data and issued

c)  The documents are negotiated and agreed

d)  One solicitor updates the data reflecting the agreed terms and the other checks and approves it

e)  Both solicitors generate automatic signing request forms to their clients using the data and the matter completes

f)  The SDLT and Land Registry forms are gnerated automatically

g)  The information required by the asset manager is sent automatically

Is there a difference?

One simply needs to consider the above two lists to realise that the reference to "automatic" pervasive in the "What could happen?" scenario means two things:

1. Efficiency and thus cost savings
2. Reduced risk of data corruption

In a world where data and cost are key drivers it seems to me inevitable that the industry will be forced down the route of agreeing a standard form of "language".  It is incumbent on all professionals within the industry to work together so that we achieve that goal as quickly as possible and create the best possible language.  Lawyers are a lynch pin in this development.  We are the source of much of the base data.  If we do not actively participate in setting it up we will be left with the rest of the industry talking a "language" we do not understand.  I for one would rather help create the language than need an interpretor!

Lost in translation: The joys of international clients

I was talking to a friend who described to me a fascinating exchange he had had with a foreign client.  Below is a hypothectical (but based on real events) transcript of an exchange between a UK real estate lawyer and a South East Asian investor client looking at buying some pretty expensive real estate in London.

Client:  I need to understand the risks associated with tenants exiting the property?
Lawyer:  The lease is for a 20 year term and there are more than 17 years left to run so the issue does not really apply to this property.
Client:  I know the term has more than 17 years left but what if the tenant leaves early?
Lawyer:  If Leman taught us anything it is that no tenant is too big to fail but this tenant has a triple-A rating so it is very unlikely that it will fail in the short term.  The assignment provisions ensure that any new tenant would need to be at least A-rated.
Client:  But what if the Tenant just walks away?
Lawyer:  There are no break options in the lease so he cannot.
Client:  But what if he just does?
Lawyer:  It is a major listed plc, it would be easy to pursue it for the rent and liabilities.  It is very unlikely as there would be reputational damage to the tenant as well.
Client:  But what if he just tore up the lease?
Lawyer:  The tenant does not have any right to tear up the lease.
Client:  Yes he does, he has a right to walk away whenever he wants.
Lawyer:  There is no right in English law to walk away from a lease.
Client:  There is in South East Asian law.
Lawyer:  Okay, now I understand your concern.  You do not need to worry.  As this property is in England and there is no right under English law for a tenant to just walk away this is not a risk for you.
Client:  But in S.E.A. there is; how do we deal with this risk
Lawyer:  I'll get back to you.

Any suggestions for the poor lawyer how he should get his S.E.A. client comfortable that English law is relevant and that the risk he perceives to exist does not actually exist?

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.