In defence of sale and leasebacks post Southern Cross

The Southern Cross collapse has cast a very strong spotlight on the use of sale and leasebacks in the care home industry and in property heavy businesses in general. Southern Cross is not the first well known name to collapse with a sale and leaseback business model; remember Woolworths? Or going back further the Forte group? But, whilst all these collapsed entities share a common theme in having utilised sale and leasebacks it is flawed to conclude that any entity which undertakes a sale and leaseback is primed for collapse and, as a response, call for such arrangements to be heavily regulated or outlawed.
How do you justify a sale and leaseback?
First of all it is important to understand the rationale for undertaking a sale and leaseback. In simple terms it is about efficient and productive use of equity. Simply put owning a property outright means your capital is tied up in an illiquid asset. It also means that not only are you running an operational business but you are also exposed to the property investment market with the value of your property fluctuating with property values generally. When the building comes to the end of its useful life (which modern buildings appear to do in a very short space of time) you then have to go to the expense of redeveloping it or selling the land for development.
Extratracting value by borrowing and securing the loan against the property might deal with the immediate issue of cash being trapped in an illiquid asset but it does not deal with the other issues highlighted above. Further owning the property outright and mortgaging has a very negative effect on a company's balance sheet something which, under current accounting principles, a lease does not.
In fact, failing to use sale and leasebacks to some extent might have hampered Southern Cross' expansion.  Whilst one might argue this would have been a good thing one has to consider how, with an increasingly ageing population, having less care beds available is necessarily in the public interest.
I have been involved in a number of sale and leaseback transactions and also acquired and sold properties which have been investments created by them including some Southern Cross properties.  Sale and leasebacks come in all shapes and sizes but I can confidently say that it is not the sale and leaseback model that is the problem but rather the way it is structured and its misuse.
A lease is a very flexible instrument and property valuation more of an art than a science.  Accordingly, by varying the lease inputs in relatively small ways the capital value of a property can be increased or decreased significantly.  But sometimes you can change the same variable without getting the same results.  For example, altering the initial rent on a sale and leaseback transaction will have a greater appreciable effect on capital receipts where rent reviews are index-linked than if they are open market.
Let's consider the Southern Cross approach.  Anecdotal evidence suggests that most of their leases were relatively long term (30+ years) on a full repairing basis with index-linked rents subject to a cap and collar.  Analysing these inputs and whether they were sensible choices for Southern Cross to make I would conclude:

• Term - on the basis that you are not going to move residents around homes you need a long term.  Further the large scale capital expenditure needs a long enough period to be amortised over the life of the lease
• Full repairing - SX would need to maintain the homes in order to comply with CQC and Care Standards so this covenant is not imposing a more onerous obligation on them.  Leasing a commercial property is not about being relieved of the financial implications of repairing it it is about best use of available cash
• Index-linked rents - SX's business model was based on local authority spending.  Historically this has always risen in line with a pricing index.  Therefore linking rents to such an index is more logical than relying on either fixed uplifts or open market reviews where true comparables are very difficult to find
• Cap and Collar - These are important for certainty.  From SX's point of view a cap limited its exposure to higher levels of inflation (and bearing in mind the concerns on inflation in 2007-2009 this was a good call).  The quid pro quo to a cap is a collar to provide the landlord with some comfort that there will always be a rise.  Frankly bearing in mind actual inflation you cannot blame the collar for the failure.

So why did SX fail and is the sale and leaseback structure blameless?
The sale and leaseback structure is not blameless but the issue is more likely that SX agreed rents that were too high in the first place.  The incentive for this is clear.  Within reason the higher the initial rent the higher a price a buyer will pay.  SX extracted maximum value for each property by agreeing to pay the maximum rent which it was felt the business operated at that care home could bear; it left no room for drops in income.  Had their assumptions borne out no one would have questioned their actions and everyone would be marvelling at what a fantastic job the board had done.
However, before singling out the board of SX for criticism regarding their assumptions let's not forget the following:

• landlords had their own advisors who were as well placed as SX to study the demographics, macro- and micro-economics behind the business and lease structure and highlight concerns - did they?
• we had a Labour government which had continued to increase year-on-year its public sector spending in key areas including elderly care and shown no interest in reducing it (even after the credit crunch hit)
• we had Gordon Brown as chancellor telling us he had "abolished boom and bust" and many were happy to believe him
• we had banks with apparantly endless resources able to lend at high leverage

In reality SX was as much a victim of the lax lending practices and flawed belief in our own perpetual success than a totally flawed and unjustifiable business model.  That others have survived where it failed may be more a matter of luck than judgement.
Jamie Buchan, SX's soon to be ex-Chief Executive, said in an interview with Adam Shaw on BBC Radio 4 Today this morning, that he expects changes in the sale and leaseback model in the future after their troubled experience.  Paul Pressland who responded to @AdamShawBiz's tweet said "it is simple, agree a rent you can sustain not one that gives you the greatest capital sum!".  Whilst it may not be that simple it certainly would be a good start.

Insolvent Companies' Directors and TUPE - a small loophole with a big cost.

Here is a bizarre scenario for you. A company exists and it is run, as all companies are, by directors. They are the mind and decision makers of the business with ultimate responsibility for the success or failure of that business.

The business fails and falls into an insolvency process. On a sale of that business the directors will automatically transfer over to the owners of the new business with the same terms and conditions unless the new owner can agree a compromise with the directors.

This is all thanks to a wonderful piece of European legislation lovingly referred to as TUPE. This legislation has a very honourable purpose - it ensures that employees of a business are protected against losing their jobs or having their terms of employment unfavourably altered just because a business changes ownership. It is widely drafted to prevent clever lawyers finding loopholes for their clients and, rightly, applies even to the sale of parts of an insolvent business to a new owner.

However, what does not appear to have been considered is that this legislation results in every employee passing across. Directors are employees (often the highest paid ones). Where a sale is one sought out by the company and it is agree that the directors will leave this is not an issue (although it does potentially create a conflict of interest for the directors concerned).

But where a company is insolvent the directors are ultimately responsible for that failure. By TUPE applying to directors even in such circumstances it has inadvertently placed directors at the front of the queue to extract payouts from any potential suitor where the money involved could have been invested in the new business providing a better chance for the future success of the phoenix entity.

So, as with the bankers and their bonuses, those with most of the responsibility for the failure of a business are given the opportunity to be compensated for their failings whilst the less responsible employee faces an uncertain financial future. An easy loophole to close if someone would just pull the right strings.

Reform the planning system . . . again!

Those of you who follow me on Twitter will already know that The British Chambers of Commerce have just released "Planning for Recovery" which is their views on the problems with and solutions for the planning system in the UK if we are to get out of the current doldrums.
The report is very well set out highlighting in separate chapters:

1. The relationship between the planning system and its effect on businesses
2. The current planning system and its shortcomings
3. Reforms to the planning system already on track
4. Recommendations for further reforms to help speed recovery

There is little doubt that the need for planning regulation will automatically result in delays and frustration. The report highlights a number of cases where the delays have been hideous, for example, Heathrow Terminal 5 where a formal planning application was lodged in 1993 but consent was only finally given in 2001.

Broadly the idea of reforming the planning system to enable applications to progress more quickly especially on large infrastructure projects where the needs of the many can often outweigh the needs of the few is one with which I agree. Further, on a street level removing the obstacles to sensible extensions and loft conversions to enable families to grow within houses rather than having to move would hopefully help keep house prices better regulated. However, I do wonder the deliverability of any such reform. It seems to me that loosening the reins in order to speed things up will only lead to minority views being totally ignored. Also, contrast the current calls for greater regulation in the financial industry as a result of the credit crunch with the calls for the loosening of regulation (not necessarily in planning) in the construction industry to help it get back on its feet - is the construction industry not partially to blame for the current situation?

On a slightly separate point, I do not feel that the current predicament of much of the construction industry is, of itself, any justification for reforming the planning system to enable them to get back on their feet. Factors in developers getting into so much trouble were taking on too much debt, being overly optimistic in their predictions and forecasts, overvaluing their assets and generally not doing a good enough due diligence and financial plan job. Should we really reward such poor judgement?

So, whilst I support reform to reduce delays it should not be at the cost of the minority voice nor merely to save those who showed poor judgement but rather to benefit those who acted with due care and attention. Now if someone can come up with such reform I will be impressed. Any ideas let me know . . .