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!

Changes to Competition Law: An end to "good estate management"?

Many thanks to Adrian Magnus, a partner in BLP's EU and Competition Law practice for his input in this blog.

From 6 April 2011, the Chapter I Prohibition under the Competition Act 1998 will apply to land agreements.  This might come as a surprise to a lot of people.  What on earth does competition law have to do with the ownership of land and why have land agreements hitherto been exempt?


Another legal tightrope for Landlords?
Photo by Donald Judge



I do not want to carry out a detailed analysis of the history of competition law and land agreements.  In summary competition law should apply to any agreement the effect (whether intended or not) of which is to be anti-competitive.  This can, for example, be by creating barriers to entry by preventing competition or by two competitors carving up markets between themselves.  Up until 6 April 2011 land agreements were exempt from the legislation.  However, the Government, in its wisdom no longer sees any justification for such differentiation and so now all land agreements will be caught.

Be warned, this change is not forward looking only and does not have any grandfathering provisions.  Even an agreement entered into 100 years ago could be in breach.

One area of particular interest for the real estate industry is the management of large retail estates especially shopping centres and retail parks.  It is not uncommon in these estates to have leases which contain different restrictions including:

• very specific user covenants limiting the use to, say, a shoe shop or a coffee shop

• allowing the landlord a right to refuse changes of use in the interests of "good estate management"
• exclusivity arrangements whereby the landlord agrees not to let other units for a specific use or to specific identified entities

Are these restrictions in breach of the law? 
Can tenants seek changes of use and threaten the landlord with reporting them to the OFT if they rely on "good estate management" as a reason for refusing the change?

Thankfully, the revised guidelines published by the OFT is an improvement on and much clearer than the first draft.  It recognises the fact that there are many legitimate reasons why a land owner might seek to impose or agree restrictions on the use of land and that only a minority of such restrictions will infringe competition law.

The OFT Guideline specifically recognises the need for user restrictions in leases in order to ensure a good mix of tenants and notes that such provisions are unlikely to be in breach of competition law.  Therefore limiting use to or prohibiting use as, for example, a shoe shop or allowing the landlord to refuse consent to a change of use in the interests of "good estate management" should not cause concern.  There are exceptions to this especially where the owner of the land is also a retailer.  For example, if Boots owned a shopping centre and in all leases for that shopping centre had an absolute restriction preventing the sale of pharmaceuticals, perfumes or personal grooming items this is much more likely to be considered an infringement.

Furthermore, exclusivity arrangements which place restrictions on the landlord's ability to let other parts of the same centre or park to a competitor carry with them bigger risks.  These can take a number of forms.  Let's take the Boots example again (nothing personal I promise).  If in a lease to Boots the landlord covenanted that it would not grant any leases within the same centre to other chemists and/or would include in all other leases of the centre a restriction on the sale of pharmaceuticals, perfumes or personal grooming items then there is a real possibility of an infringement of competition law.  The reasoning is that if no one else can sell these items in the centre this will result in reduced choose, potential for higher prices and worse service; there is no competition to encourage best practice.

Whether or not such provisions do in fact infringe competition law is not a black and white call.  This will depend on a number of things including:

• the geographical area (market) affected - for example a shopping centre such as Bluewater or the Trafford Centre may well be considered differently to the shopping arcade at Bond Street Station
• the market power of the parties concerned - for example Boots as opposed to a 5 shop franchise

There are also exemptions which may be able to be relied upon which are relevant for the shopping centre/retail park scenario.  These are applied on a case-by-case basis if the criteria is met rather than being blanket exemptions for certain types of agreement.  For example, exclusivity being granted to an anchor tenant could be justified since without the anchor tenant the proposed centre/park would not be economically viable.  Of course, this does not give a blanket exemption and the specific provisions relating to the exclusivity being granted need to be carefully considered in context to ensure that they do not go further than necessary to achieve the desired results.

In summary, the removal of the exemption from land agreements of the effects of competition law have wide ranging implications for land owners.  Shopping centre and retail park owners should carefully review and consider their agreements and developers need to consider how to operate within the rules when setting up new developments.  The good news is that "good estate management" can continue but the ability to restrict uses for the benefit of certain occupiers or the landlord is severely restricted and has become another legal tightrope for landlords to walk if they are to avoid expensive and image-damaging litigation and negative publicity.

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?

Fee cutting is no way to emerge from recession | Analysis - print | Property Week

Fee cutting is no way to emerge from recession Analysis - print Property Week

Giles Barrie, in his editorial this week, raises some interesting points regarding the effects of fee cutting in the agency world.  The same phenomenon can be seen in the legal world for the same reasons and with the same fundamental risks to buyers of legal services.

Cutting fees is bascially an attempt to grab market share by low balling now with the hope that the client will continue to instruct you when times are better and you charge more for the same service.  Understandably many buyers are attracted by the low rates on offer but before rushing to buy the cheapest service they do need to consider what they are getting at such a cheap price.

Some issues include:

• Many of the problems that are being identified now with properties should have been spotted previously but due to time, cost and deal pressures they were not.  Taking the cheapest quote is simply repeating the mistakes of the past.  Now is the time to ensure you are getting the best advice for your circumstances as a mistake now could cost a lot more than the few pounds saved in fees.
• In order to remain profitable a firm offering a cheap quote will be forced to push the work down to the lowest level possible.  I have heard of one firm hoping to put in place data capture systems which would enable all leases reviews to be carried out by trainees.  No disrespect to trainees but no matter what technical systems you have an inexperienced trainee is unlikely to spot where a rent review clause is defective or whether there might be a Good Harvest issue in the drafting.

From the suppliers' side such low balling also creates issues:

• It creates the impression that little or no skills are required for the work - if this was the case then law firm's indemnity insurance would clearly not be as high as it is!
• It demoralises staff who know that they are effectively providing a service for which the clients are not paying.  They constantly feel under pressure to cut corners to improve profitability further increasing the risk of negligence and resent the fact that they cannot do a proper job as the fees do not allow it.
• Do you honestly believe that a client having instructed you because you were cheap will stick with you when you hike your prices on the basis that you are going to offer the same service?

Therefore, as Giles notes in the agency world, fee cutting in the legal world is damaging for both customer and supplier in the long run although I suspect will continue to be the case as many fail to recognise the risks.

Contracting with a UK REIT - does it make a difference?

REITs hit the UK landscape in January 2007 and now many of the best known names in the UK property world are REITs - Land Securities, Hammerson, Great Portland Estates, British Land to name a few.  As a matter of course there are certain questions one always considers in terms of the party with whom you are contracting.  It is important to consider whether they are executing the documentation correctly and, indeed, their power to enter into the transaction.  If it is a foreign entity the obtaining of a legal opinion is advisable.

REITs add something different to the mix and the risk to a party contracting with a REIT is that without knowledgeable legal advice one can be exposed to unnecessary risks or, indeed, lose out on potential advantages.

The rules governing REITs are complex and affect not only the REIT itself but also those with whom it contracts.  A REIT's business is split into a Property Rental Business (PRB) (which must be at least 75% of its total income) and the remainder being its Residual Business.  PRB income is effectively tax exempt (there is 20% withholding tax which exempt investors can reclaim) whereas the income from the Residual Business is taxable at 28%.

It is beyond the scope of this blog to go into detail (nor would I wish to give away trade secrets quite so easily) on the potential issues and pitfalls that can arise when dealing with a REIT but some highlights include:

• the sale of shares in an SPV property company by a REIT will be a Residual Business which may have negative tax consequences
• the base cost of a property in an SPV once owned by a REIT may be higher or lower than the SPV paid for it
• the sale by a REIT of a development within 3 years of practical completion is likely to be a Residual Business which again has negative tax consequences
• whilst the PRB part of the REIT does not pay tax it still benefits from capital allowances to reduce the dividend payments it needs to make so REITs will not simply give these up
• Joint Ventures with REITs raise all sorts of governance and tax issues and potential advantages

As mentioned the REIT legislation also provides potential opportunities as well.  Therefore it is key that when you are getting into bed with a REIT you know what those opportunities are and how to exploit them for both parties' benefit.

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.

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.