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The impact of the structural changes in UK commercial leases

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The current economic conditions have perhaps impacted on the property market to a greater extent than any other sector for a number of well-known reasons. Property is vulnerable, the demand for its products is a derived demand, as other sectors see reduced business activity so the demand for space greatly reduces. The development sector is hugely dependent on a supply of debt finance; development is a high return/high risk activity and, in a climate of uncertainty, development is a risk that lenders simply can do without.

Despite this, the value of good quality commercial investments have remained relatively strong, and again the reasons for this are fairly obvious. A relatively new, well specified building with its income secured against a good covenant is a solid investment set against the uncertainty of equities and bond rates. In addition, the choking off of development supply is of benefit to the existing stock, guaranteeing a limited supply in the short to medium term. Yields have remained low and thus values have stayed  high, although there has been a flight to quality evidenced by the widening of the gap between prime and secondary yields.

This bit of good news and good performance has disguised something that has huge significance for UK investment and valuation practitioners that could be a potential source of problems come the recovery and upturn. This is the sea-change in the leasing structure of UK investments.

On 13th August 2011, Estates Gazette had a news article reporting the latest IPD/BPF data on UK commercial leases.  They looked in particular at lease length, the duration of rent free periods and the incidence of break clauses in leases.  A summary of the findings is as follows: -

  • Lease lengths
    • Average length of lease granted in the previous year in London was 6.5 years (compared to 6.7 years in the 2010 report and 12 years in 2001)
    • Rest of UK average was  5.8 years (6.3 years 2010 and 17.5 years in 2001)
  • Increase in rent free periods
    • Average rent free given for a new offices was 18.5 months on new leases in 2011 (up from 14.5 months in 2010)
    • For Industrial it was 9.1 months (8.1 in 2010)
    • For Retail 10 months (7.3 in 2010)
    • The overall average was 13.4 months rent free
  • Increase in use of break clauses
    • 40% of new leases in South East have break clauses
    • This compares to 54% in rest of UK
    • 24.8%  of retail leases have break clauses

The catalyst for this has, obviously been the recession and the weakening occupation markets and it continues the trend that started in the previous property downturns, particularly in 1989-92 where the classic UK institutional FRI 25 year, 5 yearly upward only rent review norm was severely hit. The changes bring the UK much more into line with our competitors in the developed world in all areas of the globe and also have distinct advantages for business in terms of greatly increasing their flexibility of occupation. Some of these changes will be reversed when the market improves, the rent free periods obviously, the break clause inclusions possibly (personally I am doubtful on this one) but one will obviously not be and that is the length of lease granted. They are short now and they are going to stay short.

So is this really a problem?

Well in certain respects yes, and I would cite a direct and an indirect effect of these changes as being significant, with the indirect affect perhaps being the most crucial.

The UK property investment market has always had two things which have made it unique and made the products it offered very sought after by both UK and overseas investors. The first was the ‘cleanness’ of the investment vehicle created with the FRI status allowing investors ‘hands off’ management. This largely still exists however the second, the security of income that UK investments provided, is greatly weakened. The long lease structures with five year periods between income changes tied to the upward only review clauses was effectively a long term income guarantee able to benefit from the upside of inflation but was insulated from downward market trends. Whilst upward only rent reviews still exist on paper, the effect of short leases and break clauses effectively means that they are dead, at least in office and industrial leases.

So UK property investments at the prime end have seen a dramatic transformation as an asset class. There has been a huge increase in risk both in terms of the income stream and capital values. Covenant strength cannot be guaranteed, the long projection of income stream projecting 10-15 years into the future with no interruption can no longer be securely made. This process has been inevitable, the whole rationale behind our economy is flexibility for business in all aspects of their operations and our leasing practices had looked archaic, as much of a dinosaur as closed shop unionisation now appears in labour markets. The loss of the uniqueness of UK investments is just something investors will have to live with.

This is not the primary concern of this paper. What is my concern is the indirect effect that I mentioned earlier. I believe this to be much the more serious matter.

We need to talk about valuations.

The changes that have occurred have a huge potential impact on valuers and investment advisers. The worry is that this is occurring at a time when fee incomes have been hit, when staff numbers have been reduced, when there is less investment in training and follows a long period where the skills within the valuation profession have been eroded, and, perhaps most importantly, where there is still an over-reliance on traditional valuation methods. These methods are not well suited to cope with the explicit assumptions and transparent approaches which are going to be required from now onwards.

Let us look at the fundamentals.  It has long been known in the real estate world that there are two major blocks of theory that exist; the UK approach and that characterised by the rest of the world. Essentially, Europe and USA have traditionally used a cash flow approach (DCF), whilst the UK has traditionally used the Capitalisation of Income All Risks Yield (ARY) approach. That is fine, there is a strong professional base that has developed and underpinned both sets of technique and thought and both have worked in their respective fields of interest. Vive la difference, we do things differently, what does it matter if it works?
 
Well I think we actually do need to ask the question, why? Why do we have these differences? Is it a coincidence that the UK stood out from the rest of the world in the nature of our investment market and our leasing practices and, in addition had a quaint and unique way of doing valuations? Of course it’s not coincidental. The reason for the difference in valuation approach was the fundamental differences in lease structure, admittedly allied to perhaps the most active and developed investment market anywhere in the world.

UK valuation methods grew up in and environment of long, secure leases. Normal lease terms have fallen over the last 100 years from 99 to 49 years in the immediate post war periods to 25 to 15 year lease lengths up until the current round of economic calamity. In addition these leases provided fixed income periods. When rent reviews came in to deal with the effects of post war inflation these reviews were initially of long duration but then also came down from 21 year to 14 year to 7 year and 5 year intervals, always on an upward only review basis. In addition the FRI status meant that in the majority of valuations the question of allowing for running costs in the long term needn’t be address. It is no surprise therefore that the UK essentially adopted and adapted methods used to value long term bonds. The Cap rate approach we use now is a strange hybrid that has developed to deal with the periodic stepped upward change in the income stream that were incorporated in leases. Be we look at the layer approach, term and reversion, equivalent yield and even equated yield approaches, the rationale is the same and it worked because we have an active investment market that provides yield evidence from universally similarly structured investments. It also worked because the property investments were essentially still long term bonds secured against the occupying company’s covenant for years and years.

In contrast, the European /USA markets have always been characterised by much shorter leases of 1-5 years typically, with frequently annual changes in income and often with non-recovery of all costs, these costs which would vary over time. To value these assets they therefore needed methods that projected the varying income and expenditure patterns forward. It is no surprise that these more complex and variable income streams needed a primary approach that more easily dealt with these characteristics, i.e. a DCF approach. (Note that US appraisers actually do use a variation of the ARY approach as a check method, capitalising a long term stabilised net operating income into perpetuity but this is clearly subservient to the DCF method.)

The question is, are we really that different from them now? Consider the difference between the valuation of a prime investment today and, say in the early 1990’s. The average lease then was of 15 years duration. The valuer was insulated from the future because the key events, the lease renewal or re-letting event with associated void period and costs was at a nice cosy distance in the future and therefore had a much reduced impact on value. Contrast that with a 2011 style investment that may only a five to six year term, even less if it contains a break clause. Suddenly that void period, the period where the owner is going to be responsible for all the energy costs, the UBR, additional security, the cost associated with re-letting are frighteningly close and real and are at costs that are close to their current values. In addition, horror of horrors, that nice secure rent achieved on a brand spanking new building is not going to extend long into the future protected by the rent review clause. The building may well hit the market and go up against shiny new developments with developers with huge incentive budgets. That rent probably will fall. Suddenly the poor valuer is having to take all this into account.

The thing that most will shelter behind is the market derived yield. This is supposed to be result of rational investors competing with others in the market place, weighing up all the risks involved before determining the price they pay. All the valuer is doing is taking that market evidence and applying it to investments that have similar characteristics. Well that is true however I would make the following observations, Firstly the market is very thin at the moment, who is selling? And for what reasons? Does this represent good market evidence? Secondly and more importantly comparable evidence works best when there is a high level of uniformity in the market place. We did have uniformity in the days of the institutional lease and institutional standard investments. We don’t really have it now with current leasing fashions. What we have is high levels of volatility in most investments; what will happen with one will probably not happen in another. The certainty has gone. This is another reason why the US market relies far less on market evidence and far more on the judgement of the appraiser as the characteristics of the individual investment.

Am I saying that UK valuers should now be switching to DCF as the primary valuation tool? Possibly, it certainly at least warrants debate.

Whilst there is a compelling case for adopting a DCF approach due to the reasons I have outlined above, there are well known concerns about this method. Firstly there are questions regarding the standardisation of approach; DCF’s can be unstable when not constructed correctly and there are a number of ways of constructing the models. Secondly, there are also issues for valuers regarding their assumptions being so transparent and exposed which could lead to problems if the valuation ever was the subject of litigation. In addition, many commissioners of valuations have only wanted a single figure, they often have no interest in how the figure was produced – unless things go wrong of course.

A further issue to consider is that many valuers use the same primary valuation tool in Argus Valuation Capitalisation Estate Master Investment Appraisal (IA). These valuation tools provide provision to include re-letting probabilities and variable discount rates  for reversionary yields. These, once modelled, are automatically incorporated into the valuation. The mechanisms are, therefore there to further adapt the traditional UK methods to deal with the issues created by the shorter, more flexible lease structures, however, if valuers are having to make these assumptions (which will be transparent in the valuations) to make their rather compromised traditional models work why not then go the extra step and adopt DCF, something which was designed to deal with this complexity in the first place? Estate Master IA  incorporates a DCF calculation method  as does Argus  (Argus DCF  add on DCF module) that is constructed from the same data inputs used in the conventional valuation.

Overall, case for switching over to an explicit DCF approach is not finally won but is more compelling now than it ever has been. The big issue, however, which applies to both methods is risk and uncertainty and how to report this to clients. UK prime property investments are hugely more risky than they used to be and that, by implication, must mean that the valuations done on these properties are less certain. Although the RICS have tried to tackle this issue the solutions that have been produced are, at best, unsatisfactory. The solution must lie in a statistical measure of risk but the implications of this in terms of both valuer and client education are significant.

The property world and the professionals within it are notoriously conservative. When change comes it is often forced upon us. To me it seems that time may be rapidly approaching, if it is not already with us.

Date Published: 06 Feb 2012
Category: White Papers

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