Key trends in commercial property- September 2013

The media has been awash with plenty of coverage relating to deals in the commercial property sector. With the economy showing tentative signs of recovery, it is not surprising that investors seek buildings with strong covenants, long lease terms, fixed RPI linked rent reviews and opportunities to improve their asset through management. I thought I would summarise some of the key trends in the sector, with examples of recent deals.

Office property

City of London offices have continued to perform well. The city continues to see strong demand from Insurance/ TMT tenants. It was recently announced that Henderson Global Investors have submitted plans for a new building at 40 Leadenhall Street appropriately named 'the toaster rack.' If successful, this will join the 'walkie talkie' (20 Fenchurch Street), 'the cheese grater', 'the shard' and 'the Gherkin' etc. Add to this the fact that Songbird Estates, (owners of the Canary Wharf office portfolio) have increased their underlying profits, and it appears that this sector will continue to perform well.

Industrial property

The internet is changing the way we shop. High business rates charges are making it increasingly unviable to retain traditional bricks and mortar shops.  That said, the rise of 'click and collect' is a dominant trend in the retail sector with shops acting as collection points. However, warehouses are needed to store and distribute products to the shops concerned. Thus, warehouses and distribution units have seen strong demand. See Segro's and London Metric's activities in this sector.

Regional assets

There have been signs of increased demand for regional assets from investors. As stated above, investors appear to be keen to acquire assets that are capable of being actively managed and can produce a stable long term income. See LaSalle Investment Management's recent acquisition of a Birmingham shopping centre.

The rise of Chinese Insurance funds

Commercial property professionals would be wise to pay attention to investors from the Asia Pacific region. Chinese Insurance funds are relatively new to the market. A recent regulatory change allows such funds to invest 15% of their total assets in 'non self use real estate.' As a result, such funds are likely to target high transparency markets, such as the UK, for their Investment.

The rise of alternative sources of finance

Banks are unlikely to extend their commercial real estate loan books anytime soon. This creates opportunity for alternative sources of lending such as high net worth individuals, pension funds, Insurance and sovereign wealth funds etc. Alternative investors with strong cash flows are likely to continue to generate considerable activity in the commercial property sector.

These are just a few of the current Issues and trends in the commercial real estate sector at the moment.

Recent developments in Property

My hands have been rather tied recently and I have not been able to blog as much as I would like. Fortunately, much has happened in the Property world of late. I thought I would use my return to briefly summarise some of those changes:

Office to residential conversions: The government has passed the Town and Country Planning (General Permitted Development) (Amendment) (England) Order 2013. This will allow offices and other commercial property to be converted into residential property without express planning permission. The measure is designed as part of the government's wider efforts to streamline the planning system and accelarate economic growth. Nearly all of London's boroughs have sought an exemption to protect their office stock. The problem is that not all commercial property will be suitable for residential development. If changes need to be made to a property (in order to make it suitable for development) then surely express planning permission will still be required? Perhaps the government's plans to stop the planners planning may not be quite successful after all.

Statutory Code between Pubcos and Tenants: pub Tenants on 'tied' Leases have argued that the practice is unfair and anti competitive. Under a tied Lease, a pub Tenant must buy their Beer from the parent company. Contrast this with 'free of tie' Leases where pub Tenants can purchase drinks on the open market. Tied Tenants argue that such Leases are restrictive and have forced up rents. The government has responded by proposing a statutory code to regulate the above practices. Pubcos argue that this runs contrary to the government's general aim of reducing red tape. They assert that Pubcos provide vital assistance to their Tenants in terms of branding, know how etc. This may well be an interesting example of regulation that works in favour of small businesses for once.

Marks and Spencer v BNP Paribas Securities Trust Company- this is the first case where a Tenant has succeeded in recovering rent relating to a period after the break date. The Tenant was required to pay a premium of a year's rent. The Lease contained a clause stating that there would be no recovery of rent on the break date. The Tenant paid the premium and also made other payments (service charge payments etc) that related to the period after the break date. The Tenant was subsequently successful in recovering the payments that had been made. It remains to be seen whether or not this trend will continue. In the meantime, it shifts the balance back in favour of the Tenant. Break clauses have traditionally operated in favour of the Landlord and are strictly construed by the court. This case will provide relief for many commercial Tenants.

Aurora Fashions- fashioning Leases for tough times

I was not surprised to learn that Aurora Fashions has entered into negotiations with Landlords seeking favourable rent and other terms. This is hardly surprising against a backdrop of stubborn inflation and persistently weak economic growth. When you throw in business rates (which it has been estimated costs the high street some £175m) and empty property rates it is no wonder the future looks bleak. Thus, many businesses will not want to be locked into a 'straightjacket Lease.' Many Tenants will try to negotiate monthly payments, rent free periods or even less onerous break options. As the economy continues to flatline, we may increasingly see new Leases replacing the old 25 and 50 year Leases. What will the new Leases look like?

• They may well be as short as 5 years or even less. What qualifies as a 'strong covenant' today may not tomorrow.
• They could exclude the operation of the Landlord and Tenant Act (LTA) 1954. This will alleviate the Landlord's concern that an underperforming Tenant will not 'move on' once their term has expired.
• Break clause conditions may well be less onerous. Traditionally, Landlords have drafted very tight and narrow break clauses designed to penalise a leaving Tenant. Lax break options will allow a Tenant to move on and the Landlord to create a diverse mix of Tenants in their centre or premises.
• Restrictions on assignment may well be relaxed. A struggling Tenant may wish to sub-let part of their premises to an under-Tenant. A Landlord should be encouraged to view this positively if it will allow a Tenant some breathing space to trade.

In short, a new style Lease suited to tough economic times contains advantages for both the Landlord and Tenant. It gives a struggling Tenant some leeway and allows the Landlord the chance to easily bring in new Tenants if things don't work out. The recent trend of administrations may well be showing that new fashions are replacing old ideas...

Conservation covenants

I have been following the recent BBC programme- 'The Planners.' Briefly, it follows developers up and down the country whose ambitions for development are pitted (and usually thwarted) against the wrath of local objectors and the scrutiny of local planning committees. This revealing series illustrated just why planning law is such a stimulating and interesting (albeit niche) area of law. It concerns politics, power and personalities. It is far from being dry and mundane.

Despite the above, developers of commercial property and residential housing schemes should be aware of the latest consultation paper published by the Law Commission:

http://lawcommission.justice.gov.uk/areas/conservation-covenants.htm

The paper considers the case for conservation covenants. Such covenants would be entered into between developers and landowners and a responsible body (charities / local or central government) with the explicit aim of heritage and agricultural land conservation. Such covenants exist in other countries but not the UK. Such covenants would be long lasting and designed to protect the land even after the landowner has parted with possession. Unlike restrictive covenants, they would affect both Freehold and Leasehold land and can be positive as well as negative. The Commission asserts that only 'responsible bodies' such as charities would be able to create conservation covenants. The idea is to preserve the environment for future generations. We shall have to watch this space to see how such an idea will work in practice. Developers are well advised to keep an eye on the consultation.

I have no objection to the preservation of the environment. The concerns of local residents must always be borne in mind when considering new development. However, economic growth depends on new employment opportunities through the creation of new homes, retail and leisure units. Conservation covenants may well have a laudable aim. However, the Law Commission may end up creating (rather than solving) more problems if its proposals end up thwarting much needed urban development and renewal.

Property implications of the budget

On my return to writing this blog (my hands have been rather tied as of late) I felt it pertinent to discuss some of the most important aspects of last week's budget. Overall, no major surprises. Osborne delivered a political budget. It wasn't exactly 'rabbits out of hats' but it was undoubtedly populist in tone and, frankly, did little to address the structural flaws in the UK economy. So not quite an omnishambles budget?

The main provisions of interest to the property industry are thus:

• £3bn of extra capital spending was announced for Infrastructure investment- on the one hand this is welcome news for the property industry. Investment in new schools, bridges, roads and railways can only have a positive effect on economic growth. However, the money does not start to come on flow until 2015/16. It would be more beneficial, to have the full effects of the investment coming on stream now.

• New mortgage guarantees and shared equity schemes for first time buyers- the government promised new mortgage guarantee support for first time buyers of new build residential property. We shall have to watch this space to see whether or not it will lead to increased activity in the property market. Funding for Lending had a small effect on the property market. That said, there is disappointment that the Chancellor did not do more to extend the scheme to assist SME's and business tenants. Lenders are more reluctant to lend to a business tenant than they are to a residential mortgagee. We've had project Merlin, quantitative easing, credit easing etc. All seem to have had a negligible effect on increasing lending to SME's.

• A corporation tax cut to 20% and a new employment allowance (through cuts to employer's NI contributions). The benefits are obvious. Cuts to corporation tax and NI will only reduce the business tenant's overheads. This is surely welcome relief at a time when many tenants (particularly in the retail sector) are struggling with rising rent bills. That said, the Chancellor did miss the boat and failed to listen to retailer's concerns regarding business rates. Most retailers will face a rates bill of £175m this year. I have stated before on this blog, that many Leases are up for renewal in the coming years. If no action is taken to alleviate the stress placed on retailers, then tenants may be forced to leave their properties when their Leases come up for renewal. This will result in the nightmare scenario of an empty property for the Landlord.

• An 'annual tax on enveloped dwellings' (ATED) will come into force this April. This applies to companies who purchase high end residential property. This is in addition to a stamp duty rate of 15% (for properties worth £2m or over purchased by a company) and a capital gains tax charge of 28% on a gain made by 'non natural persons.' The government does not want to deter property investment made for genuine commercial reasons. Thus, there are reliefs from the ATED e.g. if the property is purchased for charitable purposes, or is made open to the public for at least 28 days a year. This is indeed laudable, however it does show how heavily property is taxed in this country. This could well become a general trend as the government moves from a tax system based on income (which is highly mobile) to one based on property and other assets (which cannot be moved so easily). This is especially so as politicians continue to explore the possibilities of a much vaunted 'mansion tax' on high value residential property. The above suggests that it may not be necessary.

I have analysed the main provisions of the budget that will be of interest to the property industry. In short, the Chancellor has missed an opportunity by not bringing forward capital investment sooner, by not cutting business rates and by not extending government schemes to increase lending to business tenants. Many Leases are coming up for renewal. The Chancellor missed the chance to deliver a budget that would save Britain's high streets. Perhaps it has turned out to be something of an omnishambles after all...

The rise of turnover rents

It is amazing to think how many high street businesses have been consigned to the graveyard. It is difficult to know what can be done about it. There are the usual mooted suggestions- business rates cuts, greater use of 'click and collect' options by stores etc. However, I was interested to read this article in Retail Week:

http://www.retail-week.com/sports-direct-offers-turnover-deal-on-republic-stores-rent/5047295.article?blocktitle=More-News-and-Insight&contentID=5271

Republic, the fashion chain, was bought out of administration by Sports Direct (SD). SD offered Republic's Landlords 15% of the stores turnover to cover rents, rates and service charges. SD claims that 'given the number of voids on the high street, retailers’ relationships with landlords are coming to the fore. We’re doing something that’s really innovative that should be mutually beneficial.' Voids means empty shops and units. SD have also signalled that the new contracts would retain some flexibility, so that Landlords can walk away if they become unhappy with the arrangements.

The last part is interesting- the proposal by SD should be mutually beneficial to both Tenants and Landlords. This could indeed mark a sea change in the retail industry. Previously, I had written about how H & M had delivered a tough new set of Lease proposals to its Landlords. SD's proposals are completely different and a breath of fresh air. Landlords get their rent and have an interest in the continuing success of the businesses. Times are tough for Landlords- we are all aware of the rent problems they face after an administration, CVA or pre-pack deal. Landlords are caught between a rock and hard place in Lease negotiations- trying to protect the value of their investments (and the interests of their fellow investors by getting a good rent deal) and satisfying the Tenant who could walk away. SD's plans could mark a complete shift in the relationships between commercial Landlords and Tenants. Plans where both parties have a stake in the continuing success of the business and its property portfolio. We shall have to watch this space as to whether or not such proposals become commonplace in the retail industry.

Business rates rethink

I have written many times on this blog about the harm to SME's caused by business rates. The next re- evaluation is not set until 2017. In some places, rates can be higher than rents. The 'Fair Rates for Retail' campaign has called upon the Chancellor to freeze or (preferably) cut business rates in the upcoming budget. Business rates are, in the words of Kwasi Kwarteng MP (in an article in today's Guardian), a 'tax on the high street.' The Chancellor would do well to listen to his colleague as well as to struggling businesses on our high street. February showed that retail sales had grown by 2.7%. This is positive news. However, consumer spending is likely to remain depressed. The recent string of high street administrations shows this. Therefore, I was pleased to read this:

http://www.retail-week.com/in-business/policy/treasury-considers-business-rates-rethink-as-pressure-from-retailers-grows/5046900.article?blocktitle=Most-popular&contentID=-1

The government has signalled that it is considering a u - turn on business rates. Unlike the others, this u-turn will be deeply welcome and much needed. Ian Cheshire, CEO of Kingfisher and Chairman of the BRC (British Retail Consortium), states that that were it not for long-term leases he would close a quarter of the DIY retailer’s stores due to the tax burden. The following Retail Week article:

 http://www.retail-week.com/in-business/fair-rates-for-retail/fair-rates-for-retail-retailers-urge-rates-freeze/5041237.article

also makes clear that two years of punitive rate increases have added more than £500m to costs. The BRC Director General was right to assert that 'the most important four letter word in Westminster should be jobs.' The government already boasts that it has already created more than a million private sector jobs since taking office. Whether it has or hasn't, the fact remains that a business rates cut would increase the pace of job creation. Job creation is the strongest argument for a rates cut.

The Chancellor should listen. According to the article- the government is considering the way that increases in rates are calculated (by linking them to the lower rate of CPI rather than RPI). Business rates are bad news all around- bad for Tenants struggling to make a profit, bad for Landlords who need rent paying Tenants in their properties and bad for a government in need of tax receipts to balance the books. Will the Chancellor freeze or cut rates? Only budget day will tell. If the Chancellor wants a big headline initiative (that will actually have any effect) then he knows what he must do.