by Geoffrey Smyth
In the case of their respective property industries the United States and the United Kingdom are separated by completely different organisations, standards and practices. In contrast with the surveying profession’s domination of most aspects of British property, the US real estate fraternity is largely populated by self-trained non-professionals. It is remarkable that US property, which has the greatest single industry capital concentration in the world, is developed, financed and marketed by people who, by and large, have no formal training in the industry whatsoever.
It is only over the past few years that US universities and notably their business schools have had courses covering the various aspects of real estate development and finance, and these do not generally compare with the scope of training available to British surveyors.
But the very professionalism and institutionalisation of the British property industry has resulted in a stultification which is proving increasingly inimical to new approaches towards tenancies, building specifications and the general competitiveness of British property in an international context. In the US, where there is little formalised industry structure, the participants in almost all phases of the development process embrace changing approaches to design, development, financing and leasing (in response to market pressure) from which the UK could well learn. While passive institutional investment from the UK to the US has been considerable in the recent past and the world-wide investment broking contribution of the major British surveying firms has been notable, there has been little cross-fertilisation of ideas in the remaining spectrum of property development, financing and marketing (Broadgate and Stockley Park aside).
The very fact, generally recognised and admitted, that Britain is a landlord’s market carries in it the seeds of its own change. In a market economy, by definition and particularly in the context of an open Europe, the British imbalance toward the landlord cannot last.
This is not prophesying the end of the prevailing UK agency, financing and other professional relationships and practices: but it is postulating that there will be an increasing number of tenants, notably from overseas, who will look for better deals than are available at present. After all, it is the tenant’s credit which ultimately underwrites the value of all property. The deals will have less onerous leases, better space, more appropriate specifications, a more participative approach to tenant improvements and will generally acknowledge the tenants’ real long-term aspirations and objectives with respect to their facilities.
The first problem which US corporate space users face in the UK is the cost of their facilities, whether they are developing to own, completing a sale/leaseback or simply leasing space. It is one thing getting “taken” on other terms when you are paying a nice low rent, but quite another when you are paying three times what you would be back home.
The standard UK 25-year lease is the next body blow. US executives new to UK practices simply do not get it. Even those used to the UK do not get it, but they have probably learned to roll with the punches. It is inconceivable to an off-shore tenant that they are expected to sign a lease which is effectively more onerous than owning the property, in that:
(1) Rent escalates to market at occupancy, even in a build-to-suit facility where the lease may be signed one to two years prior to occupancy.
(2) The tenant indemnifies the landlord and is responsible for any building defects, although he is unqualified and unable to ascertain the quality of the fabric and, more important, the building services of the premises.
(3) There are stringent restrictions on use, subleasing and assignment and even the hours of operation of the tenant.
(4) The tenant is still liable for the lease even if the premises are destroyed and reinstated within a several-year time period.
(5) The tenant is obliged to pay for common area upgrades, guards and other “bells and whistles” that the landlord may unilaterally choose to provide.
(6) Finally, there is a continuing contingent liability for the lease in the event of default by the assignee.
While it is argued in the UK that these provisions are academic and immaterial they none the less represent an obligation which is less flexible and more binding than outright ownership: the tenant cannot even get completely out of the obligation despite the fact that the lease does not figure as a liability on the corporate balance sheet. If you own the property at least you can sell it.
Tenant improvements to a “base building” are the third area of concern. The essential disinterest in the tenant’s occupancy and the fit-out of his space are symptomatic of the 25-year lease and the passive stance of the UK property owner. Once the lease is executed the tenant is regarded more like a cryogenics case than a living asset!
In the US the intelligent landlord nurtures his tenants. He regards the initial fit-out as an important component in making a lease deal and as a critical component of a building’s value. In the long-term management of the space and its improvement lies the opportunity to retain satisfied tenants and to upgrade continually the obsolescent components of the property. So, what if the improvements last only five to 10 years?
At least half the cost elements of modern buildings have an economic life of only 10 to 15 years, particularly the mechanical, electrical, telecommunication and life-safety systems. It is this area of asset management that is causing the greatest disadvantage to tenants and the greatest reduction in long-term asset value for the owner.
It is not efficient to fit out shell office space with ceilings, lights, air-conditioning diffusers and sometimes flooring and electric sockets in advance of knowing the tenant and his requirements. It is even more difficult to justify this when, as happens, the building is preleased and the occupant known. If the base building (an office in this case) costs £90 per sq ft to build and £20 per sq ft to fit out, at least £5 of each phase would be saved by integrating the system’s design and the construction of both phases. You might even get the air conditioning to work. So we have an outright 10% saving on direct construction costs, not to mention a month or two shaved off the development schedule.
Building specifications are another area where national orthodoxies, the small scale of development and a job-shop approach to building seriously compromise the long-term utility of much UK property. British design, engineering and construction are characterised by extremes of brilliance (Lloyd’s, for example — whether you like it or not) but a preponderance of mediocrity. The US market, too, is often characterised by mediocrity, but it is one whose underlying physical standards work well. Despite some extreme regional differences within the US, developers recognise a tenant market which requires and gets more of a commodity product for its distribution and office space.
Some people have commented that the US market is more “sophisticated” than Europe’s. With the exception of their understanding of air conditioning and life-safety systems this is not the case. The US, with its diverse and usually appalling climates (either freezing cold or unbearably hot and humid), has evolved generic and standardised building and services specifications rather than sophisticated ones. The market wants them, the sources of financing understand them and they work. They apply to office towers in the north-east region and Florida; warehouses in Phoenix or Milwaukee. The glazing system may not vary very much, but the glass will. The HVAC system will not change, but the sizing will.
The UK is still inventing the wheel. Because of lack of repetition, volume decreases; as a result of low volume, unit costs increase; because of the tenant improvement structure, the in-use learning curve is shallow. Office buildings incorporating spandrel radiant/convection hot-water heating with all-air ceilling air conditioning cannot be justified; American air does not move differently from that in the UK and unless you have floor-to-ceiling glass throughout, an all-air heating and cooling system works well. A raised floor is similarly unnecessary in most office buildings. They virtually do not exist in the US (a country with far greater demand for power, telecommunications and change than the UK) yet almost every new speculative office in the UK installs them. The agents persuade the tenants that they need a raised floor; the funds start to believe that without one the building is not first class; the developers then automatically specify one in fear of not getting financing; and a vicious circle is set up which results only in higher costs, more fees and higher rents.
The latest example which seems to be becoming fashionable is to design lift cores (with or without glazed cabs) in which the lifts are dispersed at the extremities of a luxuriously appointed vestibule and summoned from a hi-tech control panel on an ostentatious pedestal at the centre of the space. The tenant then has the thrill of taking odds on which cab will be first, and then sprinting from one end of the lobby to the other when it eventually arrives. This is an unjustifiably expensive and inefficient solution in terms of basic design and engineering.
A final criticism to be levelled at the development industry concerns the extent and inter-relationship of the participants in the development process. Obviously, modern developments need a host of specialised consultants. But the number of surveyors involved, representing developers, contractors, subcontractors, tenants, interim lenders and permanent funds is farcical. It can, and does, too easily result in obfuscation of purpose in an already diffuse process. It contributes to the suboptimisation identified previously.
One simple but telling deal involving a US tenant and an off-shore fund is an interesting case in circumventing established norms to mutual advantage. A US manufacturer decided to set up in the UK and identified a factory that it wished to lease. When all it was offered was a 25-year lease at £5 per sq ft the company’s board refused the deal: as a “start-up”, if the operation was not successful within three years they wanted out, with no contingent liabilities. A private fund heard about the situation and asked what rent the manufacturer would pay for a five-year lease with a three-year break option. To the manufacturer the rent was a high but still minor part of the start-up costs and it responded with a £7.50 offer. Having evaluated the manufacturer’s credit and the likelihood of its success the fund agreed to buy or headlease the factory and lease it to the tenant at the 50% premium. At the end of the three- or five-year term the fund has the alternative of renewing the lease (presumably at a comparable premium), of reletting at conventional market terms or of selling. Not a bad deal for all concerned.
So what is the bottom line? The bottom line is that there is money to be made here: by developing better buildings more cheaply; by responding more creatively to the market; by understanding what will and will not contribute to long-term value; and by adopting a strategic approach which questions conventional wisdom and evades as many as possible of the restrictive practices which are too prevalent in British property. It is likely that off-shore users and investors will be at the forefront of such initiatives.