Norman Bowie
Life is not meant to be easy — Malcolm Fraser when Prime Minister of the Lucky Country.
It has never been easy, except with the benefit of hindsight, for property investors and advisers to plan future investment policy. Today’s strange property market has several new and often conflicting forces at work, so any feeling of deja vu would wrongly portray the future.
On the world stage, the oil price has tumbled, to the distress of oil exporters and petro-currencies but to the benefit of oil importers. This downward thrust has been accompanied by falling prices of many commodities, whether measured in sterling or in SDR (the world basket of currencies) terms.
Government bond rates in most developed countries — except Australia, Spain and Italy — are in single figures and there is pressure on Japan at 5.1% and Germany at 6.3% to drop their rates even further to stimulate world economic activity.
Inflation rates are well down to two points or so or even less, with Germany now in a state of true deflation and Japan close to a zero rate.
Historical high real interest rates, often around 5%, are exerting a deflationary force in many countries. They present a performance challenge in yield-gap terms to low-yield investments while attracting investors to pick up high yilders and personal savers to place their surplus moneys on deposit.
At home, a number of interesting features have emerged which must be brought into policy considerations. The trend to invest in financial assets continues unabated. More life assurance companies are coming back into the commercial mortgage market and the house lenders have multiplied in number. Allocations of new money by institutions to property remain at lower levels than a few years ago.
Those retailers selling properties and leasing back may well be taking the view that, over a period, it will be cheaper to pay rent so as to obtain a better return from the business on the capital released. The new thrusting property companies refuse to cede any equity on developments and so they seek and obtain either debentures or loans from the banking system, with the loans often on a non-recourse basis from overseas lenders. The share prices of a number of property companies stand at a premium over asset value — requiring an act of faith by investors in managers’ skills linked with future growth in rents or a maintenance of dealing profits.
The older hands in the market have seen development profit margins squeezed in recent years under competitive pressure — particularly from institutions entering this sector — from around the traditional one-third to perhaps as low as a fifth of cost. These lower margins have resulted in the payment of higher land prices and as the risk/reward ratio has tightened so the development profitability becomes more vulnerable to any unexpected turn of events.
Shopping habit shift
Consumer spending remains high, supported by increased personal indebtedness so that family units become more highly geared. It is no wonder that retailers have their eyes on the car-borne shopper, while the expansion of retail space, mostly on the edge of towns, anticipates both an increase in volume and a shift of shopping habits. The balance between the sale of goods and services is changing with the greater emphasis in the latter field.
The recent prognosis from the University of Warwick on the employment scene forecasts the continuing shift of workers from the factory floor to the office desk. The new white-collar or white-coat workers are seeking employment in modern surroundings and attractive locations. It is not everyone who can be enticed into the cores of the conurbations with their difficult travelling conditions and less pleasing surroundings. All this is good news for the providers of new or modernised space and the locations thriving on better accessibility backed up by forward-looking planning authorities.
It looks as if the proposed changes in the Use Classes Order will be blessed by Government and Parliament. The acres of light industrial estates developed in the 1960s will form the raw material for the business park, campus office, and hi-tech buildings — and the planners will not be able to stem the tide. The consumer, whether tenant or owner, will have a wider choice, probably at competitive prices and on lease terms more favourable to the tenant than in past decades. Investors are now aware that hi-tech relates to high rates of obsolesence.
A consumer’s market is a healthy one for the economy as it keeps down abnormal price rises so that quality and price become all-important. On the other hand, a widening of choice erodes the expectations of higher real rates of growth and leads to higher investment yields and a better understanding of the rate of obsolescence of buildings and their components.
And over everything now looms the cloud of political uncertainty. This is an important new factor which cannot be ignored. Already the promises are being dangled in front of the electorate. The release of more capital moneys to the local authorities for early spending, the re-affirmed promise to cut income tax and the desire to lower interest rates (provided inflation can be kept down) come from the party in power. On the other side, there are proposals to boost welfare services and capital expenditure to provide employment, both to be paid by more borrowings and raising taxes on the wealthy. There appears to be no direct threat to property from any quarter. Persuasive repatriation of overseas institutional investment would release more funds for home investment, although that might be countered by foreign withdrawals from the bond and money markets. The impact of exchange controls on the operations in the City of London of the international financial conglomerates and their consequent demand for space is a matter of conjecture, coinciding perhaps with the arrival on-stream of new schemes currently projected by developers.
The scene all adds up to fluctuating and wobbly markets as different perceptions by investors gain and lose ground. In such times, the high-yield fund recently described (see “More thoughts on the market” in our July 5 1986 issue at p 24) has great attraction: another area well worth considering is that of leisure-related properties. All governments woo the overseas tourist, who helps to ease the strain on the exchange rate under all regimes, working hours continue to shorten, and the pounds in people’s pockets increase to the benefit of the leisure industry. Tourism in this country is one of the fastest growth areas for employment — and that means more buildings.
The investment problem in leisure property is basically that there are insufficient “arm’s length” transactions for investors to follow the traditional landlord/tenant route, and there is no real market. Within the RICS Background Paper on The Valuation of Properties having regard to Trading Potential, it is suggested, lie the clues to the answer. These properties change hands lock, stock and barrel, ie as fully equipped units. There is sufficient evidence in the market-place for the valuer, but these capital transactions often contain an element of goodwill that cannot be easily apportioned between the land and buildings and the management. The result is that there is no rental evidence, because true rents are seldom paid.
The way through the problem, unless the investor prefers to take the securities route of investing in the total business, is quite simple, and should be capable of being acceptable to both the landlord and the tenant. It must be recognised that the resulting structure does not have a ready market but it is an interesting mix of a land/buildings lease and a chattel finance lease topped up by a percentage turnover rent.
The starting point is for the landlord to provide the whole of the capital represented by the fixed assets, namely land/buildings and the whole of the fixed equipment and chattels. A lease is then structured with three elements of rent:
(1) The capital sum allocated to the land and buildings to be rentalised at a fixed percentage, say 7% to 8%, without review for a term of years equal to the economic life of the buildings.
(2) The capital sum allocated to the fixed equipment and chattels to be rentalised at a higher fixed percentage, say 10%, without review for the same term of years. The tenant/operator to set aside each year into a joint fund or other agreed vehicle an annual sum sufficient to meet the cost of replacement over the economic lives of these items, which will usually be 5 to 10 years according to their nature. The joint fund to be adjusted for inflation and drawn upon to replace these assets as they wear out so as to maintain the earning power of the whole property. It also ensures that in the event of a tenant/operator failure, the landlord resumes possession of a fully equipped unit maintained to an acceptable standard and not full of worn-out movables.
(3) An agreed percentage on gross turnover. This provides, in effect, an equity shares as the substitute for the “no rent review” in the two fixed rents and also cover for building obsolescence.
The tenant would be expected to take a full repairing lease and meet all outgoings as a normal operating expense.
Certain fundamental rules should also be applied:
(1) Choose freehold urban or fringe urban sites with a potential alternative use.
(2) Select established management and operators for tenants.
(3) Avoid properties and tenants where a large number of customers are in an all-embracing package, as the gross take may not be capable of fair allocation as between the property, other properties and travel.
(4) Avoid users of large areas of land.
(5) Good audit facilities are needed (VAT returns can be helpful as the Customs/Excise may do part of the job — for nothing!).
(6) Avoid historic and listed buildings, also conservation areas.
(7) The structural design to be such as to ensure future flexibility.
(8) Some spare land can be a useful bonus on successful operations for future expansion.
This approach should in many cases give a start yield in double figures and is capable of adaptation for hotels, hospitals, exhibition buildings and so on, and also innovatively fully equipped retail and store units.
The investor should be prepared to hold for at least the medium term and should recognise that in the absence as yet of an established market for leisure property, he should be well compensated by higher returns than available elsewhere in real estate.
In the coming months, investments which produce good returns and are less liable to shifts in market predictions on future levels of income could form a safe and sound haven against unexpected economic and political changes.
