Swallow Ltd is a start-up business pioneered by Tom and Ned, two callow youths who reckon they have spotted a gap in the market for cravats, using cheap imported Chinese silk. In late 2016, they persuade Headline Properties plc to grant Swallow a five-year lease of a shop in a struggling tertiary retail parade known as the Mall, with a six-month rent free period, followed by a goodly rent. Swallow trades for six months (if trade is an appropriate description for its desultory performance), and then collapses into liquidation in April 2017.
Amazon Ltd (no relation, of course) is a successful discount supermarket chain, which, under the leadership of Rosie, its dynamic chief executive, has made a name for itself by acquiring and rejuvenating tertiary shopping stores, supplied by a superb distribution chain. One of Rosie’s most recent acquisitions in early 2017 was the anchor store in the Mall, which she takes on a 15-year lease, at a rent which Headline discounts to reflect Rosie’s winning ways.
Fifty Pee Stores is another tenant in the Mall. Its rent was due to be reviewed in March 2017. The parties could not agree the amount of the revised rent, and referred it to arbitration. Following detailed and impressive reports on behalf of each party, which say all that can be said, and more besides, the arbitrator publishes an award which treats the Swallow and Amazon lettings as the only relevant evidence; gives little weight to Amazon, because the rent is said to have been discounted from the market rent to secure an anchor letting, but by an amount which is difficult to establish; and places all conceivable weight on Swallow, on the footing that that was an open market letting unsullied by such features.
The surveyor representing Fifty Pee had pointed out that Swallow did not even make it to summer, and had traded through its rent-free period only, suggesting that it had not cared what rent it paid. The arbitrator brushes this aside in his award, saying that the unfortunate demise of Swallow occurred after the review date, and could not therefore be taken into account.
Better drowned than duffers
My readers will, for the most part, be familiar with this sort of caper – because the two tenants whose situations I parody above are symptomatic of the two ends of the spectrum that are routinely encountered in property valuation. At one end, we have the solid covenant, whose inclusion in a landlord’s portfolio will gladden the institutional heart, but which will use its track record and desirability to negotiate a low rent; at the other is the high risk, brand-new (and brand-less) covenant which will sign up to anything, including a high rent, little fearing the consequences of default.
Ironically, most well-drafted leases recognise this covenant strength factor as a vitally important consideration for landlords in deciding whether to grant consent to assignment. The prospective assignee is commonly required to satisfy a number of financial tests designed to establish covenant strength.
Accounts and references are commonly required as an absolute minimum. A high initial rent is all very well – but sensible investors are not interested merely in a letting at a headline rent that keeps the portfolio looking good; they are also interested in security of income stream. In the real world, therefore, scrutiny is routinely applied to covenant strength, not merely on the occasion of assignment, but also on the original letting.
By and large, rent review is intended to replicate the real world. Accordingly, where a third party is seeking to decide the market rent, he or she should surely have covenant strength well in mind when sizing up the comparables.
In the example given above, just as the Amazon anchor letting should be seen as a transaction that may well have been made for less than the market rent, so too should the Swallow letting be treated as one that may well have been at more. Quite how much (if any) less or more is of course a matter for the evidence.
Duffers do drown
There is little learning on this topic that I have been able to find – but the point that cashflow security is critical when it comes to rent pricing is surely so obvious as not to need stating.
The decision of the High Court in Curry’s Group plc v Martin [1999] 3 EGLR 165 is the only detailed analysis of which I am aware which grapples with covenant strength, in the context of an accusation that an independent expert had fixed too high a rent, by depending wrongly on three comparables consisting of lettings to tenants all of whom subsequently ceased trading (and two of whom were known to have done so after the review date but before the determination).
In that case, the attack on the determination failed, on the footing that there were no grounds at the review date on which it could be said that any of the three lettings were vulnerable. In many other cases, however, the seeds of destruction of the tenancy will be ascertainable by the review date. In such cases, surveyors and third parties in all valuation scenarios – not just rent review – will wish to reflect on the extent to which their evaluation of the evidence should take into account the viability of the party offering to pay an apparently high rent. If they do not do so, they are surely neglecting a vital component of the determination of a market rent.
Guy Fetherstonhaugh, Falcon Chambers
