by Leslie Aarons
The cynic, according to Oscar Wilde, is someone who knows the price of everything and the value of nothing. In the marketplace, however, price tends to equate to value, and it is a valuer’s duty to inform his client of the price that an interest in property is likely to fetch. While this does not present an intellectual challenge in the context, for instance, of an investment property or vacant possession house, there is little unanimity as to valuation and analysis of retail premiums. Guidelines, to put it bluntly, are thin on the ground.
The misunderstanding of the nature of premiums on retail properties has led many valuers to attempt to decapitalise the sum involved, resulting in an estimated rental value grossly in excess of any level that could conceivably be supported by the market. Many valuers are unable to look beyond their textbooks into the market place, and can only reconcile such premiums with a hypothetically high market rental value.
Charles Boston, in his contribution to the debate “Making Sense of Key Money” (Estates Gazette, October 3 1987), bravely addressed the problem and criticised those valuers who suggest that value only exists “to the extent to which they can justify it”. In my opinion Mr Boston was correct in accusing such valuers of arrogance. The challenge was met by John Sedgewick in arguing in his article in Estates Gazette on February 27 1988, “Money for Jam?”, that whatever the size of the premium paid for an assignment of a shop this was solely due to the profit rental value to be enjoyed by an assignee of the leasehold interest (although this could include an element for goodwill and tenants’ improvements).
Mr Sedgewick suggested that one needed an understanding of the motivation behind any premium payment that was made, but was in some doubt as to whether one should analyse such a premium over the unexpired period to the next review, the lease expiry date or in perpetuity. However, he made no attempt to answer his own questions either with regard to the potential assignee’s motivation or upon a correct analysis of a premium. As a director of several property companies, Mr Sedgewick, not surprisingly, took it as read that the general perception of an open market rental value was “ludicrously” low, evidenced by the level of premiums passing in prime retail locations.
On the other hand, Charles Boston, while considering retailers neither naive nor unsophisticated, was unable to put forward any reason why the “key money” was paid (other than for goodwill and improvements), but voyaged further into uncharted territory by arguing that if a retailer would make a key money payment on a rack-rented property then even an open-market letting at a rack rent should be treated with caution, since part of the “rental bid will inevitably contain an element of key money”.
What is more to the point, perhaps, is that Mr Boston would undoubtedly have no difficulty, at least in principle, in putting a price on a retail rack-rented shop (on a direct comparison method), whereas Mr Sedgewick would surely be completely at sea.
Why, then, does such key money exist? To answer this question one must surely return to first principles.
Premiums in the market
An occupying lessee of commercial property wishing to dispose of his premises will, subject to the state of the market, seek a premium for the benefit of the residue of his leasehold interest. In theory the premium representing the value of the lease will be calculated by assessing the market rental value of the premises, deducting the current rent passing, and capitalising the resultant profit rent by multiplying by a figure representing the YP for the period unexpired until the lease expiry or next date of review (which ever is the shorter) when the rent passing will increase to the full market rental value.
By way of example, if a rent passing is £50,000 pa with two years to review, but the full market rental value is £80,000 pa, then the expected premium would be calculated as £30,000 pa multiplied by a YP of between 1 and 1.5. To this should be added the value of any fixtures and fittings belonging to the tenant, goodwill etc.
It is important to draw a distinction between the level of premiums that pass on “non-trading” and “trading” commercial premises. In the case of offices and industrial or warehouse premises, the approach would be as I have outlined above, the premium being the aggregate of capitalised profit rent and fixtures and fittings, but only very rarely (if ever) an additional goodwill element.
It will be appreciated that the ability of a tenant to make profits is not directly affected to any material extent by the precise location of his office or production or storage facilities. Furthermore, the market has a reasonably good supply at any time of alternative locations if a prospective tenant is disappointed in his attempt to acquire a particular property for office, industrial or warehousing purposes.
The same is not true with regard to trading properties. In the principal retail thoroughfare exemplified by Mr Boston’s Sloane Street, it is relatively rare that more than one unit is available at any one time. Consequently, there may be several prospective lessees willing to pay a very substantial premium in order to acquire an existing lease.
It is rare for any goodwill to be acquired on such transactions, and equally rarely is there any value in fixtures and fittings, since most leading retailers will tend totally to refit any shop premises that they may acquire. To explain away such substantial premiums as being key money ducks the question “What reasons lie behind such high prices being paid?” To my mind, there are three separate underlying reasons.
The imperfect market
Textbooks on economics will define the market price of a commodity as that price that will be obtained when demand and supply are in equilibrium. Therefore, the price of apples will be that price at which all the apples will be sold at the highest price. If the price is too high, then not all the apples will be sold, and if the price is too low, then the seller will not maximise his returns.
From the point of view of the purchaser of apples, however, some purchasers may value an apple at greater than the market price and will derive an element of value known as the “consumer’s surplus”. Such a purchaser will be willing to bid more than the market price.
The market for trading properties is, however, an imperfect market, since it is rare to find two identical properties and even rarer to find two even similar properties on the market at the same time. If a property is sold by tender, the price will be determined by the bid that would be made by the person that valued the property most highly. At an auction the price will be that price slightly in excess of the value placed by the second highest bidder.
In a private treaty sale with a willing vendor, the purchaser will be the first person to agree to the price required by the vendor and which could be materially below the value placed on the property by any other possible purchaser.
Opportunity value or prospective goodwill
Excessive premiums, often described as being key money, are considered somewhat patronisingly by valuers as an almost irrational bid based on a subjective view of the value of a property. The “key”, however, does not unlock the door to the property itself, but to the prospective tenant’s own ability to create profits by trading in the property and to establish goodwill for himself.
As I have said, it is rare for more than one suitable property to become available at any one time in any given location. Therefore, the result of a failed bid is an inability to carry on business. In order to unlock his ability to make profits, a potential tenant will pay an entry fee to be represented in any vicinity. It is a one-off payment not related to his willingness to pay rent, or even directly to the value of the premises. The phrase “key money” would perhaps be better interpreted as “opportunity value”.
The amount of such key money will disappear if surplus demand is eliminated, ie if there are two or more similar premises available at the same time tending to even out supply and demand. It is noticeable that new shopping developments are let on straightforward rents with no premium being asked for by a developer landlord.
Favourable lease terms
Most commercial leases will contain provisions for rent review — say, every five years — with rents to be increased to a hypothetical market rental value based on certain assumptions. These assumptions artificially depress the rent that would otherwise have to be paid. If a rent review clause contains none of the usual disregards, then the rent that would have to be paid would be the figure which could be supported on the open market taking into account the benefit of, inter alia, the goodwill established by the tenant. This would be the true market rental value.
The normal lease, however, directs that this should be excluded from the calculation of rental value. A tenant will, therefore, appreciate on taking a modern commercial lease that he will be protected from paying the full market rent on review and will, therefore, enjoy a surplus value for the entirety of the lease — and indeed be entitled to such surplus value on any lease renewal.
It is my opinion that, if the usual disregards were not assumed, then any premium that might be paid by way of key money would decline substantially, if not totally. I recently advised a restaurant client who was willing, in principle, to pay a premium of £200,000 for a restaurant in a well-known thoroughfare, the rent being below market rental value and subject to review in about two years’ time. On being instructed to see if a lower premium could be negotiated, I advised, on seeing the lease, that reviews were to the full market rental value of the premises without the usual disregards. The client was advised of the consequences and decided not to proceed. Unusually for restaurant premises, the property remained empty for a further 12 months before being assigned for a modest premium, whereas it is not at all uncommon for similar restaurants let at, or close to, full market rents to be assigned at premiums of £250,000, and more.
Accordingly, it is my opinion that a substantial premium may be paid in the market to acquire a lease at even “a full market rent”, since on future reviews the rent will be set at an artificially low level.
More caution in future analysis
There has for some time been a tacit agreement among surveyors to treat premium evidence with extreme caution, whether acting for landlords or tenants, when dealing with rent review and lease renewal negotiations. Such caution has, however, been tempered by doubt as to how one’s views would be dealt with either by the courts or at arbitration. It is my view that surveyors can, however, be far more confident of their ability to reject an analysis of a premium as an indicator of rental value unless there is a clear indication of any particular transaction that the premium payment was made in lieu of rent. Such a case is that referred to by Mr Sedgewick in his article (Ratners Jewellers Ltd v Lemnoll Ltd (1980) 255 EG 987), but it would be foolish for landlords to derive any great comfort from that case.
Not only should both courts and arbitrators be persuaded to ignore premiums, they should be similarly persuaded to treat with caution lettings of units at unexpectedly high rents not because they can, as is often the case, be explained as “swallows”, but because they may well contain a similar “premium” element. That will no doubt be a more difficult nut to crack.
