by Robin Worthington
Licensed property is beginning to take a higher profile in the property industry, partly as a result of the much-publicised report of the Monopolies and Mergers Commission, and partly owing to a generally greater awareness of the need for asset-backing by the larger publicly quoted companies. It is therefore an appropriate time to review licensed property as an investment in its own right, and to try to identify the benefits or otherwise of investing in the sector.
To appreciate fully the fundamental changes to the industry over the past two or three years it is useful to look back at the position which, for many years, had remained unchanged.
Historically, the performance of public houses as property assets was a question that was never posed. Breweries made their profit from brewing and distributing beer, added retail margins to this by direct management of the larger outlets and took whatever benefits there were in the growing value of the estate by way of an irregular property revaluation which itself was largely based on multipliers of beer volume and brewers’ margins. In the late 1970s, however, as a result of economic pressure, the breweries embarked on a much more aggressive disposal programme of their lower-volume outlets, realising in the process not only a great deal of money but that there was something to be gained from property after all.
At that time the majority of public houses were owned and operated by breweries, either directly under management, or indirectly through complicated “tied tenancy agreements”. The common themes in these agreements were:
- A short period of 1,3,5 years or exceptionally 7 or 10 years in the case of turnover-related agreements.
- They were non-assignable.
- Internal repairing obligation only on the tenant for shorter agreements, increasing with the longer agreements.
- Tie to the brewery for the supply of all beers, and sometimes soft drinks and wines and spirits.
- Tie for either the supply of, and certainly a share of income from, machines.
- No alterations.
- Muddled ownership over landlord’s fixtures and fittings.
- Exclusion from Part II of the Landlord and Tenant Act 1954, but inclusion within a code of practice, drawn up between the brewers and the tenant representatives and policed by the Brewers’ Society.
- The constant threat of all houses being taken back for direct management by the breweries for whatever reason.
Each of these provisions led to one or both of two things – a rental value lower than the free market would justify, subsidised by the profit on beer, and an almost complete lack of investment in the property by either party.
Add to these depressed rents, various bonuses or other incentives, some related to turnover or volume or beer sold, and others not, then this was the receipe for what was, at best, a specialist property sector never touched by institutions and, at worst, total confusion as to what was the true value of property in either rental or capital terms.
So what has changed?
The Monopolies and Mergers Commission (MMC) report — The Supply of Beer
In broad terms, the MMC criticised the industry for being “vertically integrated”, that is, having overriding interest at all stages of the manufacturing and retailing process through its ownership and operation of breweries, distribution networks and the retail outlets. This, the MMC alleges, has given rise to hidden inefficiencies and controls which work against the public interest.
Whether that conclusion is right remains to be seen, but it has certainly brought to a head an increasing recognition by the breweries that their operations can be divided into three principal sectors — brewing, retailing and property. Increasingly, these operational areas have been separated, and cross-subsidies, where they exist, taken out. In some cases, notably GrandMet, Boddingtons and most recently Greenhall Whitley, action has already been taken to separate the brewery interest altogether, leaving retailing and property as the key operations for the future. The breaking of this operational link is therefore not only assisting in throwing light on where the main opportunities lie in the industry but is also beginning to open up consumer choice through wider availability of both national and local brands, greater trading freedom, improved quality of operations and, overall, a greater number of individual business units. This is the real key to the future of operating pubs — increased attraction to the consumer through greater investment and more professional retailing.
Changes in legislation affecting licensed property
During the past few years there have been several fundamental changes in legislation affecting licensed property, some related to the MMC inquiry, some not. In particular:
- Use Classes Order 1987 — public houses are now in Use Class A3, which includes not only wine bars, restaurants and the like but also the valuable hot-food take-away operations, epitomised by McDonald’s and BurgerKing. This gives the public house total flexibility to change its operation and/or occupier to reflect current demand.
- General Development Order 1987 — A3 operations can now be changed to either A2 or A1 usage without the need for planning consent, enabling a quick and easy switch into more valuable uses should market conditions warrant. No other sector of the property market has such flexibility.
- A proposal to reduce the restriction on the grant of liquor licences so as to avoid the, obligation to prove “need”, thus separating out the value of the licence, an element which has confused the property issues.
- In mid-1992 all licensed properties will be afforded protection under Part II of the Landlord and Tenant Act 1954, ie they will obtain security of tenure, in many cases for the first time. (With the exception of some food-based operations, licensed premises were always excluded from this part of the Act.)
- The obligation on major brewers to release almost 12,000 pubs from any sort of trading tie by 1992. It could be argued that, while the lessor obtained some part of his income from sources other than rent, then any potential purchaser of the freehold interest could only be a trading company such as a brewery. This will shortly no longer be the case, with the lessor’s only income being in the form of rent.
- All properties freed from the tie as a result of the MMC inquiry must be converted to an FRI basis and at an arm’s length rent. Although there are some legal technicalities, this is likely to happen at the time of the 1954 Act protection being introduced.
In summary, within a short time-scale, it will be essential that licensed estates are managed on a fully commercial basis, similar to accepted institutional requirements. Until then the tenant has no opportunity to build up capital value and this situation, combined with the lack of any security, has depressed rental values and held back improvements.
Grand Metropolitan anticipated this scenario more than two years ago when Grand Metropolitan Estates introduced 20-year, fully repairing, assignable leases at open market rents with only the minimum trading obligations — and even those obligations can be waived at any time in return for a rent review to open market levels. This initiative, known as Inntrepreneur, has been a great success, with over two-thirds of the estate (almost 2,500 houses) moving over to
Other breweries have already announced plans to follow this lead with Allied Lyons’ Vanguard, Control Securities with 25-year leases and many other breweries introducing similar arrangements of differing length.
The emergence of the leisure sector
“Leisure” now covers everything from hotels, intensive sports facilities, golf and discotheques — and arguably fast-food operations and most forms of non-food comparison shopping. Many institutions now have direct involvement in this field, through equity or loans, and in some cases direct development.
As a result of this involvement, there are probably now four key sectors of property investment: retail, offices, industrial and leisure. Public houses are unusual in coming within two of these sectors (retail and leisure) with the inherent ability to maximise whichever opportunity offers the best rewards.
Some of the national brewers have branched out into mainstream leisure, for example Bass with the “Point” at Milton Keynes, and Scottish & Newcastle, through their involvement in Pontins and Centreparcs, being typical cases. But brewing as an operation is no more part of the leisure sector than is an owner of a cotton plantation in shirt retailing. Public houses, and licensed property in general, are, however, linked with this new core area.
Growth potential
Figures can prove anything, and in this case would be misleading since, for the reasons given, licensed property performance has been hidden within the historical perspective of the brewery sector. Not only that, it is only in recent times that the property awareness of the leading players has increased so as to apply pressure on those assets to generate growth rather than stand and watch.
Several licensed property companies are currently working to produce an index for licensed property capital and rental value growth, with preliminary results proving that growth rates have been as good as, if not better than, equivalent retail units. There is no doubt that the switch to more commercial forms of agreement and a relaxation of the trading tie will lead to a significant hike in values in the short-to medium-term, simply through a transfer of all the lessor’s income into rent.
Quality
The quality of the letting will also be fundamental in underpinning investment values and it is undoubtedly a fact that the traditional pub tenant has been no better than one would find in, say, a secondary parade of shops. This is likely to improve significantly in the short term for the following reasons:
- The increasing number of prospective lessees for any particular property. In the past, letting a public house has been similar to letting a secondary shop, where there are so many restrictions on the type of operator that there would be perhaps only two or three likely candidates in each case. What is already happening is that the greater freedom afforded by “arm’s length” agreements has, certainly in Inntrepreneur’s case, meant that there is now a greater parallel with letting a prime shop unit, where any number of potential lessees will be bidding for the opportunity.
- The past two years have also seen growth in the number of multiple tenants, or small private operations, which have been helped by the willingness of the merchant banks to provide finance secured on the value of the lease.
- Several of the smaller breweries have already indicated their likely intention to concentrate on the retailing opportunity, rather than the brewery operations, and this will lead to much larger and well-established names taking full FRI leases from their erstwhile competitors.
All this activity will drive up competition for outlets across the range.
Summary
The direct involvement of institutions in property has traditionally been confined to the three core sectors of retail, office and industrial. As a result of this long involvement, these sectors now provide the benchmark for institutional criteria, ie:
- let by way of agreements which are easily managed, with no repairing or other responsibilities on the landlord;
- easily understood and compared with other forms of investment;
- a proven track record of rental and capital growth;
- an inherent value quite independent from the value of the operation carried on inside the property; and
- provide good-quality lessees.
So far as public houses are concerned, most of these criteria are already met, and others are likely to be met in the near future. This is likely to bring about a rerating of the sector in both capital and rental terms in the short to medium term.
