After years of stagnation, London office rent reviews are starting to show surprisingly high levels of rental growth. Malcolm Hull explains
The latest London Office Crane Survey (Deloitte Real Estate, winter 2013) predicts a continuing upward trend in rents. For 2014 reviews, prime office rents in the West End are expected to rise by 40%; in the City by 12%; and in Midtown by 30%. Of all the central London submarkets, Docklands will be the only growth-free zone on a five-year rent review cycle. This presents a huge contrast to the last four years, when the vast majority of London office reviews were settled at nil increase.
Why and who?
The key to this change in fortune lies in the dark days of 2008. In the three months following the banking collapse, London office rents plunged by around 30%, meaning that the starting point for reviews due in early 2014 is far lower than for those due in autumn 2013, and the growth prospects are correspondingly enhanced. However, headline growth prediction figures are averages and there is often significant variation on rents for individual buildings.
Occupiers with reviews in 2014 and beyond may need to budget for significant rental increases while investors competing for limited available stock will need to get to grips with the assessment of reversionary potential. Understanding the intricacies of rent reviews and the disparity between headline and net effective rents may be a challenge for some overseas buyers. Managing existing assets to achieve the best results at review is an art, which new entrants to the market will need to learn.
Experienced rent review negotiators who understand these issues will be in demand, not just from clients wanting advice on rent reviews, but also investors and valuers interested in their expertise. Predictions of the performance of a building at rent review will become central to its attractiveness as an investment.
What’s new?
The rent review world experienced a burst of innovation and creativity in the 1980s. There was seldom a week without the latest case featuring in EG. While improvements to lease drafting and the Arbitration Act 1996 have since reduced the scope for disputes, there are still a few old chestnuts that remain unresolved as well as some new issues of contention.
Sustainability: the rent review world has yet to master green issues, despite their significant effect on rents. Discounts of up to 10% awarded at arbitration for the presence of R22 refrigerant in air-conditioning systems illustrate the potent impact that green regulations can have.
A hot topic is the proposed introduction of regulations under the Energy Act 2011 to cover minimum energy standards and prevent, from April 2018, the letting of buildings with an energy performance certificate (“EPC”) rating of F or G (the two lowest grades of energy efficiency). The potential implication at review for buildings with these ratings is that the rent will be discounted. This reflects an expectation that a disposal during a hypothetical lease term beyond 2018 will require the need for expenditure to upgrade the EPC. Up to 25% of central London office buildings are potentially affected, but the effect on rents will depend on the individual buildings and lease details as well as the final wording of the regulations. A public consultation on the proposed regulations is due later this year.
Rent-free periods: new lettings are still attracting long rent-free periods. In Midtown, for example, a tenant would typically be expected to achieve an 18-month rent-free period for signing up to a new 10-year lease without breaks at a headline rent. For a 15-year commitment this might rise to 27 months. At review, leases usually require the new rent to be set on a net effective basis, ie the rent which would have been set if no rent-free had been granted. The methodology for calculating this net figure has been heavily disputed.
Another key debate is the period over which a rent-free period is amortised. Years ago, when rent-free periods were shorter, the value was analysed up to the next review after five years. This was rationalised on the basis that the tenant would have to pay the full market rent after five years. Landlords viewed this as unfair, pointing out that the length of a rent-free period granted was closely linked to the length of the term certain. In the last review cycle, central London review negotiators compromised between these two positions: for example, by devaluing the rent-free period on a 15-year term over 10 years rather than until just the first rent review.
In practice, only a few of the larger office lettings nowadays involve a commitment of more than 10 years. But at review, it is still common for lease wording to require a 15-year term to be assumed for rental valuation. Faced with such assumptions, landlords will again be pressing for rent-free periods to be amortised over the full lease term and evidence of market practice on new lettings will be key. The effect of changes in how tenants account for incentives such as rent-free periods, resulting from the new UKGAAP accounting standard effective from 1 January 2015 (FRS102), may prompt a review of practice. For those rent-free periods that run beyond the design life of a landlord’s category-A fit-out, obsolescence and depreciation will also need to be factored into rental valuations.
Cast of characters
The lean years have taken their toll on the rent review fraternity as old friends (and foes) have retired or changed careers. The effect of retirements has been compounded by relatively few new entrants into this specialism. Attendees at a recent dinner showed a strong bias towards male rent review surveyors over 50. So, with an expected pick-up in demand, and experienced rent review surveyors in short supply, those juniors who decided to specialise in this field during the lean years may well find that their time has come.
Malcolm Hull is a partner at Deloitte Real Estate