The respondents to Investment Property Forum research on commercial lease reform control more than £55bn of property. Their answers enabled the IPF to quantify the possible cost of Government intervention. Richard Harrold reports.
While the DOE consultation paper on lease reform looks at confidentiality clauses and alternative dispute resolution, by far the most contentious subject dealt with is upwardonly rent reviews. And it was in this area that the Investment Property Forum/Association of British Insurers research produced the most interesting findings.
The UORR clause is generally regarded as one of the cornerstones of the leasing agreement which underpins property asset values in the UK. In the survey, 80% of respondents had never settled for upward and downward rent review clauses in new lettings and favour no change to the existing situation.
However, although the pendulum has swung in the tenants’ favour recently, if UORRs were prohibited – as mooted in the consultation paper – enforceability would inevitably present difficulties.
But from the research it is possible to begin to see the market effects of legislation.
Rental values on new leases would be expected to rise if UORRs were to be outlawed. Tenants would consider leases less onerous and would be prepared to pay – and landlords would demand – more rent for the benefit. Even though any legislation in this area would not be retrospective, the assumption that it would not affect the rental values for existing leases is incorrect since rent on review would be based on a new letting under a hypothetical lease which could not contain an outlawed clause.
Respondents indicated that the following increases in rent would occur:
- At rent review+6.7%
- At lease renewal+8.8%
- New lettings+8.1 %
In the long run, the effect could become more serious. Property would become less attractive as an asset class and would have a long-term restrictive effect on supply. Consequently, tenants would be competing for available space, thus bidding rents up further.
The current practice of using incentives to maintain headline rents on new lettings at levels greater than true rental values would become inadvisable. Clearly, with a downward review after five years, it would no longer be viable to pursue such a course. It is estimated that headline rents would fall closer to true market levels while at the same time incentives would reduce. This could produce an even greater effect on capital values where these two factors combine.
Interviews with valuers produced similar results as to the likely effects on values if UORRs were prohibited. Respondents indicated that average capitalisation rates would increase as follows:
- Offices+1.40%
- Retail+1.15%
- Industrial+1.40%
Professor Crosby constructed a valuation model to ascertain the effect on capital values, taking into account the survey and interview results. It concluded that a significant downward shift in capital values would occur. Furthermore, this study concluded that the value of properties let on both new and existing leases could be affected.
For properties with new leases the reduction in value could be:
- Offices-13.3%
- Retail-13.6%
- Industrial-12%
This excludes the effects of lease structures and any impact on rental values. If the prohibition of UORRs were to affect both capitalisation rates and headline rents the impact on values would be even more severe at up to -28.5%.
The effect on the value of properties let on existing leases would be a function of the number of years unexpired on the lease coupled with the ratio of rent passing to rental value. The research findings indicate that prohibition would be most marked where an existing lease had less than 15 years.
For example, a property let on an existing lease with five years unexpired would experience a fall of -16%.
Using the lease expiry profile of the IPD as a surrogate for the UK commercial property market, the model was used to examine the overall change on values if UORRs were to be prohibited. The prediction was that there would be an immediate fall in value of -4.3%, increasing to -13% as leases expire. This could wipe around £1.5bn off the total IPD-monitored holdings which are currently valued at about £35bn.
Assuming that the IPD reflects the structure of the total property market, the implication for the sector as a whole – which has an estimated value of £217bn – would be a drop in value of £9.3bn
A fall of this magnitude would seriously undermine the value of all property, adversely affecting the collateral of lending institutions, the solvency margins of insurance companies and the balance sheets of corporates.
It would clearly make property less attractive for both UK and overseas investors and restrict the strong inflow of capital into the UK economy.
Owner-occupied property would also be affected. The value of non-specialised property in owner-occupation is based upon investment values and the assumption as to vacant possession. Therefore, unless a particular local market is dominated by owner-occupiers, the decreases in value of investment property let on new leases would transfer directly to the value of owner-occupied property.
This would be a particularly likely scenario for High Street retail property where there are direct comparisons with investment properties.
The adverse affects on values would clearly have a knock-on effect on other activities: the additional income risk would require developers to seek a higher target return and banks would be less inclined to lend. These trends in combination would most likely constrain the supply of space. The resultant undersupply would inflate rents as the market returned to equilibrium.
The analyis carried out by the IPF has concluded that the main plank of the possible reform outlined in the DOE paper would result in significant effects on rental, and especially capital, values.
Richard Harrold is head of property investment at Postel Investment Management and chairman of Investment Property Forum Working Party.
Copies of the full response can be obtained from the IPF. Please contact Patricia Monahan at the RICS on 071-222 7000.
