The Landlord's Perspective
Recent months have seen a tide of investor sentiment turn against lesser quality and short income assets. Early in 2011 interest was starting to re-emerge for secondary assets. However, investors have turned risk averse again as the UK economy slows.
Buyers are seeking long and secure income streams, which suggest that a shift in buyers’ priorities back towards prime is underway. In the retail sector, for example, investor interest has been firmly focussed on the better quality assets across all sub-sectors and due to the limited availability of prime stock, transactional volumes over the first six months of 2012 were down 52% on the same period last year. The yield gap between longer income streams and shorter leases has increased due to yield compression for secure income and yield softening for shorter income and hence the marriage value created from a lease re-gear can be substantial. Pro-active asset management and lease re-gearing is essential to capitalise on the investor shift towards length of income and draw buyer attention. My view, however, is that the real threat of vacant space and tenant default (and with it the liability for void rates/insurance/security/unrecovered service charge etc) has focussed landlords’ attention on effective asset management. No longer can landlords ‘wait and see’; they must be proactive and work their assets.
From a landlord’s perspective, lease re-gearing is an opportunity to protect capital value and reduce the risk of void periods with associated marketing and legal costs. Almost 60% of leases that expired by the end of 2011 were unable to be relet by the end of the second quarter of 2012, the highest level in the last decade (IPD/Strutt and Parker Lease Events Review). The key findings of the report were that 59% of tenants vacated their property at the end of the lease – the highest number since 1998 when the research began. This rose to 75% in the office sector, but was only 42% in the retail sector. In order to consider the level of inducement that should be given to a tenant in exchange for a longer commitment, there are three key areas which need to be considered carefully.
- The investment value implications of a lease re-gear: The lease re-gear will aim to enhance the capital value of the asset by extending the lease term or removal of the tenant break option. It is important to estimate the yield shift and share of the enhanced value created and to assess the % of the marriage value that should be offered to the tenant in that particular market. As part of his assessment he will quantify the costs of the unit becoming vacant.
- The local occupational market: A break clause or lease expiry provides obvious opportunities to re-gear and well advised tenants will be fully aware of incentive packages available on competing buildings in excess of 12 months prior to the lease event. The Landlord will need to model the financial implications of any lease re-gear proposal against the incentives available on competing buildings.
- Dilapidations/IT infrastructure/fit out costs: Prior to considering the level of any lease re-gear proposal whether it be by way of reduced rent/rent free or capital contribution, the well advised Landlord should be aware of the tenant’s liability for any accrued dilapidations and works undertaken in the building in order to secure the best possible terms for a lease regear.
The Tenant’s Perspective
A lease re-gear offers the tenant the opportunity to revisit lease terms which may have been agreed in a stronger market and often to secure significant rent free periods/reduced rents or capital contribution in exchange for extended lease terms or the removal of break options. There is no better time to do this than during a recession when rental values are on the floor and when a tenant’s negotiation strength is at its strongest. A tenant can also look at negotiating away onerous alienation or rent review clauses and the removal of guarantors.
The tenant will need to gauge the strength of its negotiating position by research into the four key areas outlined below:-
- The value of the tenant’s tenancy following a lease re-gear: The tenant will need to accurately assess the yield shift and subsequent enhanced value to the landlord created following a lease re-gear and since the tenant is creating the marriage value it should aim to secure the “lions share” of the marriage value. Having said this, it still ‘takes two to tango’ and often we see a 50:50 apportionment being agreed to get the deal done. This figure varies from market to market.
- The local occupational market: In the regional office market there are some significant incentive packages available on Grade A buildings and a lease break/expiry offers the tenant the opportunity to realign its lease commitment to the current market conditions. I would suggest the opportunity is also available for tenants of secondary/tertiary property where the prospect of a building becoming vacant could seriously influence the landlord’s thinking. In such circumstances we have seen many tenants take advantage of the position offered by the re-gear to cap their repairing liability by the introduction of a schedule of condition.
- Dilapidations/IT infrastructure/fit out costs: In some cases, the cost of moving to alternative premises, the disruption to the business plus the making good of accrued dilapidations extinguishes in part the inducement available on competing buildings.
- Soft costs: Staff retention, goodwill and relocation costs will need to be considered in detail.
Richard Clark, Knight Frank