The credit crunch on the worldwide real estate market adversely affected almost every real estate asset class offering both traditional and more liquid forms. However, there have been some interesting trends developing in the UK market affecting buyers and sellers, landlords and tenants, and “adaptability” is a skill market participants must acquire – oftentimes just to survive. Squire Sanders’ London office has been proactive in assisting both new and existing clients who have been looking to maximize or to defend their market positions. This article will review what we see as being the market changes and developing practices amongst asset class holders in the UK.
General Macro Market Trends
Today there is no doubt that there is an awful lot of cash circling the real estate sector, in particular, the London market. That cash seems to be predominantly based on investors from the United States, Middle East and Asia who appear now to be considering that the fall in the UK real estate prices means certain asset classes now represent good value. As an example, a well-known Chinabased bank has recently purchased its headquarters in London in a confidence-building boost to London’s real estate market.
However, set against this is the significant lack of available “prime” real estate. This actually led to a shortening of yields and drove the price up by as much as 100 basis points in 2009 for those assets. Today this shortage of stock is combined with an unwillingness of the banking sector, generally, to liquidate on a wholesale basis vast portfolios of assets they hold. This arguably would adversely affect the price they could achieve and increase losses further. Therefore certainly in the prime investment market in the city of London, whilst buildings are coming onto the market, and indeed deals are being done off market, unless there is a compelling reason to sell, driven by banking covenant breach or financial pressures, many would-be sellers are hanging on to their real estate with a view to the market improving in the coming year. Indeed, some commentators in the real estate agency field expect positive growth in the year 2010, especially in the prime market.
Another area that is attracting investment into the UK is high-end residential property in London’s traditional strongholds. The very prime sites have, according to some market commentators, not actually experienced any falls in value but have increased. One real estate agency, operating in the prime market, has reported that it has had its busiest trading period since it opened its doors many years ago. Interestingly, it is not just in London but across the UK where the most desirable properties in each area are still selling. This is fueled principally by available equity and, once again, the availability of cheap debt. Even though the loan-to-value ratios have been reduced considerably, sometimes down to as low as 50/50 equity to debt, the desire to own prime residential real estate is still strong. In London areas such as Westminster, Chelsea and Kensington, properties are now attracting significant cash buyers who are looking to secure well-located quality stock with a view to leveraging in due course. That is a trend that is expected to continue, although perhaps not at the speed in past years when the payment of bankers’ bonuses was a key generator of transactions in this market. Elsewhere, residential prices have, according to the UK Government Land Registry, actually risen by an average of 5.9 percent or thereabouts in 2009. This is driven by a shortage of stock, and increasingly assisted by a willingness of banks to lend as the UK government fiscal stimulus trickles through to those parts of the banking sector where individuals generally operate.
Other asset classes such as retail, industrial and shopping centers are all faring on a mixed basis. Suffice it to say that a number of institutions have been placed into administration by the banks, and this has presented large scale buying opportunities for Max Property (for the Industrious portfolio) and other institutions, such as those looking at the Kenmore portfolios. Those institutions willing to buy in Q2 2009 and take a risk on the market have seen their yields contract, and in some instances those properties are now being resold based on that yield contraction, which has generated a profit for its purchases. It is a trend that is also expected to continue.
In the hotel and leisure sector, in which Squire Sanders has a preeminent practice, once again we are seeing a number of potential purchasers for both distressed hotels as going concerns, and vacant hotels which have the potential for a different use. This interest is once again generated principally by overseas investors taking advantage of both currency fluctuations and value propositions. Our firm’s connections mean that we have seen a number of opportunities that we have been happy to pass on to potential clients, purchasers and vendors as a way of assisting clients evolving their own businesses.
Going into 2010 we expect to be assisting buyers and sellers of physical real estate and liquid real estate investment funds, and assisting in more novel debt-based transactions and restructurings to acquire real estate for both national and multinational clients.
Micro Market Trends
Clearly the availability of credit has made it difficult for businesses to operate, and this affects landlords and tenants, as well as buyers and sellers. This part of the article concentrates on landlord and tenant relationship issues that have become far more prominent in the last 12 months, and which we expect to continue going forward into 2010.
In general terms payment of rent has become an issue as cash flow is being squeezed. Traditionally most UK leases are drawn on the basis that rent is paid quarterly in advance, and this has proven difficult for retail tenants. We have seen a growing willingness on institutional landlords’ part to accept requests from tenants to pay rent monthly in advance, which has helped secure tenants’ cash flow for the landlord. In addition, some of the big retail shopping center landlords have reviewed their service charge arrangements and have been reducing service charge requirements for tenants to assist them. However, almost always, this is on a temporary basis. Landlords’ expectations are that those concession elements return to the terms of the lease as originally drawn and agreed, in due course.
Repair and Dilapidation Issues
The issue of dilapidations, and the tenant’s obligations to put properties into the state of repair they were in at the time they took the leases, or, depending on the terms of the lease, into an almost brand new state, has always been a significant point for discussion between landlords and tenants. However in the current climate we have seen that it has assumed an even greater importance, in particular, when combined with the ability of a tenant to breaker a lease, by exercising a right of termination. We have seen developing trends where, if termination rights are conditional in any way, landlords tend to be looking to ensure that there is absolute compliance with the relevant lease terms. Any failure to do so is then utilized as a way forward to keep the tenant from exercising its right of termination successfully, i.e. leaving it contractually bound to continue paying rents and complying with its obligation under the lease – even if it is not in occupation. This behavior is driven principally by a poor tenant letting market which is of course dogged by the inability to raise finance to pay for moves, new equipment, removal costs and set up costs, by the tenants.
Rights of Termination Issues
Tenants are advised to look very carefully at their existing leases and lease terms to see whether or not any right of termination they benefit from needs to be strictly followed to achieve a break. We have counseled a number of tenants recently that they will have great difficulty in exercising their breaks unless stringent and expensive steps are taken to comply with the termination rights. These conditions can relate to minimum periods of notice that have to be given, where notices have to be served, on whom they have to be served, compliance with the repair and dilapidations covenants in the leases (which can be onerous), ensuring payment of rents – the list can be endless, and the property may remain empty. Clients who have attempted or who are attempting to mitigate their rental liabilities by subletting or licensing space to third parties need to carefully examine those arrangements if a termination right is to be utilized effectively.
The flip side of a termination right in favor of a tenant is that if, as should be the case, the termination rights are unconditional, then the tenants are more able to use this as a bargaining tool with their landlord to try to get better terms for themselves. In essence, a threat to exercise a termination right can often lead to a fruitful negotiation with the landlord that does not wish to lose its tenant. Reduced rental terms or obligations within the lease or indeed new leases for shorter terms may result. This does not always work, and must be balanced against commercial relationships between landlord and tenant and the tenant’s desire to continue to do business at the site.
For some businesses a move is a major upheaval and great care should be taken when considering this sort of strategy. We are more than happy to review clients’ leases to give an overview of potential benefits and pitfalls for entities wishing to consider using their lease termination rights for leverage purposes with their landlord, or indeed for clients generally needing to vacate space and relocate, often to cheaper premises. Such relocations or business closures can often be complicated by the need to comply with the stringent UK employment and labor laws but, again, we are well placed to advise clients in this respect.
Overall, going into 2010, our expectations are that the UK real estate market, especially prime property, will continue to harden and yields generally should start to move in. However, the degree to which that will benefit non-prime property is in part somewhat unknown and driven perhaps by the willingness of sellers to accept realistic prices for their property. Banks may, in the Q2 or Q3 2010, decide to be more aggressive in their treatment of what they would consider to be distressed assets in their portfolios. Increased transaction levels will also be driven by the willingness of the same banks to lend money, or indeed staple debt, to enhance the ability of buyers to purchase. Critical to the overall market will be the ability of the tenants to generate cash to pay rents, developers to start developing again based on that projected cash flow and landlords and tenants to be as flexible as possible to help their businesses survive and grow.