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| The world of property has changed dramatically. The unknown is the extent and the consequences of this dramatic change. One consequence has been the damage to the traditional structure of landlord and tenant relationships writes Frank O’Neill. |
The world as we knew it
The property world in Ireland and the UK has been living in something of a time warp with its foundations based on a rigid 25 year (once 35 year!) long FRI (full repairing and insuring) leases with their landlord biased provisions - particularly upwards only rent reviews.
The established rules were:
- a developer acquired/assembled a site, prepared his design, secured his planning and then, the earlier in the development process the better, signed up tenants of seemingly undoubted financial strength to agree to pay him rent on the above FRI basis for 25 years - a marketable/fundable “investment” had now been created,
- the investment’s value was embellished by the comforts (to the landlord) of rent paid quarterly in advance, restrictions (on the tenant’s) rights of assignment or sub-letting, costly (to the tenant) break options and onerous (on the tenant) repairing obligations - this was the way of the world,
- the developer then either used the investment value created to provide the collateral to finance the scheme or had a sellable product to offer to the investment market,
- in latter years the investment market was characterised by a dearth of investment product and a surplus of cheap finance - values rocketed,
- an understanding of financial engineering replaced property knowledge as the core competence of the acquiring investor,
- the tenant paid the rent and in a buoyant economy the upwards only rent review provisions seemed somewhat irrelevant as rents rose inexorably and dramatically,
- demand for space was greater than supply - if the Landlord lost a tenant another one could be secured at equivalent rent
An archaic body of law, supportive and benefiting professional fraternities and a bizarre VAT regime sustained the structural torpor.
The system worked for the landlord. The long FRI lease to quality tenant was termed a “dry” investment. Dryness was the measure of the degree to which an investor could be hands off - ideally simply sending out his 5 invoices a year (1 each quarter for rent and 1 a year for insurance). Once every 5 years an agent would be engaged to lock horns with the tenant on the rent review. In the buoyant world of the Celtic Tiger rents increased year on year. Dry investors prospered.
Importantly, the creation of investment value facilitated development and provided the cash or collateral for developers with relatively limited initial resources to complete their schemes and to move on to the next one. The attractiveness of the FRI model from a investor’s perspective was further evidenced by owner-occupiers using it as the mechanism to extract maximum value for their property assets by way of sale/leaseback to third parties or as a vehicle for directors’ personal wealth management planning (as landlord) with his company as the occupier (tenant). The tradable investment commodity created was the basis of transactions and transactions generated fees for the professionals - lawyers, surveyors accountants - the more complex and opaque the transactions, the greater the professional input was required.
The new world
However, outside of our industry and national cocoons the destabilising influences of globalisation were gathering force and accelerating. With the credit crunch and economic slowdown the world has changed.
The stark reality of the changed world means that the dry landlord is now facing a quadruple whammy:
• the previously undoubted financial strength of tenants is now under scrutiny,
• the investment market has been turned on its head and is now characterised by an absolute dearth of finance and an abundant supply of investment product – values have plummeted,
• a large number of tenants either want a reduction in their rent or cannot/will not pay their rent at all or, and
• the supply of space across all sectors is far in excess of occupier demand.
The proximate symptoms of the property world’s malaise are that the landlord and tenant relationships are breaking down. The ultimate cause of the malaise is the unsuitability of the long inflexible FRI upwards only rent review lease in a rapidly changing economic environment.
Case in point - the retail sector
The property sector which has the greatest interaction with the general public and therefore the highest profile - retail - has suffered most.
Retail enjoyed the biggest upswing before the change and its decline has been the greatest. Retail was the worst performing sector in terms of return for 2008 according to Investment Property Databank (IPD). Capital values have plummeted by more than 40%. Bearing in mind that IPD’s indicators are based on the performance of an institutional portfolio, the quality of which is on average of higher quality that the general investment market, it is a fair assumption that the decrease in value of the overall market is actually greater than the figures reported by IPD.
The variety and range of issues facing retail landlords and tenants are vast. Some tenants are now fighting for their lives and either by way of negotiation or unilateral action are seeking to reduce their rents. Tactics vary and in the way of the world it is sometimes the less scrupulous tenants who are making more progress than
the honourable.
Retail landlords have seen their investment value haemorrhage. A landlord who on top of the fall in capital value is faced with the prospect of a defaulting tenant is in an invidious position. His interest clock will still tick and his investment may become a drain on, rather than a generator of, income. In such circumstances the detail of the mortgage document is crucial. What triggers a default? If the lender is in default can the terms of the loan be changed - cash calls, higher margins, accelerated amortisation? Has the bank recourse to assets other than the property? If the property was bought by more than one party, are the purchasers’ liability to the bank joint and several?
Seemingly clever sale/leaseback arrangements may have left owners with significant personal liability for a failing business’s property as well as the stress of managing the business through its difficulties. Co-investors purchasing properties together were united by success, failure is divisive.
Reckless over development
In addition to the general economic problems, the retail sector suffered more than other property sectors from irrational and insufficiently regulated development.
New retail development was in many instances recklessly conceived, permitted, financed and built. Developers’ plans were overambitious. Rates hungry local authorities, particularly those adjacent to boundaries of urban areas under another authority’s jurisdiction, were irresponsible in granting planning. Rapidly expanding retailers were careless in scheme selection. Bankers were sloppily too accommodating. Many new schemes have flopped disastrously and/or sucked the life out of traditional town centres or older schemes.
Shopping is an emotional, and for some a recreational, activity to be enjoyed. The shopping experience is vital. A part-empty shopping centre or main street with boarded up or whitewashed windows quickly spirals downwards as shoppers desert it for more uplifting destinations.
Sector in disarray
National and international retailers are failing - top of the agenda for receivers and administrators are the repudiation of the leases of properties in weaker locations and the renegotiation of the rental levels of the units in better locations.
Symbolically Grafton Street the nation’s retail flagship is suffering. Shop units which traditionally commanded a premium on assignment are vacant and the incumbent tenants are offering prospective assignees a reverse premium. It’s not that Grafton Street is no longer a fashionable and desirable retail location - it is. It’s that the rental levels set in better times under the one-way system of the upwards only review mechanism are too high for retailers to trade profitably in changed circumstances. There is a limit to the period of time the incumbent tenant will pay rent on an unprofitable or vacant property - something will give.
At the other end of the quality spectrum - a faltering regional centre- the same principle applies but the tenants simply cannot afford to trade unprofitably.
The mismatch between the rents set in better times and the profitability of the retailers cannot be addressed under the FRI structure.
The vacating of a unit in either location (Grafton Street or the regional centre) represents a failure of the property market to respond to changed circumstances and invariably it is to the detriment of the interests of both the landlord and tenant. The location will suffer as a desirable retail destination, legal costs will be incurred, the property will not be utilised and reputational damage will be caused.
Loss of rent will be compounded by unpaid insurance, service charges and rates. If the unit remains vacant the landlord will incur further costs - security, increased insurance and utilities. A defaulting tenant will probably have fitted out the unit for his business and left it in an untenable state - rectification shall involve more cost.
The landlord of a unit in a shopping centre with a defaulting tenant may come under pressure from the centre’s manager not to evict the tenant - understandable perhaps from the manager’s perspective but not necessarily in the best interest of the unit’s landlord unless he has a number of other units in the centre or the other landlords are prepared to share his pain.
How does a landlord respond to a request from a tenant to reduce the rent? Each case will need to be decided on its merits. The traditional FRI structure does not offer any solutions other than penalties for late payment, facilitation of the landlord securing a judgement and ultimately the repossession of the unit. In the new market realities these steps will be pointless unless the landlord has a reasonable prospect of recovery of monies due from the tenant and the unit a realistic prospect of being re-let. In all likelihood the former is fanciful and the latter unlikely - if it was otherwise a rational and honourable tenant would not have allowed matters to escalate.
A landlord will need to adapt as a dry investment’s moisture content increases. What in the past he would have regarded as a credit control or legal problem is actually a commercial problem with legal implications. Commercial judgement, empathy and patience will be required.
The solution
In the first instance the landlord needs to establish the sincerity of the tenant’s stated position and properly understand his predicament. This may involve the tenant opening his books to the landlord. The landlord should then be in a position to make an informed decision and hopefully formulate a compromise that prevents the mutually disadvantageous position of unilateral default, legal costs and vacancy. Rent reduction - temporary or otherwise, monthly rental payments, turnover related rents may be part of the solution.
However, most landlords have borrowings and therefore they also have a banker to consider. The banker’s and the landlord’s interests in regard to the relationship with a tenant are usually closely aligned. The stark realities of the economy and the occupational markets are no different for the banker than for the landlord. In fact the unrealisability of the investment value in the frozen markets and the extent and multiplicity of the banker’s other problems mean that in all likelihood that the bank will be resigned to allowing the landlord to sort out the mess and limit the damage. The extent and the nature of the bank’s security and the financial strength of the borrower are key - are other assets cross-collateralised or are there personal guarantees? The landlord will need to agree a back-to-back compromise with the banker to dovetail with that reached with the tenant. A spirit of partnership will be required between all 3 parties that will transcend the reliance on the documentational detail that previously would have determined the landlord’s and banker’s approach to these relationships.
The future
A new paradigm needs to emerge to enable the property world to adapt to the fast changing business environment.
A rational retailer will no longer be prepared to give a commitment to pay rent on an upwards only basis for 25 years – the world is changing too quickly and too dramatically for contemplation of such an arrangement. Consequently financing will be more difficult and developer/investor gearing will be lower. More robust diligence by developers, bankers and retailers and more prudent planning will be required to prevent the excesses of the recent past.
The days of the one property investor are numbered. The specific risk of individual properties’ which the FRI structure sought to mitigate will be too high. Portfolio management theory tells us that that diversification is the only rational antidote to specific risk. Diversification can only be achieved by an investor having a balanced portfolio. Going forward the fragmentation of property ownership that occurred over the recent decades shall be largely reversed and property ownership shall revert to being dominated by institutions, property companies and ultra high worth individuals.
The influence of the FRI lease structure was to reduce the landlord/tenant relationship to a zero sum game that fostered confrontational approaches to every issue.
Going forward, a new more suitable and cooperative structure is required. Changes in VAT on property rules and the availability of the option for tenants to waive their statutory rights of renewal on any commercial lease will facilitate the transition to shorter, more flexible and more equitable leasehold arrangements. But, tenants be warned in the longer term once the economy recovers and the current glut of accommodation is absorbed, rents will have to rise to make development viable and to compensate investors for the higher risks of ownership under a new model. |
Frank O’Neill is a director of W.K. Nowlan & Associates - a specialist property asset management consultancy practice.
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