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How to Appraise a Shop Investment
02/June/2014
The short answer to the question how to appraise a shop investment is that everything about the proposition is reflected in the level of Zone A rent. But, because people generally like to have things spelled out, if only to ensure nothing much has been overlooked, here is the long version.
Shop investments are valued by reference to specifics, rather than generalities: namely, the nature of the particular town and importance of the particular trading position in that town. Towns and cities are ranked in terms of national and regional importance, according to multiple retailer representation and associated criteria, such as customer spending-power. The era of local and catchment population only shopping in the town where they live and/or work is long gone. Nowadays, spending-power, drive-time, parking facilities and the customer experience overall are determining factors. While each town will have its own trading positions, more important for investment potential is the relationship between one particular town and another, together with any wider influences that could affect that importance, such as new developments in the offing.
Towns vary in character, heritage, population (resident and catchment) and other socio-economic demographics. Each town has its own trading positions: in-town, the best position is the prime position, which might include a purpose-built shopping centre or mall at the heart of the town centre; everything else is classified as secondary. Secondary comprises secondary, tertiary, local, and neighbourhood. Out-of-town (including edge-of-town) shopping centres, malls, precincts, outlet centres and supermarkets are in a league of their own and depending upon the overall shopping experience may be the dominant shopping location for the whole town.
Over time, sometimes almost overnight in the case of a new shopping development, in-town trading positions can change. What used to be the prime position may become secondary, and vice versa. The presence of multiple retailers does not itself define a prime position: many multiple retailers prefer secondary positions.
Unlike town centre 'high streets' including secondary positions where the ownership of shop property comprises different landlords and owner-occupiers, purpose-built shopping centres, whether in- or out-of-town, are usually owned by a single landlord able to control tenant-mix. Shopping centre management is directed toward maximising the trading potential for both the centre's owner and the centre's tenants, whereas with fragmented ownerships, different landlords and so on, each individual landlord is likely to have their own investment policy, tenants having to fend for themselves.
Purpose-built shopping centres, being privately-owned, can be managed to a marketing plan, but investing in individual properties in the 'high street' is riskier. In the firing line of day-to-day trading reality, retailers fall into two categories: those that actively support and contribute to community initiatives to generate custom, and those that don't. Those that don't are sometimes criticised by those that do but only because those that do resent the freely cashing-in on community initiatives. It's not that those that don't are anti-social, so much as a difference in approach to attracting custom.
Some retailers are destinations in their own right, others rely far more on passing trade. Ideologically, a town centre might be presented as a community but, in practice, it is not a level playing field: business is not an extension of social services. Ultimately, some retailers are better at attracting profitable trade than others. Generally, the least capable are prone to bleating, the more successful adjust and adapt.
Amongst the factors affecting asset management and investment potential is not just the relationship between each particular building and its trading position, but also the relationship between that trading position and other trading positions in the town and other towns elsewhere. In the absence of a united front involving all interested parties, competing interests between (1) owners and their tenants in single ownership shopping centres and (2) the relatively dysfunctional policies of different landlords and tenants in 'high streets' can result in the 'high street' interests losing out.
Unlike single-ownership shopping centres where rent levels are geared to positioning of the tenant mix, with all leases generally containing more or less the same terms and conditions, other than rent, there is no obligation on a landlord of an individual shop property in 'high street' trading position to want the highest rent and/or to pursue rent review so, for example, rent reviews might remain outstanding. Consequently, rental levels even in the same street do not have to be consistent. Furthermore, since transactions are particular landlord-tenant specific, a tenant is not obliged to agree the lowest rent and many retailers are rumoured to ingratiate themselves with landlords in exchange for preferential treatment elsewhere. Establishing a surveyor-acceptable common denominator for the level of rents is a matter for informed opinion. The adage 'one swallow does not make a summer' is cited whenever a transaction is thought to be out of line.
For decades, it's been said there are too many shops. The polarisation of the retail market over the past twenty years or so suggests there may now be too many towns. To evaluate prospects for a town, thinking that it's nice place to live in may not be the correct criterion. It also has to be a nice place for most people to shop compared to whatever else is nearby. To avoid being subjective the definition of "a nice place to shop" must allow for different tastes and spending-power. A busy-looking town centre might suggest popularity but is not necessarily indicative of a growth area for investment.
Having decided whether the town itself would be worthwhile investing in, the next decision is to select the trading position in that town. As well as monitoring footfall, (passers-by, where do they come from, where are they going), the question is what influences if any could affect the potential for that trading position. Depending upon the location, influences are numerous, ranging from tourist attractions and public transport facilities to proposed redevelopments. Successful retailers have it within their power to make or break the popularity of a trading position. Unless one is privy to the facts, it is difficult if not impossible to assess whether a particular tenant or other retailers nearby are doing well. A shop that looks busy isn't necessarily a profitable business. The stability of a trading position and its attraction for new tenants will depend upon whether the established tenants are trading profitably as defined by the established retailers' particular requirements. It is possible to buy a service that assesses tenant-covenant, financial standing and so on - in my opinion the sort of information for gauging rental security that is readily available on-line if you know where to look - but rarely will an investor get the sort of information that is vital. It's all very well paying to be told that 'x plc' has for example 300 branches, a turnover of £xM, net profit £yM and net assets of £zM but what's equally if not more important is whether that particular retailer intends to remain in occupation in a particular trading position and for how long. In the absence of procuring confidential commercially-sensitive information, including whether the shop lease is on the market, the experienced-eye becomes the reliant factor.
The best properties rarely come on to the market so generally investors will have to be content with second-best and within their affordable price range. Property dealers trade on opportunity, but private investors like to buy for long term hold, often the life of a mortgage of say 20 years. The prospects for the investment should be assessed by reference to the envisaged period of ownership. Using the 20 years example, how likely is is that the proposition will perform as investment over 20 years? I reckon towns that provide a ready supply of propositions available on the market tend to be unstable and lacking investment prospects. Many properties do the rounds, cropping up for sale over the years, sometimes via the same auctioneers or agencies. At present, I'm advising on a shop property that's been sold in 5 different auctions since 1999, on each occasion at a different price.
The proposition is a particular property so the nature of the property itself is important. Generally, investors prefer to own complete buildings (shop and upper part) rather buy piecemeal (shop only, upper part sold off). For residential investors looking for bargains, there is a lot to be said for a shop and upper part. It may be possible to convert the upper part into one or more flats, and/or to sell any existing flat separately should the opportunity arise. Where the shop premises includes a flat above, all let on a business tenancy, and where the shop tenant is not in occupation of the flat, there is potential within the Landlord & Tenant Act 1954 for opposing renewal of the whole on expiry or denying the shop tenant the right to renew of the flat as well and getting the flat back for a relatively low amount of compensation.
Having selected the property, the next point to consider is the rental value. The benchmark is the open market rent for the premises. The open market rent differs from the closed market. The closed market is where the tenant has negotiating rights and a dispute resolution procedure. The practical distinction is whether the landlord is in control and the tenant’s only choice to take or leave it.
When the shop property is let already, the starting point for comparison with the benchmark is the rent currently payable (the 'passing' rent). When the shop is vacant and to let, the starting point is the estimated rental that would be obtainable on the grant of a new lease. The passing rent is certain. The estimated rental is uncertain.
The first question is whether the passing rent is correct, or too high or too low. To answer, first establish the type of occupancy: is it a tenancy (popularly a lease), a periodic tenancy, a tenancy-at-will, or a bare licence? The passing rent would have been agreed on some basis: the question upon what basis includes what rights, if any, does the tenant have. It is also necessary to read the existing documentation.
The basis for the rent is important. Rent does not exist in isolation: rent is the product of the terms and conditions of the lease upon which the premises are let and would be let. One cannot state categorically “this is the rent for the premises” without also defining the terms and conditions in the lease. That surveyors generally do say 'this is the rent for the premises' includes, by implication, assumptions regarding the terms and conditions of the lease granted or to be granted. Anyone that answers the question 'what is the estimated rent?' for premises that are let already without taking into account the terms and conditions of the lease or the nature of the occupancy that is in force is likely to come up with the wrong answer. For example, if the existing lease contained a restricted user clause then the passing rent might be lower than if there were no restriction. Similarly, if tenant has carried out structural alterations to the property then the effect on rent of those improvements might have been disregarded at the last rent review; the question then is whether and when the rental value of those improvements would revert to the landlord.
(On renewal of an existing tenancy where Landlord and Tenant Act 1954 case-management procedure is underway, a draft lease for the uncontentious terms and conditions will be agreed between the respective parties’ lawyers before the respective parties' expert witness surveyor reports on rental value are prepared and exchanged. To value a rent, the surveyors must have something tangible and agreed in principle to go on. With a brand new letting, it is rare for the draft lease to be submitted before the tenant makes an acceptable offer of rent. Usually, the draft lease is submitted after outline terms and conditions are agreed in principle (heads of terms, subject to contract, etc). Since rent is a product of the terms and conditions of the actual lease, the test of integrity when drafting the lease is whether if there were a rent review on the same day as completion of the lease the rent would then be the same as the initial rent.)
To compare the passing rent with the estimated open market rent, the passing rent is devalued. Depending upon the type and size of the premises, shop rents are normally devalued to the Zone A rate. Zoning is a measuring methodology for comparing shops of different sizes and layouts to arrive at a common denominator. Having calculated the area in terms of Zone A (known as “ITZA”) and deducted values for non-zoned parts of the premises including, for example, any residential accommodation, the net rent for the shop is divided by ITZA and the result is the Zone A rent. You can find out more about zoning here.
To make a comparison with the estimated open market rent, it is necessary to devalue the evidence, preferably of open market lettings but if not available then the next best thing, according to the hierarchy of evidence. Evidence generally is what other landlords and tenants have agreed or had ascertained for similar types of premises. However, evidence is not only of other rents agreed but also the terms and conditions of the leases and other types of occupancy. For that you would need to know precisely or as near as possible exactly what has been agreed by others.
For the do-it-yourself investor/landlord, sourcing comparable evidence is not straightforward. Rents and agreements are confidential to the parties concerned. There is no public register. The nearest to a national resource is to buy copy leases that are registered with the Land Registry. However, having a copy of someone else’s lease isn’t going to get you very far if you don’t have the rental devaluation. Rateable value could be a clue: rating areas on-line are freely accessible but rating areas, as well as being notoriously unreliable (arithmetical inaccuracies, also it depends when the premises were last referenced (measured) for rating), often differ from valuation areas for actual rent so can only provide a rough guide and should not be relied upon. Other quasi-public domain sources include shop agents' websites, auction catalogues, and stock exchange public property company results and announcements. For surveyors, our sources include subscriber-databases (generally a mishmash of agents particulars, auction catalogues, and industry press-releases), information that we obtain direct from landlords, tenants, and other surveyors, our experience from work undertaken and in-hand, and our own record systems. Created in 1975 for my own use, I own possibly one of the largest computerised databases of shop rents; at the touch of a button, I can access information in seconds and whilst I don’t profess to know about everything happening in the places I monitor, it doesn’t take me long to familiarise and gather evidence.
An important point to remember about comparable evidence is that transactions are confidential and the information, often of considerable value, is guarded jealously. The commercial property market thrives on the free circulation of comparable evidence but it’s not ‘free’ in the true sense: it comes with the implied understanding to not misuse it. Arguably, Data Protection Act limitations apply; it is suggested that either or both parties' permission should be obtained before facts are released. In any event, it is not compulsory for either landlord or tenant and/or their respective surveyors to cooperate with requests for evidence. Since shop tenants tend to close ranks over disclosure of rental agreements, unless it suits them to co-operate, it can be difficult if not impossible for a landlord wanting to establish the facts if you don't have the contacts.
The reason surveyors are more likely to be able to procure evidence is that landlords and tenants come and go, whereas surveyors endure, so are likely to come into contact with one another sufficiently regularly to want to reciprocate. The shop property market comprises thousands of different landlords and tenants, (approximately 400,000 trading fascias have been identified) but there are only about 4,000 multiple retailers (including banks) which narrows things down a bit, and since fewer surveyors deal with shop property rents on a regular basis and reliably so, knowing whom to ask comes from experience.
Having devalued the evidence and compared the Zone A level with the passing rent Zone A, any other differences must be considered carefully. Apart from any technical adjustments and allowances, the effective date of the evidence is important. Evidence can be historic and the definition of historic varies. Generally, evidence within the same year or so, unless 2008 when before August that year predated the downturn, is preferred but where there is no recent evidence it becomes a matter of informed opinion which is where surveyors come into their own: informed opinion may also be used as evidence.
Particulars for the sale or auction catalogues of shop investments often mention Zone A rents nearby. Such mentions should be treated with caution. As I’ve said, it’s not just extrapolating the Zone A rent from one transaction and applying it to the shop premises under scrutiny: the terms and conditions of the respective leases are also vital.
After ascertaining the Zone A relationship between the passing rent and open market rent, the next question is how to value the investment. Where the passing and open market Zone A rents are about the same, the question is why or whether the rent should increase at the next opportunity, normally a review or lease expiry/renewal. In my last missive, I've already said that 'upward-only' rent review doesn't mean the rent necessarily has to increase. Why is about the future direction of the market for the premises, also known as supply and demand. A change in ownership of an existing property does not increase the supply so the question is whether there is any demand for the premises. If there’s no likelihood of any increase then the investment is not going to perform, except in the context of the buyer’s subjective reasons for wanting the proposition.
Historically, a rule-of-thumb yield for non-growth propositions was at least 10% but since the early 1970s - when for reasons, if you’re interested, you can read more about here Valuation and Overpaying - the traditional demarcation of the market into non-growth and growth is virtually non-existent. Based upon the cost of borrowing, the same nationwide, yield rather than ‘location, location, location’ has become the determining factor for most buyers.
Assessing risk by reference to yield depends upon the tenant's covenant. National companies, multiple retailers and banks, all considered more secure propositions tend to fetch higher prices than shops let to independent retailers and local shopkeepers. The fact that larger companies can up-sticks or go broke without warning doesn’t seem to have altered a view amongst some investors that a shop let to a multiple retailer is likely to relet to another multiple retailer. That view is based on no evidence whatsoever: one reason many trading positions (including numerous ‘high streets’) are not as primary as they were is that multiple retailers have relocated to better locations.
When the passing Zone A rent exceeds the open market Zone A rent, the question is for how long is the passing rent secure. Assuming the tenant does not go bust in the meantime, the over-renting will expire on renewal of the lease when the market rent will apply.
When the passing Zone A rent is below the open market rent, the investment is reversionary. Reversionary implies growth because the reversionary rent is the rental value of the property if it were let now at the estimated open market rental. Since the estimated rental would not be known for certain, either agreed or ascertained, until sometime in the future, the reversionary value is deferred by the number of years to the reversion. (I've emphasised 'implies' because growth is not certain merely because of differences in the respective Zone A levels. The next rent review date may be years off by which time what is now the latest open market letting could be historic; in the meantime, the market might have changed.)
The starting point for the valuation of a shop investment ought to be the valuation of the property if vacant, but invariably it is not. Vacant possession value could be more than or less than or the same as the investment value, depending upon the location and trading position.
Shop property let already is generally valued subject to the benefit of the existing lease (occupancy) so the two elements get muddled and the proposition (property plus investment) treated as one. Since the tenant's covenant (identity of the tenant) often makes a difference to the value of the investment, it can be difficult to distinguish the separate elements.
The muddling of values (where the shop premises are let already) tends to be linked to sentiment. Generally, sentiment is a better driver of market momentum than technical valuation. Hence, depending upon the degree of sentiment in the market, the same shop property investment could, for example, be valued at anything between about 1% and 15%+ which means that the timing of the purchase becomes critical if you want to avoid overpaying, and the timing of selling if you want to avoid becoming lumbered.
The property industry has debated at length the difference between price, worth and value. In outline, price is what the seller asks and buyer agrees and the amount that the proposition fetches is what the proposition is worth to the actual buyer. In other words, worth is subjective. Value is objective: what the property would fetch generally, regardless of whether anyone would pay more. Anyone who has agreed a price with a buyer only to have the property down-valued by a surveyor for the bank will have their own views, but thinking that value must surely be what the particular buyer pays is wrong because that view makes no allowance for the actual circumstances.
There is a school of thought that will only buy where a profit can be had from the difference between the cost of borrowing and the starting yield from the property. There is nothing wrong with that, provided it is not confused with property investment. The cost of borrowing, interest rates generally, is nothing to do with the value of property, but that doesn’t stop countless investors believing there is. Consequently, prices vary according to prevailing interest rates and market sentiment. Strong demand, combined with easy borrowing, generally results in lower yields.
When price is sentiment-oriented, the technical value can be difficult to gauge. Arguably, the best indication is the forced-sale valuation that banks and lenders require. The challenge of sentiment is that it is subjective to the buyer and geared to market-momentum. It may sound bizarre for a proposition to be priced at 3%, 7%, 10% or whatever depending upon the instability of market momentum, but that's sentiment for you. Sentiment distorts underlying value. When you buy priced on sentiment, you are taking a risk that the market would be at least equally sentimental when you want to sell the investment. One reason guide prices for auction lots often bear no relationship to the result is not a consequence of the auctioneer or seller underpricing, but of underestimating the degree of sentiment. Auction reserves are normally based on technical valuation considerations.
When you buy on valuation, as distinct from sentiment, you are also taking a risk that the valuation is correct. Since valuation is only an opinion, albeit an informed opinion, the question is whether the opinion would prove correct when tested in the market. The beauty of opinion, at least from the surveyor's perspective, is that the valuation is at a certain date. It is not possible to value in advance - that's prediction - so it's anyone guess whether the opinion would stand the test of time. There are valuation criteria that surveyors have to respect, also a duty of care, but a margin for error is permissible. Study case-law on negligence claims and you’ll find they tend to be circumstances-specific.
Capital value is expressed as percentage or years' purchase ('YP'). Whether % or YP, each is another way of saying the same. Yield is the income return on capital and is calculated by multiplying the required return by the passing rent plus the estimated rental value deferred. (Some landlords and surveyors prefer discounted cash flow ('DCF') analysis, which is a method of valuing using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values —the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.)
YP is a similar calculation but instead of percentage yield is expressed as a number of years. For example, a property let at £100,000 a year yielding 10% would be priced at £1M. 10% = 10 YP. (100/10=10). One advantage of thinking years' purchase is not just to have an instant calculation of the number of years to get your money back, as much as to increase awareness of the potential. For example, at present 7% yield sounds better than 1 or 2% interest from cash on deposit but it'll take 14.28 years (ignoring tax, etc) to get your money back by which time anything could happen to the particular property and/or the tenant and/or the location you're buying into.
In conclusion, to appraise a shop investment properly requires a technical approach and a thorough understanding of business tenancy law and and valuation, which is why it's advisable to consult an experienced retail property surveyor. If you don't want to pay for what might be perceived common sense, instead perhaps taking comfort from what others are paying for similar propositions, then at the very least, in my opinion, you really ought, with respect, be giving more credence to whether (1) the town and (2) the trading position will endure, (3) the passing rent would reasonably be expected to increase during the remainder of the term and on renewal, and (4) for how long the tenant's covenant (for which you may be paying a premium) at the property will last. If you skip all that and simply focus on the yield and tenant covenant then more than likely you'll come unstuck.
Shop investments are valued by reference to specifics, rather than generalities: namely, the nature of the particular town and importance of the particular trading position in that town. Towns and cities are ranked in terms of national and regional importance, according to multiple retailer representation and associated criteria, such as customer spending-power. The era of local and catchment population only shopping in the town where they live and/or work is long gone. Nowadays, spending-power, drive-time, parking facilities and the customer experience overall are determining factors. While each town will have its own trading positions, more important for investment potential is the relationship between one particular town and another, together with any wider influences that could affect that importance, such as new developments in the offing.
Towns vary in character, heritage, population (resident and catchment) and other socio-economic demographics. Each town has its own trading positions: in-town, the best position is the prime position, which might include a purpose-built shopping centre or mall at the heart of the town centre; everything else is classified as secondary. Secondary comprises secondary, tertiary, local, and neighbourhood. Out-of-town (including edge-of-town) shopping centres, malls, precincts, outlet centres and supermarkets are in a league of their own and depending upon the overall shopping experience may be the dominant shopping location for the whole town.
Over time, sometimes almost overnight in the case of a new shopping development, in-town trading positions can change. What used to be the prime position may become secondary, and vice versa. The presence of multiple retailers does not itself define a prime position: many multiple retailers prefer secondary positions.
Unlike town centre 'high streets' including secondary positions where the ownership of shop property comprises different landlords and owner-occupiers, purpose-built shopping centres, whether in- or out-of-town, are usually owned by a single landlord able to control tenant-mix. Shopping centre management is directed toward maximising the trading potential for both the centre's owner and the centre's tenants, whereas with fragmented ownerships, different landlords and so on, each individual landlord is likely to have their own investment policy, tenants having to fend for themselves.
Purpose-built shopping centres, being privately-owned, can be managed to a marketing plan, but investing in individual properties in the 'high street' is riskier. In the firing line of day-to-day trading reality, retailers fall into two categories: those that actively support and contribute to community initiatives to generate custom, and those that don't. Those that don't are sometimes criticised by those that do but only because those that do resent the freely cashing-in on community initiatives. It's not that those that don't are anti-social, so much as a difference in approach to attracting custom.
Some retailers are destinations in their own right, others rely far more on passing trade. Ideologically, a town centre might be presented as a community but, in practice, it is not a level playing field: business is not an extension of social services. Ultimately, some retailers are better at attracting profitable trade than others. Generally, the least capable are prone to bleating, the more successful adjust and adapt.
Amongst the factors affecting asset management and investment potential is not just the relationship between each particular building and its trading position, but also the relationship between that trading position and other trading positions in the town and other towns elsewhere. In the absence of a united front involving all interested parties, competing interests between (1) owners and their tenants in single ownership shopping centres and (2) the relatively dysfunctional policies of different landlords and tenants in 'high streets' can result in the 'high street' interests losing out.
Unlike single-ownership shopping centres where rent levels are geared to positioning of the tenant mix, with all leases generally containing more or less the same terms and conditions, other than rent, there is no obligation on a landlord of an individual shop property in 'high street' trading position to want the highest rent and/or to pursue rent review so, for example, rent reviews might remain outstanding. Consequently, rental levels even in the same street do not have to be consistent. Furthermore, since transactions are particular landlord-tenant specific, a tenant is not obliged to agree the lowest rent and many retailers are rumoured to ingratiate themselves with landlords in exchange for preferential treatment elsewhere. Establishing a surveyor-acceptable common denominator for the level of rents is a matter for informed opinion. The adage 'one swallow does not make a summer' is cited whenever a transaction is thought to be out of line.
For decades, it's been said there are too many shops. The polarisation of the retail market over the past twenty years or so suggests there may now be too many towns. To evaluate prospects for a town, thinking that it's nice place to live in may not be the correct criterion. It also has to be a nice place for most people to shop compared to whatever else is nearby. To avoid being subjective the definition of "a nice place to shop" must allow for different tastes and spending-power. A busy-looking town centre might suggest popularity but is not necessarily indicative of a growth area for investment.
Having decided whether the town itself would be worthwhile investing in, the next decision is to select the trading position in that town. As well as monitoring footfall, (passers-by, where do they come from, where are they going), the question is what influences if any could affect the potential for that trading position. Depending upon the location, influences are numerous, ranging from tourist attractions and public transport facilities to proposed redevelopments. Successful retailers have it within their power to make or break the popularity of a trading position. Unless one is privy to the facts, it is difficult if not impossible to assess whether a particular tenant or other retailers nearby are doing well. A shop that looks busy isn't necessarily a profitable business. The stability of a trading position and its attraction for new tenants will depend upon whether the established tenants are trading profitably as defined by the established retailers' particular requirements. It is possible to buy a service that assesses tenant-covenant, financial standing and so on - in my opinion the sort of information for gauging rental security that is readily available on-line if you know where to look - but rarely will an investor get the sort of information that is vital. It's all very well paying to be told that 'x plc' has for example 300 branches, a turnover of £xM, net profit £yM and net assets of £zM but what's equally if not more important is whether that particular retailer intends to remain in occupation in a particular trading position and for how long. In the absence of procuring confidential commercially-sensitive information, including whether the shop lease is on the market, the experienced-eye becomes the reliant factor.
The best properties rarely come on to the market so generally investors will have to be content with second-best and within their affordable price range. Property dealers trade on opportunity, but private investors like to buy for long term hold, often the life of a mortgage of say 20 years. The prospects for the investment should be assessed by reference to the envisaged period of ownership. Using the 20 years example, how likely is is that the proposition will perform as investment over 20 years? I reckon towns that provide a ready supply of propositions available on the market tend to be unstable and lacking investment prospects. Many properties do the rounds, cropping up for sale over the years, sometimes via the same auctioneers or agencies. At present, I'm advising on a shop property that's been sold in 5 different auctions since 1999, on each occasion at a different price.
The proposition is a particular property so the nature of the property itself is important. Generally, investors prefer to own complete buildings (shop and upper part) rather buy piecemeal (shop only, upper part sold off). For residential investors looking for bargains, there is a lot to be said for a shop and upper part. It may be possible to convert the upper part into one or more flats, and/or to sell any existing flat separately should the opportunity arise. Where the shop premises includes a flat above, all let on a business tenancy, and where the shop tenant is not in occupation of the flat, there is potential within the Landlord & Tenant Act 1954 for opposing renewal of the whole on expiry or denying the shop tenant the right to renew of the flat as well and getting the flat back for a relatively low amount of compensation.
Having selected the property, the next point to consider is the rental value. The benchmark is the open market rent for the premises. The open market rent differs from the closed market. The closed market is where the tenant has negotiating rights and a dispute resolution procedure. The practical distinction is whether the landlord is in control and the tenant’s only choice to take or leave it.
When the shop property is let already, the starting point for comparison with the benchmark is the rent currently payable (the 'passing' rent). When the shop is vacant and to let, the starting point is the estimated rental that would be obtainable on the grant of a new lease. The passing rent is certain. The estimated rental is uncertain.
The first question is whether the passing rent is correct, or too high or too low. To answer, first establish the type of occupancy: is it a tenancy (popularly a lease), a periodic tenancy, a tenancy-at-will, or a bare licence? The passing rent would have been agreed on some basis: the question upon what basis includes what rights, if any, does the tenant have. It is also necessary to read the existing documentation.
The basis for the rent is important. Rent does not exist in isolation: rent is the product of the terms and conditions of the lease upon which the premises are let and would be let. One cannot state categorically “this is the rent for the premises” without also defining the terms and conditions in the lease. That surveyors generally do say 'this is the rent for the premises' includes, by implication, assumptions regarding the terms and conditions of the lease granted or to be granted. Anyone that answers the question 'what is the estimated rent?' for premises that are let already without taking into account the terms and conditions of the lease or the nature of the occupancy that is in force is likely to come up with the wrong answer. For example, if the existing lease contained a restricted user clause then the passing rent might be lower than if there were no restriction. Similarly, if tenant has carried out structural alterations to the property then the effect on rent of those improvements might have been disregarded at the last rent review; the question then is whether and when the rental value of those improvements would revert to the landlord.
(On renewal of an existing tenancy where Landlord and Tenant Act 1954 case-management procedure is underway, a draft lease for the uncontentious terms and conditions will be agreed between the respective parties’ lawyers before the respective parties' expert witness surveyor reports on rental value are prepared and exchanged. To value a rent, the surveyors must have something tangible and agreed in principle to go on. With a brand new letting, it is rare for the draft lease to be submitted before the tenant makes an acceptable offer of rent. Usually, the draft lease is submitted after outline terms and conditions are agreed in principle (heads of terms, subject to contract, etc). Since rent is a product of the terms and conditions of the actual lease, the test of integrity when drafting the lease is whether if there were a rent review on the same day as completion of the lease the rent would then be the same as the initial rent.)
To compare the passing rent with the estimated open market rent, the passing rent is devalued. Depending upon the type and size of the premises, shop rents are normally devalued to the Zone A rate. Zoning is a measuring methodology for comparing shops of different sizes and layouts to arrive at a common denominator. Having calculated the area in terms of Zone A (known as “ITZA”) and deducted values for non-zoned parts of the premises including, for example, any residential accommodation, the net rent for the shop is divided by ITZA and the result is the Zone A rent. You can find out more about zoning here.
To make a comparison with the estimated open market rent, it is necessary to devalue the evidence, preferably of open market lettings but if not available then the next best thing, according to the hierarchy of evidence. Evidence generally is what other landlords and tenants have agreed or had ascertained for similar types of premises. However, evidence is not only of other rents agreed but also the terms and conditions of the leases and other types of occupancy. For that you would need to know precisely or as near as possible exactly what has been agreed by others.
For the do-it-yourself investor/landlord, sourcing comparable evidence is not straightforward. Rents and agreements are confidential to the parties concerned. There is no public register. The nearest to a national resource is to buy copy leases that are registered with the Land Registry. However, having a copy of someone else’s lease isn’t going to get you very far if you don’t have the rental devaluation. Rateable value could be a clue: rating areas on-line are freely accessible but rating areas, as well as being notoriously unreliable (arithmetical inaccuracies, also it depends when the premises were last referenced (measured) for rating), often differ from valuation areas for actual rent so can only provide a rough guide and should not be relied upon. Other quasi-public domain sources include shop agents' websites, auction catalogues, and stock exchange public property company results and announcements. For surveyors, our sources include subscriber-databases (generally a mishmash of agents particulars, auction catalogues, and industry press-releases), information that we obtain direct from landlords, tenants, and other surveyors, our experience from work undertaken and in-hand, and our own record systems. Created in 1975 for my own use, I own possibly one of the largest computerised databases of shop rents; at the touch of a button, I can access information in seconds and whilst I don’t profess to know about everything happening in the places I monitor, it doesn’t take me long to familiarise and gather evidence.
An important point to remember about comparable evidence is that transactions are confidential and the information, often of considerable value, is guarded jealously. The commercial property market thrives on the free circulation of comparable evidence but it’s not ‘free’ in the true sense: it comes with the implied understanding to not misuse it. Arguably, Data Protection Act limitations apply; it is suggested that either or both parties' permission should be obtained before facts are released. In any event, it is not compulsory for either landlord or tenant and/or their respective surveyors to cooperate with requests for evidence. Since shop tenants tend to close ranks over disclosure of rental agreements, unless it suits them to co-operate, it can be difficult if not impossible for a landlord wanting to establish the facts if you don't have the contacts.
The reason surveyors are more likely to be able to procure evidence is that landlords and tenants come and go, whereas surveyors endure, so are likely to come into contact with one another sufficiently regularly to want to reciprocate. The shop property market comprises thousands of different landlords and tenants, (approximately 400,000 trading fascias have been identified) but there are only about 4,000 multiple retailers (including banks) which narrows things down a bit, and since fewer surveyors deal with shop property rents on a regular basis and reliably so, knowing whom to ask comes from experience.
Having devalued the evidence and compared the Zone A level with the passing rent Zone A, any other differences must be considered carefully. Apart from any technical adjustments and allowances, the effective date of the evidence is important. Evidence can be historic and the definition of historic varies. Generally, evidence within the same year or so, unless 2008 when before August that year predated the downturn, is preferred but where there is no recent evidence it becomes a matter of informed opinion which is where surveyors come into their own: informed opinion may also be used as evidence.
Particulars for the sale or auction catalogues of shop investments often mention Zone A rents nearby. Such mentions should be treated with caution. As I’ve said, it’s not just extrapolating the Zone A rent from one transaction and applying it to the shop premises under scrutiny: the terms and conditions of the respective leases are also vital.
After ascertaining the Zone A relationship between the passing rent and open market rent, the next question is how to value the investment. Where the passing and open market Zone A rents are about the same, the question is why or whether the rent should increase at the next opportunity, normally a review or lease expiry/renewal. In my last missive, I've already said that 'upward-only' rent review doesn't mean the rent necessarily has to increase. Why is about the future direction of the market for the premises, also known as supply and demand. A change in ownership of an existing property does not increase the supply so the question is whether there is any demand for the premises. If there’s no likelihood of any increase then the investment is not going to perform, except in the context of the buyer’s subjective reasons for wanting the proposition.
Historically, a rule-of-thumb yield for non-growth propositions was at least 10% but since the early 1970s - when for reasons, if you’re interested, you can read more about here Valuation and Overpaying - the traditional demarcation of the market into non-growth and growth is virtually non-existent. Based upon the cost of borrowing, the same nationwide, yield rather than ‘location, location, location’ has become the determining factor for most buyers.
Assessing risk by reference to yield depends upon the tenant's covenant. National companies, multiple retailers and banks, all considered more secure propositions tend to fetch higher prices than shops let to independent retailers and local shopkeepers. The fact that larger companies can up-sticks or go broke without warning doesn’t seem to have altered a view amongst some investors that a shop let to a multiple retailer is likely to relet to another multiple retailer. That view is based on no evidence whatsoever: one reason many trading positions (including numerous ‘high streets’) are not as primary as they were is that multiple retailers have relocated to better locations.
When the passing Zone A rent exceeds the open market Zone A rent, the question is for how long is the passing rent secure. Assuming the tenant does not go bust in the meantime, the over-renting will expire on renewal of the lease when the market rent will apply.
When the passing Zone A rent is below the open market rent, the investment is reversionary. Reversionary implies growth because the reversionary rent is the rental value of the property if it were let now at the estimated open market rental. Since the estimated rental would not be known for certain, either agreed or ascertained, until sometime in the future, the reversionary value is deferred by the number of years to the reversion. (I've emphasised 'implies' because growth is not certain merely because of differences in the respective Zone A levels. The next rent review date may be years off by which time what is now the latest open market letting could be historic; in the meantime, the market might have changed.)
The starting point for the valuation of a shop investment ought to be the valuation of the property if vacant, but invariably it is not. Vacant possession value could be more than or less than or the same as the investment value, depending upon the location and trading position.
Shop property let already is generally valued subject to the benefit of the existing lease (occupancy) so the two elements get muddled and the proposition (property plus investment) treated as one. Since the tenant's covenant (identity of the tenant) often makes a difference to the value of the investment, it can be difficult to distinguish the separate elements.
The muddling of values (where the shop premises are let already) tends to be linked to sentiment. Generally, sentiment is a better driver of market momentum than technical valuation. Hence, depending upon the degree of sentiment in the market, the same shop property investment could, for example, be valued at anything between about 1% and 15%+ which means that the timing of the purchase becomes critical if you want to avoid overpaying, and the timing of selling if you want to avoid becoming lumbered.
The property industry has debated at length the difference between price, worth and value. In outline, price is what the seller asks and buyer agrees and the amount that the proposition fetches is what the proposition is worth to the actual buyer. In other words, worth is subjective. Value is objective: what the property would fetch generally, regardless of whether anyone would pay more. Anyone who has agreed a price with a buyer only to have the property down-valued by a surveyor for the bank will have their own views, but thinking that value must surely be what the particular buyer pays is wrong because that view makes no allowance for the actual circumstances.
There is a school of thought that will only buy where a profit can be had from the difference between the cost of borrowing and the starting yield from the property. There is nothing wrong with that, provided it is not confused with property investment. The cost of borrowing, interest rates generally, is nothing to do with the value of property, but that doesn’t stop countless investors believing there is. Consequently, prices vary according to prevailing interest rates and market sentiment. Strong demand, combined with easy borrowing, generally results in lower yields.
When price is sentiment-oriented, the technical value can be difficult to gauge. Arguably, the best indication is the forced-sale valuation that banks and lenders require. The challenge of sentiment is that it is subjective to the buyer and geared to market-momentum. It may sound bizarre for a proposition to be priced at 3%, 7%, 10% or whatever depending upon the instability of market momentum, but that's sentiment for you. Sentiment distorts underlying value. When you buy priced on sentiment, you are taking a risk that the market would be at least equally sentimental when you want to sell the investment. One reason guide prices for auction lots often bear no relationship to the result is not a consequence of the auctioneer or seller underpricing, but of underestimating the degree of sentiment. Auction reserves are normally based on technical valuation considerations.
When you buy on valuation, as distinct from sentiment, you are also taking a risk that the valuation is correct. Since valuation is only an opinion, albeit an informed opinion, the question is whether the opinion would prove correct when tested in the market. The beauty of opinion, at least from the surveyor's perspective, is that the valuation is at a certain date. It is not possible to value in advance - that's prediction - so it's anyone guess whether the opinion would stand the test of time. There are valuation criteria that surveyors have to respect, also a duty of care, but a margin for error is permissible. Study case-law on negligence claims and you’ll find they tend to be circumstances-specific.
Capital value is expressed as percentage or years' purchase ('YP'). Whether % or YP, each is another way of saying the same. Yield is the income return on capital and is calculated by multiplying the required return by the passing rent plus the estimated rental value deferred. (Some landlords and surveyors prefer discounted cash flow ('DCF') analysis, which is a method of valuing using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values —the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.)
YP is a similar calculation but instead of percentage yield is expressed as a number of years. For example, a property let at £100,000 a year yielding 10% would be priced at £1M. 10% = 10 YP. (100/10=10). One advantage of thinking years' purchase is not just to have an instant calculation of the number of years to get your money back, as much as to increase awareness of the potential. For example, at present 7% yield sounds better than 1 or 2% interest from cash on deposit but it'll take 14.28 years (ignoring tax, etc) to get your money back by which time anything could happen to the particular property and/or the tenant and/or the location you're buying into.
In conclusion, to appraise a shop investment properly requires a technical approach and a thorough understanding of business tenancy law and and valuation, which is why it's advisable to consult an experienced retail property surveyor. If you don't want to pay for what might be perceived common sense, instead perhaps taking comfort from what others are paying for similar propositions, then at the very least, in my opinion, you really ought, with respect, be giving more credence to whether (1) the town and (2) the trading position will endure, (3) the passing rent would reasonably be expected to increase during the remainder of the term and on renewal, and (4) for how long the tenant's covenant (for which you may be paying a premium) at the property will last. If you skip all that and simply focus on the yield and tenant covenant then more than likely you'll come unstuck.
Location, location, location
12/April/2014
In the last blog (April Fool or Successful Investor, 01 April 2014), I said “successful investment in commercial property includes the ability to be discerning, the more adept you become, the more you can gauge at a glance whether the proposition is likely to perform. Performance despite any resistance by the tenant. Why would the tenant resist?”
Apart from vacant property that might go up in value of its own accord, an occurrence that can reflect change of use for planning permission, development potential, and demand from owner-occupiers, the investment potential in commercial property depends upon tenants.
Tenants are the customers for investors in commercial property.
The property-relationship between landlord and tenant hinges on the terms and conditions of the tenancy; in popular parlance, the lease. Generally, investors prefer what is known as a ‘clean’ lease: an institutional standard whereby most if not all the responsibilities for the use of the premises fall on the tenant, and with no ambiguity in the interpretation of the contract.
Leases in the commercial property market are a challenge for investors, because there is no standard form of lease in common usage. Many landlords and tenants and lawyers have their own standard leases that incorporate specific requirements, but all are subjective. To assume the terms and conditions in each lease would be the same in every other is a mistake.
Drafting a lease is about recording the agreement in writing, the choice of words and phrases that spell out the responsibilities between landlord and tenant. On grant of a new lease, the onus is on the landlord’s side to draft and on the tenant’s side to approve. Sometimes, where the tenant has specific requirements, the tenant’s lawyer will offer to draft the lease but that is usually only to save time. Better for the tenant to provide the wording required rather than the landlord have to guess. Unfortunately, whether through drafting inexperience or error, and because many landlords and tenants can’t be bothered to read the ‘small print’ before signing the document, the wording of a lease will often differ from what the parties intended, so ambiguities in interpretation can arise.
Disputes involving differences in interpretation that are taken to court constitute the body of case-law. The drafting of leases is also fashionable. The widespread use of precedents, often followed slavishly, can result in little or no thought being given to ensuring the performance of the investment.
The duration of a lease, the term of the tenancy, is often for years. Leases may be shorter now, 10 years perhaps with a break clause at the 5th year, but 15-25 years remain popular, not least because bank criteria for lending to tenants requires a secure term of at least 8 years.
Leases are fixed documents whose terms and conditions can only be varied by mutual agreement, or rectification usually only by the original parties. The market, however, is not fixed: it is continually changing. What is a market? A market is anywhere business is done. Transactions are usually for money, but may involve bartering goods and are conducted between sellers and buyers, or through agents, wholesalers, manufacturers, brokers, etc. Marketing happens when we want to satisfy a need and are willing to exchange something with someone able to help us satisfy that need. The process exists to bring buyers and sellers into a market. In business, the transaction is reciprocal. Business is about helping people in exchange for money.
Markets exist to serve the needs of participants and for identification have classifications and categories: for example, the property market, whose categories include residential property, commercial property, and so on. Naturally inactive, markets become active when fuelled and driven by a range of different influences, all of which originate in how the participants in the particular market respond to whatever is or perceived to be happening in the reality that the market exists to serve.
With commercial property, the ups-and-downs of the market are not necessarily dependent upon whatever is happening in the economy at large so the line of reasoning may be hard to follow, but that doesn’t mean we cannot remain in sync with any changes: all that’s needed is flexibility. Leases, however, are inflexible: what was agreed years ago may not be relevant now.
Where the landlord and tenant are the same parties throughout the term, it is probably less likely for either or both to want to interpret the terms and conditions of the lease in a way that differed from their original intention, unless to material advantage and being unconcerned about the risk of falling out over a dispute. Where one or both of the original parties have changed, and since leases are themselves assets that can be bought and sold (subject to any restrictions), a successor-landlord or successor-tenant might have a different view of the intention of the original parties.
Buying an existing investment means taking over a lease that may be outmoded or badly drafted, whose terms and conditions may work against the investment objective. Conversely, leases may contain words and phrases that serve the landlord more than the tenant. It is a question of finding. As I say, anyone can read a lease, it’s knowing what to look for that really counts.
Once upon a time, it would have been unusual for tenants to take professional advice from surveyors. Surveyors acted for landlords and tenants generally did as they were told. Tenants were subservient. For many years, on the RICS application form for dispute resolution procedure, under the heading ‘tenant representative’ were the words, in parentheses, “if any”.
Life was never the same again for landlords following the House of Lords ruling in United Scientific Holdings v Burnley Borough Council [1978]. Briefly, the landlord had missed the date for the rent review notice, so the tenant argued the landlord had lost the right to review the rent.
As I said, (01 April 2014) “We (surveyors) know that landlords become successful when their investments perform. We also know that tenants become successful not just when their businesses are performing well but also when the total property cost commitment is kept to a minimum.” Reducing property costs and minimising tenancy liabilities makes sense for tenants but is unlikely to make any sense for landlords. The idea that provided the premises are economical, tenants more likely to stay the course, is defeated because tenants want to have it both ways. They want the lowest rents and the least liabilities together with the most flexibility. Scrutinising the wording and phrasing of the terms and conditions of leases in the hope of scoring points either for landlord or tenant is big business for surveyors and lawyers. It works both ways: landlords can benefit enormously from a different interpretation; for tenants, a single word, a turn of phrase, can often result in a substantial reduction in rent or relief from liability.
Apart from whether the landlord is legally entitled to more (as distinct from having the right to expect more) and whether the tenant is legally entitled to less (as distinct from thinking the world owes it a living), landlord and tenant each in their own ways want to maintain a profitable relationship with the location of the property. The adage “location, location, location” is a fundamental ingredient for successful investment which might be thought ‘old school’ compared with the relatively recent popular demand for tenant-covenant, but the adage remains nevertheless the more important. Unlike covenant which depends upon the tenant wanting to remain in occupation, the property is fixed and immoveable. In other words, if you buy a property let, for example, to a bank which, as a blue-chip covenant, would normally fetch a higher price in the investment market, but the bank does not renew its lease or exercises a break clause then you’d no longer have the bank as a tenant but you still have the property.
Subject to compliance with the lease, how the tenant chooses to run its business is nothing to do with the landlord, but it is to do with the customers whom the tenant’s business serves. Why those customers and/or type of customers choose to have their needs satisfied by one particular business over another is a function of marketing, and of location. Therefore, the challenge for any tenant that is doing well is whether the success of the business venture is more a reflection of the tenant’s modus operandi or mostly a spin-off from the popularity of the location. For example, acting for a landlord, I let a shop to a business specialising in sale and hire of videos (DVDs, etc) of old movies. The tenant needed to relocate from nearby because its premises there were going to be redeveloped. The tenant was convinced he was doing well because of the specialised nature of his business but as he soon discovered it was more to do with where he was based before. My Client’s shop was not in such a good position and the passing trade was not enough to support the tenant’s business at rent the tenant had agreed. That didn’t make the rent wrong in itself; but just for that type of business.
Appraising the merits of location has become more difficult now that on-line commerce is accepted generally amongst customers. There are many tenants that have downsized to improve efficiency and consolidated premises in order to reduce costs. Many retailers have closed their bricks-and-mortar presence on the high street because the cost of providing a physical place for doing business is considerably more expensive than trading on-line. A virtual presence on-line is akin to mail order but with trimmings.
For multiple retailers, it used to be that to have branches in 200 towns (and cities) would provide almost 100% geographical catchment. Now it’s 50 or so and in future a few stores in top centres might be all that is needed. Whenever locations become centres of attention, the benchmark changes for everyone else. Hence, the ongoing and potentially improving popularity of the location, attractiveness and so on, is important for a landlord. A location that doesn’t have what it takes to attract the calibre of tenant that would contribute to the appeal of the location is unlikely to be able to compete successfully with those locations that do. Since the location is where the property is, the potential for the property should be considered by reference to the factors that obviously contribute now and those in the offing.
Factors in the offing may not be apparent, or rather not so acceptable to the majority: what is clear to some or a few may be laughable to others, but location is not about personal resistance to change, but swirling undercurrents gathering steam, the groundswell of powerful feelings. For example, in the June 1989 issue of my newsletter for clients and contacts, I said that the emergence of the ‘Green’ consumer marked the onset of a major shift in attitude that would have repercussions for all aspects of future retailing. Nowadays, ‘Green’ issues and all that they have spawned such as sustainability, Energy Performance Certificates, and such like, are taken for granted but in the same way the world-wide-web has only been with us for 25 years yet seems like forever so ‘Green’ is a relatively new entrant to mainstream thinking.
Essentially, the direction of a market is geared to progress, which, in the context of personal and business development, may be inwards or outwards depending upon priorities and aspirations. The challenge for all business tenants is to synchronise with customers, and for all landlords to synchronise with tenants, but that does not have to mean the actual tenant. Whether a landlord wants to hang on the actual tenant, rather than take its chances in the market, is a matter of investment policy. And whether a tenant wants to become a tenant of a particular landlord depends upon what that landlord has to offer in the way of property. Similarly, whether a tenant wants to continue catering for a particular type of customer is a matter for that particular tenant. Not so much an instability as the desire to remain in sync, the constant re-aligning, rejigging, pruning and fine-tuning of freehold and leasehold interests by thousands of landlords and tenants is the reason for the number of commercial properties in the market at any time.
For retailers, for example, trading positions change according to the influences on (potential) trade. A prime position today could be become secondary in future, and vice versa. The identity of multiple retailers is not in itself a reliable indicator of a good location: the question is whether most if not all of those particular multiple retailers would jump at the chance of getting a shop in that location if they were not already there. Or would they leap at the first opportunity to get out? When you buy a property, you are not buying the whole of the market, you are buying a particular property. Assessing tenant-covenant is not just about appraising the financial standing of the tenant as a whole, but also identifying the tenant’s intention for that particular property. What you have to ask is if the tenant vacates on break clause or end of the lease, whether the property would relet to a tenant whose covenant would at least be on a par with the outgoing tenant and the rent, the terms and conditions of the new lease at least maintain the investment value.
Since properties worth keeping through thick and thin are rarely offered for sale, which means 99% of propositions in any auction catalogue are probably not worth buying, anyone following my advice might think they’d never buy anything! But why buy for the sake of it? Why invest in buying and owning a commercial property if there’s little or no likelihood of it performing? Of you being better off than you were? One answer, of course, is that I could be wrong. In a market whose prices are mostly driven by sentiment, rather than technicalities, surely any property acquired at the right price will perform over the long term at least? Therefore, it may be not that you shouldn’t buy anything that takes your fancy, but just a question of price. The answer to whether the price is right can only be subjective. The intrinsic value of an asset, over and above its scrap value is largely based on sentiment. [Talking of scrap value, just because the property could cost more to build than the asking price for the end-product does not make the property worth buying. All property has a shelf-life in the demand-market, regardless of any potential for change of planning use.]
Sentiment can get in the way of appraisal by scoffing at technicalities as surmountable. In other words, if all else fails then buy yourself out of trouble. If I were an investor in property then frankly I’d rather not waste time on what is likely to prove a non-performing investment based on technicalities, but since I don’t invest in property (other than a home) the only way I can emphasise with sentiment-investment is in the context of trading: buy to resell on the momentum. Otherwise all I can do is point out the pitfalls and what can go wrong by ignoring the technicalities. What can wrong because the tenant resists resolutely. Hence, my contribution to the success of the landlord’s choice of commercial property is to use my know-how to either at least maintain or better still improve the investment performance. And for that one needs an in-depth knowledge of the technicalities and negotiating psychology, because it is through the use of the technicalities and ploys that tenants can make or break the landlord’s investment.
Although the pace of change is tenant-demand geared to customers, the driving force that has transformed the commercial property landscape from a relatively level-playing field into a polarised market is the successful use of the technicalities and negotiating ploys by tenants and their advisers. Consequently, at a macro-level, some locations have what is takes and have gone for it, others are fighting for survival and in many cases dying on their feet. In the quest for solutions to the havoc wreaked on local economies and communities, one can pinpoint the more obvious macro- reasons for decline, business rates, high rents, local authority parking charges, out-of-town supermarkets, retail parks, etc, but since those factors are nationwide, it still doesn’t explain why some locations are more successful than others.
In my opinion, the underlying reason is organic: a feeling that is equivalent to the institutional property investor’s idea of a ‘clean’ lease. In its tangible form, it is a desire by profitable customers and successful and aspirational tenants to avoid mixing with all and sundry. Why lease tatty premises from a greedy amateur investor in a declining area when one can rent a gleaming building from a professional landlord in a good location, and often for not that much more, all told. The desire for organic in the sense of authenticity, open communication and transparency remains as strong as ever. In my opinion, one that seems to be shared by a good many others, most provincial towns have gone ex-growth. The core organic positions have been redeveloped, thereby acting as a magnet for the tenant-spending power, leaving the peripheral positions to fend for themselves.
The art of selling investments that in future will under-perform has succeeded in wooing hundreds of private investors into dud locations. The dumping of non-performing investments by shrewd sellers on the inexperienced is nothing new but, nowadays, with the bulk of investments offered at auction the fever has spread. There is, of course, nothing wrong with wanting to buy a property currently let to a good tenant in a nice place. But that’s not the point: it’s not whether you as the landlord would like the location, but whether the tenant would renew the lease on at least the same overall basis as now, and the premises would if vacant be lettable to a tenant whose corporate image would help enhance the location and stimulate demand from other like-minded tenants as well. If there is any doubt whatsoever about either one or both of those factors then until a change arises you are stuck with the technicalities, so you may as well use them to your advantage.
to be continued……
Apart from vacant property that might go up in value of its own accord, an occurrence that can reflect change of use for planning permission, development potential, and demand from owner-occupiers, the investment potential in commercial property depends upon tenants.
Tenants are the customers for investors in commercial property.
The property-relationship between landlord and tenant hinges on the terms and conditions of the tenancy; in popular parlance, the lease. Generally, investors prefer what is known as a ‘clean’ lease: an institutional standard whereby most if not all the responsibilities for the use of the premises fall on the tenant, and with no ambiguity in the interpretation of the contract.
Leases in the commercial property market are a challenge for investors, because there is no standard form of lease in common usage. Many landlords and tenants and lawyers have their own standard leases that incorporate specific requirements, but all are subjective. To assume the terms and conditions in each lease would be the same in every other is a mistake.
Drafting a lease is about recording the agreement in writing, the choice of words and phrases that spell out the responsibilities between landlord and tenant. On grant of a new lease, the onus is on the landlord’s side to draft and on the tenant’s side to approve. Sometimes, where the tenant has specific requirements, the tenant’s lawyer will offer to draft the lease but that is usually only to save time. Better for the tenant to provide the wording required rather than the landlord have to guess. Unfortunately, whether through drafting inexperience or error, and because many landlords and tenants can’t be bothered to read the ‘small print’ before signing the document, the wording of a lease will often differ from what the parties intended, so ambiguities in interpretation can arise.
Disputes involving differences in interpretation that are taken to court constitute the body of case-law. The drafting of leases is also fashionable. The widespread use of precedents, often followed slavishly, can result in little or no thought being given to ensuring the performance of the investment.
The duration of a lease, the term of the tenancy, is often for years. Leases may be shorter now, 10 years perhaps with a break clause at the 5th year, but 15-25 years remain popular, not least because bank criteria for lending to tenants requires a secure term of at least 8 years.
Leases are fixed documents whose terms and conditions can only be varied by mutual agreement, or rectification usually only by the original parties. The market, however, is not fixed: it is continually changing. What is a market? A market is anywhere business is done. Transactions are usually for money, but may involve bartering goods and are conducted between sellers and buyers, or through agents, wholesalers, manufacturers, brokers, etc. Marketing happens when we want to satisfy a need and are willing to exchange something with someone able to help us satisfy that need. The process exists to bring buyers and sellers into a market. In business, the transaction is reciprocal. Business is about helping people in exchange for money.
Markets exist to serve the needs of participants and for identification have classifications and categories: for example, the property market, whose categories include residential property, commercial property, and so on. Naturally inactive, markets become active when fuelled and driven by a range of different influences, all of which originate in how the participants in the particular market respond to whatever is or perceived to be happening in the reality that the market exists to serve.
With commercial property, the ups-and-downs of the market are not necessarily dependent upon whatever is happening in the economy at large so the line of reasoning may be hard to follow, but that doesn’t mean we cannot remain in sync with any changes: all that’s needed is flexibility. Leases, however, are inflexible: what was agreed years ago may not be relevant now.
Where the landlord and tenant are the same parties throughout the term, it is probably less likely for either or both to want to interpret the terms and conditions of the lease in a way that differed from their original intention, unless to material advantage and being unconcerned about the risk of falling out over a dispute. Where one or both of the original parties have changed, and since leases are themselves assets that can be bought and sold (subject to any restrictions), a successor-landlord or successor-tenant might have a different view of the intention of the original parties.
Buying an existing investment means taking over a lease that may be outmoded or badly drafted, whose terms and conditions may work against the investment objective. Conversely, leases may contain words and phrases that serve the landlord more than the tenant. It is a question of finding. As I say, anyone can read a lease, it’s knowing what to look for that really counts.
Once upon a time, it would have been unusual for tenants to take professional advice from surveyors. Surveyors acted for landlords and tenants generally did as they were told. Tenants were subservient. For many years, on the RICS application form for dispute resolution procedure, under the heading ‘tenant representative’ were the words, in parentheses, “if any”.
Life was never the same again for landlords following the House of Lords ruling in United Scientific Holdings v Burnley Borough Council [1978]. Briefly, the landlord had missed the date for the rent review notice, so the tenant argued the landlord had lost the right to review the rent.
As I said, (01 April 2014) “We (surveyors) know that landlords become successful when their investments perform. We also know that tenants become successful not just when their businesses are performing well but also when the total property cost commitment is kept to a minimum.” Reducing property costs and minimising tenancy liabilities makes sense for tenants but is unlikely to make any sense for landlords. The idea that provided the premises are economical, tenants more likely to stay the course, is defeated because tenants want to have it both ways. They want the lowest rents and the least liabilities together with the most flexibility. Scrutinising the wording and phrasing of the terms and conditions of leases in the hope of scoring points either for landlord or tenant is big business for surveyors and lawyers. It works both ways: landlords can benefit enormously from a different interpretation; for tenants, a single word, a turn of phrase, can often result in a substantial reduction in rent or relief from liability.
Apart from whether the landlord is legally entitled to more (as distinct from having the right to expect more) and whether the tenant is legally entitled to less (as distinct from thinking the world owes it a living), landlord and tenant each in their own ways want to maintain a profitable relationship with the location of the property. The adage “location, location, location” is a fundamental ingredient for successful investment which might be thought ‘old school’ compared with the relatively recent popular demand for tenant-covenant, but the adage remains nevertheless the more important. Unlike covenant which depends upon the tenant wanting to remain in occupation, the property is fixed and immoveable. In other words, if you buy a property let, for example, to a bank which, as a blue-chip covenant, would normally fetch a higher price in the investment market, but the bank does not renew its lease or exercises a break clause then you’d no longer have the bank as a tenant but you still have the property.
Subject to compliance with the lease, how the tenant chooses to run its business is nothing to do with the landlord, but it is to do with the customers whom the tenant’s business serves. Why those customers and/or type of customers choose to have their needs satisfied by one particular business over another is a function of marketing, and of location. Therefore, the challenge for any tenant that is doing well is whether the success of the business venture is more a reflection of the tenant’s modus operandi or mostly a spin-off from the popularity of the location. For example, acting for a landlord, I let a shop to a business specialising in sale and hire of videos (DVDs, etc) of old movies. The tenant needed to relocate from nearby because its premises there were going to be redeveloped. The tenant was convinced he was doing well because of the specialised nature of his business but as he soon discovered it was more to do with where he was based before. My Client’s shop was not in such a good position and the passing trade was not enough to support the tenant’s business at rent the tenant had agreed. That didn’t make the rent wrong in itself; but just for that type of business.
Appraising the merits of location has become more difficult now that on-line commerce is accepted generally amongst customers. There are many tenants that have downsized to improve efficiency and consolidated premises in order to reduce costs. Many retailers have closed their bricks-and-mortar presence on the high street because the cost of providing a physical place for doing business is considerably more expensive than trading on-line. A virtual presence on-line is akin to mail order but with trimmings.
For multiple retailers, it used to be that to have branches in 200 towns (and cities) would provide almost 100% geographical catchment. Now it’s 50 or so and in future a few stores in top centres might be all that is needed. Whenever locations become centres of attention, the benchmark changes for everyone else. Hence, the ongoing and potentially improving popularity of the location, attractiveness and so on, is important for a landlord. A location that doesn’t have what it takes to attract the calibre of tenant that would contribute to the appeal of the location is unlikely to be able to compete successfully with those locations that do. Since the location is where the property is, the potential for the property should be considered by reference to the factors that obviously contribute now and those in the offing.
Factors in the offing may not be apparent, or rather not so acceptable to the majority: what is clear to some or a few may be laughable to others, but location is not about personal resistance to change, but swirling undercurrents gathering steam, the groundswell of powerful feelings. For example, in the June 1989 issue of my newsletter for clients and contacts, I said that the emergence of the ‘Green’ consumer marked the onset of a major shift in attitude that would have repercussions for all aspects of future retailing. Nowadays, ‘Green’ issues and all that they have spawned such as sustainability, Energy Performance Certificates, and such like, are taken for granted but in the same way the world-wide-web has only been with us for 25 years yet seems like forever so ‘Green’ is a relatively new entrant to mainstream thinking.
Essentially, the direction of a market is geared to progress, which, in the context of personal and business development, may be inwards or outwards depending upon priorities and aspirations. The challenge for all business tenants is to synchronise with customers, and for all landlords to synchronise with tenants, but that does not have to mean the actual tenant. Whether a landlord wants to hang on the actual tenant, rather than take its chances in the market, is a matter of investment policy. And whether a tenant wants to become a tenant of a particular landlord depends upon what that landlord has to offer in the way of property. Similarly, whether a tenant wants to continue catering for a particular type of customer is a matter for that particular tenant. Not so much an instability as the desire to remain in sync, the constant re-aligning, rejigging, pruning and fine-tuning of freehold and leasehold interests by thousands of landlords and tenants is the reason for the number of commercial properties in the market at any time.
For retailers, for example, trading positions change according to the influences on (potential) trade. A prime position today could be become secondary in future, and vice versa. The identity of multiple retailers is not in itself a reliable indicator of a good location: the question is whether most if not all of those particular multiple retailers would jump at the chance of getting a shop in that location if they were not already there. Or would they leap at the first opportunity to get out? When you buy a property, you are not buying the whole of the market, you are buying a particular property. Assessing tenant-covenant is not just about appraising the financial standing of the tenant as a whole, but also identifying the tenant’s intention for that particular property. What you have to ask is if the tenant vacates on break clause or end of the lease, whether the property would relet to a tenant whose covenant would at least be on a par with the outgoing tenant and the rent, the terms and conditions of the new lease at least maintain the investment value.
Since properties worth keeping through thick and thin are rarely offered for sale, which means 99% of propositions in any auction catalogue are probably not worth buying, anyone following my advice might think they’d never buy anything! But why buy for the sake of it? Why invest in buying and owning a commercial property if there’s little or no likelihood of it performing? Of you being better off than you were? One answer, of course, is that I could be wrong. In a market whose prices are mostly driven by sentiment, rather than technicalities, surely any property acquired at the right price will perform over the long term at least? Therefore, it may be not that you shouldn’t buy anything that takes your fancy, but just a question of price. The answer to whether the price is right can only be subjective. The intrinsic value of an asset, over and above its scrap value is largely based on sentiment. [Talking of scrap value, just because the property could cost more to build than the asking price for the end-product does not make the property worth buying. All property has a shelf-life in the demand-market, regardless of any potential for change of planning use.]
Sentiment can get in the way of appraisal by scoffing at technicalities as surmountable. In other words, if all else fails then buy yourself out of trouble. If I were an investor in property then frankly I’d rather not waste time on what is likely to prove a non-performing investment based on technicalities, but since I don’t invest in property (other than a home) the only way I can emphasise with sentiment-investment is in the context of trading: buy to resell on the momentum. Otherwise all I can do is point out the pitfalls and what can go wrong by ignoring the technicalities. What can wrong because the tenant resists resolutely. Hence, my contribution to the success of the landlord’s choice of commercial property is to use my know-how to either at least maintain or better still improve the investment performance. And for that one needs an in-depth knowledge of the technicalities and negotiating psychology, because it is through the use of the technicalities and ploys that tenants can make or break the landlord’s investment.
Although the pace of change is tenant-demand geared to customers, the driving force that has transformed the commercial property landscape from a relatively level-playing field into a polarised market is the successful use of the technicalities and negotiating ploys by tenants and their advisers. Consequently, at a macro-level, some locations have what is takes and have gone for it, others are fighting for survival and in many cases dying on their feet. In the quest for solutions to the havoc wreaked on local economies and communities, one can pinpoint the more obvious macro- reasons for decline, business rates, high rents, local authority parking charges, out-of-town supermarkets, retail parks, etc, but since those factors are nationwide, it still doesn’t explain why some locations are more successful than others.
In my opinion, the underlying reason is organic: a feeling that is equivalent to the institutional property investor’s idea of a ‘clean’ lease. In its tangible form, it is a desire by profitable customers and successful and aspirational tenants to avoid mixing with all and sundry. Why lease tatty premises from a greedy amateur investor in a declining area when one can rent a gleaming building from a professional landlord in a good location, and often for not that much more, all told. The desire for organic in the sense of authenticity, open communication and transparency remains as strong as ever. In my opinion, one that seems to be shared by a good many others, most provincial towns have gone ex-growth. The core organic positions have been redeveloped, thereby acting as a magnet for the tenant-spending power, leaving the peripheral positions to fend for themselves.
The art of selling investments that in future will under-perform has succeeded in wooing hundreds of private investors into dud locations. The dumping of non-performing investments by shrewd sellers on the inexperienced is nothing new but, nowadays, with the bulk of investments offered at auction the fever has spread. There is, of course, nothing wrong with wanting to buy a property currently let to a good tenant in a nice place. But that’s not the point: it’s not whether you as the landlord would like the location, but whether the tenant would renew the lease on at least the same overall basis as now, and the premises would if vacant be lettable to a tenant whose corporate image would help enhance the location and stimulate demand from other like-minded tenants as well. If there is any doubt whatsoever about either one or both of those factors then until a change arises you are stuck with the technicalities, so you may as well use them to your advantage.
to be continued……