Simplicity the key to using managed business space
Copyright: David Lawson - published Property Week March 2005
The key element of managed space is openness and simplicity. No intricate leases, stepped rents, hidden service charges or general uncertainty over who pays for what. But a storm is ruffling these calm waters. New international accounting regulations of mind-numbing complexity threaten to rip the heart out of some businesses. Ironically, they are aimed at exposing property costs normally swept under the carpet. And the good news is that they could massively boost demand for serviced space.
A seemingly obscure principle lies at the heart of the storm. In the past, conventional leases were considered ‘operational’ and appeared only in landlords’ accounts. This rankled with regulators, who felt it gave a false picture about the costs and benefits to tenants. New international accounting rules could classify some agreements as ‘finance’ leases, under which occupiers have to include future rent liabilities. These will be balanced by the benefits of occupation but raise problems such as making it appear firms are more heavily indebted.
Most UK leases will not be affected, according to Stephen Herring, tax and real estate partner with accounting giant BDO Stoy Hayward. The measures are aimed chiefly at exposing relatively rare ‘synthetic’ and ‘back-to-back’ agreements designed to hide costs and benefits away from the balance sheet. Even the blurred area of bundling services into rents will not create a new burden as long as agreements do not step over a crucial line by transferring risks and rewards from landlord to occupier.
The British Property Federation has compiled a checklist of key questions to help decide who could be affected. But failing even one of the tests means having to burrow deeper into lease agreements, says Shan Kennedy, valuations director at Chiltern Real Estate Group. The sheer complexity is revealed by the fact that a summary of the changes she produced for business centre operators runs to four pages of financial analysis which is probably unintelligible to the average manager. It includes some scary possibilities, such as the possibility of separating land from buildings because one could qualify for an operational lease and the other classed as financial.
Operators will need to sit down with an expert like Ms Kennedy and dig through every lease. That raises another problem, as many accountants will not be up to speed. Even major companies are struggling to find qualified analysts after leaving this work to the last minute. Yet even those convinced they are sheltered from the storm can’t afford to rest easy. Ms Kennedy says further changes could bring all leases onto company balance sheets within a couple of years, so they should start analysing agreements now rather than burying their heads in the sand.
Changes in accounting regulations will provide a massive boost for serviced and managed space, according to Andrew Blurton, finance director of MWB Group, one of the sector’s big names. As property costs move onto balance sheets, occupiers will be reluctant to take conventional leases which could leave them exposed. ‘During the past five years, as economic factors have caused companies to retrench, there has been a marked increase in the number of large corporate occupiers possessing commitments to office space that is now surplus to requirements,’ he says. Under the new international accounting standard, these companies will be required to quantify the onerous cost of leases on properties that are empty with no plans to re-occupy, and to recognise them as liabilities.
EXAMPLE:
A company signs an agreement to lease 50,000 sq ft at a rent of £40 per sq ft. Rents subsequently fall and the market rent at the balance sheet date is only £25 per sq ft. Under the new international accounting standard [IAS 17] the discounted value of the future onerous rental payments - the difference between the £40 payable and the £25 market value - must be recognised as a liability in the balance sheet, probably reducing the company’s net worth.
The logic is that until the lease expires, is sold or the space sub-let, this business is paying rent on an asset that is not providing the benefit of occupation. It should be recorded as an up-front capital liability rather than slowly written off on an annual basis. The new standard aims to ensure such information is declared ‘transparently’. In other words, stakeholders and shareholders can see at a glance that it is an immediate liability.
There is an alternative, says Blurton. Rather than taking long-term leases, companies can use flexible licenses – and in particular serviced office space. Under a license, with its inherent ability for the occupier to terminate on short notice, there will be no requirement to assess any negative value, and thus no impact on the company from the introduction of IAS 17. As property occupancy costs become more transparent, it is estimated that larger corporate occupiers could outsource at least 20% of property requirements to operators of flexible space. Companies will identify core staff and accommodate only them in property to which long term commitments have been made. Other staff, especially those whose roles are subject to peaks and troughs of business demand such as project teams, support staff and service engineers, would be accommodated in outsourced space.
Major occupiers are beginning to hand over surplus space to managers as a way of filling potential black holes in their accounts. This is not just a way of helping defer costs. Many are in prime locations and could easily sub-let on the open market. But they might find it hard to match rents agreed in more buoyant times and any shortfall would have to be revealed under new accounting rules.
Managed space lets at a premium, however, particularly if services are part of the deal. ‘We achieve much higher rents than those sub-letting,’ says Rob Hamilton, managing director of Instant Offices, which has moved from a listings agent to also offer strategic advice and management. He cites a 120,000 sq ft office block in central London’s Jermyn Street, where a top business tenant had two floors of surplus space. Sub-letting would probably have meant accepting open market rents around £10 a sq ft less than the level agreed with the landlord for the whole building.
That would ameliorate some of the annual bill but still mean an implied loss of around £200,000 a year, which would need to be shown in the accounts under the new international rules. Instead, the space was put into a management partnership for short-letting and Instant Offices has achieved rents of £80-90/sq ft. These are not just higher than conventional sub-lets but far above the passing rent to the landlord.
US firms are particularly concerned about this kind of potential embarrassment with the drive to greater transparency following scandals like Enron, says Hamilton. He expects more to consider similar management agreements. It will also boost the supply of Class A space in areas like central London, where it is often available only for conventional letting. That, in turn, will encourage blue-chip tenants to consider managed space rather than being forced into long leases. One top name is already planning to exercise a break clause in the lease on a West End office block in four years and find a smaller base for core staff, outsourcing as much as 50% of the rest of its requirements.