Copyright: David Lawson– Property Week April 1999Home page
Sparks flew when Kingspark jumped into the big league of distribution developers last year. Backed by the huge resources of new US parent ProLogis and a near-evangelical mission to offer short leases, this former tiddler threatened to change all the ground rules overnight.
Some mistake, surely? Offices might lend themselves to new-fangled management and financial jiggery-pokery, but not the bog-standard, ever-reliable, unglamorous shed? On the contrary. This is probably where shorter leases and intensive management is most suited.
At the top level, big occupiers have consistently railed against a mismatch of contracts and lease tenures. Third-party distributors live in a cutthroat world in which deals are rarely set for more than three years yet the quality premises they require are owned by landlords equally determined to stick to institutional leases.
Down in the basement, meanwhile, is a milling mass of small operators with little interest, let alone knowledge, of bricks and mortar. These have an even more tenuous hold on economic survival, often living hand-to-mouth and in dire need of a sympathetic financial nursemaid.
But who wants to be involved in such a messy business? Back upstairs, some market stalwarts have doubts about whether there is much space for US-style operations. John Duggan, veteran managing director of Gazeley, pointed out shortly after a bunch of his former associates set up ProLogis Kingspark that the whole UK distribution market came to only 750,000 sq metres (8m sq ft). And most of that was hogged by owner-occupiers.
He also questioned whether big distributors would pay a premium for shorter leases when the competition was so strong that margins were already wafer-thin. What hope then for PK's ambitions to create a 500m pound portfolio of short-leased, intensively managed, premium-rented property, let alone capacity for others to join the revolution?
All eyes will be firmly fixed on Grange Park, Northampton, the firm's first move into the market. After spending around 20m pounds for just under 50ha off the M1 and a further shedload of money on infrastructure, it is due to test the short-lease concept with a 100,000 sq ft spec building.
Perhaps when it happens, managing director John Cutts will spare time from his busy schedule to talk about further moves at sites near Heathrow, Basingstoke and off the M6. As Property Week went to press, however, he remained stubbornly elusive.
That leaves others to plead the cause for a revolution in distribution management. Surprisingly, they are not so thin on the ground as headlines over PK's 'breakthrough' implied. In fact, shorter leases are part of most portfolios nowadays. As Roger Carey of Saville Gordon says, they emerged in the recession and have refused to go away.
Admittedly, they tend to be more common for secondary, harder-to-let, non-institutional property but the growing acceptance of cashflow as an acceptable form of valuation is edging activity up the market.
'There are no real problems with valuers any more and the banks have learned to understand us,' says John Harrison of Marylebone Warwick Balfour.
Investors are still not thick on the ground but there is a feeling of inevitability that big sheds could follow the way of leisure parks and retail warehouses, which also started off slowly.
'Funds are desperately short of product, so they are becoming more receptive to shorter leases on new sheds,' says Rob Bould, head of investment at GVA Grimley. Within 18 months there should be a number of schemes being developed on this basis.'
The next battle now looms. Fully-serviced offices are becoming commonplace; serviced sheds may be harder to digest. How do you value the benefit of a conference facility or creche on a distribution park? One is to charge for them. 'In a low inflation environment, investors have to make assets sweat and extra services can provide income,' says Bould.
But the acid test will be faster lettings and premium rents for the buildings around them. Now all we need is market evidence.
One traditional UK landlord may be about to prove that you don't need a fistful of dollars to revolutionise a market. REIT-backed operators like ProLogis Kingspark were expected to open the door to new kinds of tenure in the distribution sector but Burford may nip in first.
The company is in advanced negotiations to let the first 100,000 sq ft speculative first phase on Cabot Park, near Bristol, on terms of one to three years.
Short leases are not new. Standard Life is working along these lines in Basildon and Schroder financed Spitfire Park in Birmingham this way. But each has extenuating circumstances. Standard, for instance, picked up its land cheaply, giving leeway to experiment.
Burford is dealing in prime big sheds. Director Duncan Moss could comfortably expect a conventional lease in this emerging hotspot but his reward for breaking the mould could be juicy: up to 86 pounds/sq metre (8 pounds/sq ft) compared with 5.75 less than 62 pounds/sq metre.
Burford has the classic opportunity to test the market because on a massive 450acre site it can balance new kinds of tenure against a mass of fund-friendly conventional deals. Moss expects to produce up to 250,000 sq ft of similar short-lease deals. He even has enough space to farm out part of the job to the multi-let specialist io Group, which has bought a slice of Cabot Park for one of its proposed new centres.
'They are good at the small end while we handle the big fish,' he says. 'They will be growing tenants for us.'
The match could go further, as Burford extends into fully serviced leases. Moss has already trodden that path at Heywood Park in the Midlands, providing services like landscaping, security and administration.
'There are many ways we can help tenants with facilities like telephone services, weighbridges, catering and conference facilities,' he says. Nor is it just altruism. At Heywood, a lorry park gave tenants security and but also made 1m pounds a year profit.
Short tenures are a myth, says Roger Carey, chief executive of Saville Gordon. Tenants may sign up for brief leases but they usually renew. That dispels many fears that have made traditional landlords shy away from meeting the real demands of their customers.
'They are scared stiff about what they can do with property if a tenant leaves after a couple of years. The simple answer is that they don't leave,' he says. 'When a lease comes up for renewal, the person in the strongest negotiating position is the existing tenant. They generally don't want to leave.'
This discovery dawned during the recession when Carey was still heading up the giant development program at Slough Estates, and shorter leases were being offered to attract tenants. 'If the answer was right then, it should be right now,' he says.
The chance to put this into practice came when he took over at SG, where the 93,000 sq metre (11m sq ft) portfolio is dominated by property ranging from 1,000 to 30,000 sq ft. He recognized that short leases are less likely on big specialised buildings, where fitting out costs have to be amortized over a long period. But smaller operators were crying out for a more flexible approach.
More than half SG's portfolio is now held on leases of less than five years. In return, it is posting strong returns by achieving rents as much as 15% above local markets. Moving to fully serviced leases are still some time away, however.
'It is not as obvious a benefit as the office sector,' says Carey. 'Small tenants may refuse to pay for bundled services.' But the time will come when an all-in charge including facilities like water and power are acceptable.
'Traditional landlords have set terms in the past which have tied clients in knots. More of us are now breaking away to match what they want.'
Marylebone Warwick Balfour
Landlords have been complacent too long about the real needs of tenants, according to John Harrison of Marylebone Warwick Balfour. They need to adjust to what distributors really want rather than stick to an obsolete idea about asset management.
A quarter of the firm's 121,000 sq metre (1.3m sq ft) portfolio has already been converted to short leasing. 'We aim to make that 100% in the next two years,' he says.
MWB has gone further than manipulating lease lengths, however. Harrison points out that intensive management is required to maximise performance of the low-grade sheds which form the bedrock of the market. That merges naturally into the kind of packages the firm is also developing in its new serviced office arm.
Conference facilities, for instance, are being introduced to save tenants the expense of hiring a local hotel. These can be housed in conventional space such as the office facilities on the front of a unit, and hired out by the hour.
This kind of enhancement is taking a bog-standard industrial portfolio scattered across Wales and the south to a new level, he says. 'It has been transformed into a strongly cash-generative vehicle.'
The 3.5m pounds/yr rent income is expected to swell as more tenants switch terms. Up to four deals a week are being signed on licences of nine to 12 months, ranging from middle-level operators to start-ups. Some need to go as short as six months as they take trial contracts.
Harrison refuses to estimate average rent premiums because he says this is not how the market works. 'These occupiers work on annual bills, not pounds per square foot,' he says. It is an adjustment other landlords will have to make if they are to keep pace.
It is hard to imagine John Sims and his team shouldering picks and shovels and chanting a Disney ditty. But with a name like io and a hint of marketing hype which insists this must be written in lower case, competitors love to conjure the picture of Snow White's little helpers harmonising the company song Off to Work we Go.'
A touch of jealously here? The io team has quickly carved out a niche as the leading players in the new market for serviced, multi-let developments. They are certainly not economic dwarves in the eyes of investors, attracting more than 300m pounds from big names like PRICOA and Hermes in less than three years. There are even plans afoot for a 1bn expansion into mainland Europe.
It all started quite modestly, when Sims led a management buy-out of his Industrial Ownership group back in the days when companies still used capital letters. The aim was to provide a vehicle for institutions to gain the high-yielding returns of management-intensive property without getting their hands dirty.
He got rid of existing property and formed a limited partnership - the closest thing the UK has come to American REIT-style structures - which are based on fixed term investments, fixed fees and performance related pay.
He had already proved the potential, producing annual returns averaging more than 14% in the recession-hit early Nineties through a joint venture with CIN on 30 industrial estates. PRICOA provided the backing for the first big moves after the 1995 MBO, helping draws in top funds to create the 130m Industrial Partnership. It recorded ungeared returns of more than 30% a year by mid-1998 from 40 estates totalling 418,000 sq metres (4.5m sq ft).
A second fund raised a further 180m pounds to continue buying up estates - usually in off-market deals. Meanwhile, another arm is concentrating on developing new centres and has raised 40m pounds in partnership with Hermes.
It all seems a very obvious licence to print money. So why has no-one else reached these heights? Both approaches concentrate on the same pattern of intensive, hands-on management, involving a mix of freehold disposals and short leases at premium rents.
'Anyone can buy high-yielding property,' says estates director Steven Tattersall. 'The skill is to keep it performing.'
The trick is to know your markets and not be too ambitious. The group will buy an estate which is perhaps sixth in the pecking order in a town and use a combination of renovation and business advice to raise it to third or fourth. That boosts the overall average value.
The other, ongoing secret is to adjust to tenants rather than force them into a compromise. 'We ask them what they want. We can do as short a term as six months so they can try out property - or even three months for one that may need a brief expansion,' says Tattersall. That brings premiums of maybe 1 pound a sq ft in the south and 50p in the north.
Every estate has a business plan which makes allowance for some property to be sold. The same applies to the chain of io centres being created in the development partnership. 'We offer a wide range from virtual freeholds through short enures to standard leases,' says development director Peter James. One innovation has bee to fix a purchase price a couple of years ahead in return for a premium rent, so tenants can plan ahead.
And if they change their mind? 'We keep in close touch and can tell what they want. We can always renegotiate the lease,' he says.
Three new io centres are on the drawing board. Work has started on a first phase of almost 8,000 sq metres (86,000 sq ft) at Redditch, with two units already in solicitors' hands. A chunk of Cabot Park, Bristol, bought from Burford, is being delayed by talks on highway provisions but a third of the planned 21,400 sq metres (230,000 sq ft) should be starting in the summer. The same timescale is expected at Swindon, where existing buildings are being demolished to make way for around 14,000 sq metres (150,000 sq ft).
Tenants are sniffing around them all. 'They are generally middle-range, local firms with turnovers of up to 1m pounds rather than start-ups,' says James. 'They are good covenants and have always wanted new property on flexible terms in the past but have had to put up with old stuff on conventional leases. We are just giving the market what it demands.'
Watch out for another development partnership as io chants its company song in as-yet unexplored markets like Manchester, Leeds, Southampton and Northampton.