Copyright: David Lawson – appeared Property Week September 1998Home page
There seems little doubt that shorter leases are here to stay. The recession began prising fund managers' fingers away from their comfortable, long-term contracts as occupiers gained the whip hand. Now an invasion of US investors seems to have wiped out the chance of recovery restoring the status quo. But what does that mean for the way property is financed?
Few see a complete transition to US and continental systems. 'No-one paying 100 pounds/sq ft to fit out their office block is going to argue for a shorter lease,' said one fund manager. But this could create a significant new market tier, which will lead to new questions about how bankers and surveyors estimate values. Some insiders believe it could be the straw which breaks the back of conventional valuation methods.
Storms have swept through the industry since investigations like the Mallinson Report questioned narrow interpretations of the surveyor's 'bible' - the so-called Red Book. 'This will add even more pressure for moves towards DCF (discounted cash flow) techniques,' says Richard Baldwin of Weatherall Green & Smith, who saw the revolution begin while chairman of the Assets Standards and Valuations Board.
US investors are comfortable with judging assets through estimated future income flow rather than some fixed formula about long-term yields. That means leases as short as five years can be justified, as newly-acquired UK Security Capital subsidiaries Akeler, Kingspark and City & West End Developers are threatening to prove.
One crucial point to remember is that this revolution is not as fundamental as it seems. Schroder financed the Bracknell Beeches office village on five-year leases and is planning Spitfire Park speculative industrial in Birmingham the same way. Standard Life, Threadneedle and Argyll have all been involved in similar projects.
'The Americans are grabbing headlines under false pretences,' says William Hill, managing director of Schroder's property fund. Short leases can be part of any good portfolio in the right circumstances because they mix different risks and rewards.
But there are limitations. 'You would not expect someone running a 50m pound fund to use short leases because of the extra risk,' he says. And a 70,000 sq ft building might not merit a three-year lease but it is common for funds to offer them on multi-let estates of small premises. Standard Life fund manager Francis Salway is considering five-year terms on a distribution scheme in Basildon, but this is because the scheme came at a good price.
But US-influenced firms like Akeler are suggesting short leases are feasible substantial property and prime locations like Surrey. When Salway ran a slide rule over such investments, he could not make them stack up because costs were too high. New-build in general is a fundamental problem, he says. The yield an investor demands to cover the added risk is nowhere near what the developer requires to turn a reasonable profit.
That gap in requirements lies at the heart of the problem - and could prove a rising cause of friction. Firstly, occupiers will have to pay for the extra risk of shorter leases. Some may be unwilling - or unable - to stump up. Distributors desperate for leases which match their short contracts are competing on wafer-thin margins, says John Duggan, MD of Gazeley. They may struggle to pay premiums. As the economy slows, landlords may also find it difficult to charge more than the rest of the market.
Relations between investors, valuers and bankers could also become increasingly fraught. 'Investment surveyors have stifled the market for 20 years,' says Peter Kershaw of HQ Business Centres, who had long experience of large developments like Broadgate and London Bridge City before moving the serviced office sector. Shorter leases should be worth more because these are attractive to occupiers, he says. Hill is also critical of the use of 'textbooks and sub-clauses' for judging investments. 'Valuations are about what someone is willing to pay,' he says.
Try telling that to a banker. David Hill, a consultant at Knight Frank points out that banks lend on thin margins and are reluctant to take risks. They will usually value on the basis of vacant possession rather than rely on lease renewal after three or five years.
Attitudes can change, however. Birkby is a valuer's nightmare, as its shopping centres deals in leases lasting months rather than years. 'Our banks had to be educated,' says chief executive Kim Taylor-Smith. Valuations are based on income flows rather than tenant status. Essentially, this is a bet on management rather than property. It also helps that risk is spread over a wide portfolio. A few small tenants leaving their stalls in one town balances out against low vacancy rates in another.
Serviced offices should be no different, yet leading players Regus and HQ have both turned to US investors who understand their business much better. Again, however, frontiers are being pushed forward. Schroder funded the Regus centre at Stockley Park - admittedly at a yield a half-point above normal value. Rupert Clarke of JLW Finance says business centres can be funded at a reasonably small premium. He points to Regalian's Marble Arch Tower, where the figures stack up for short-lease offices.
Again, there is a diversion into betting on management that valuers need to grasp. 'It is not difficult,' says John Edge at Knight Frank. But he is speaking from a depth of experience working with hotels, which display similar characteristics. Perhaps the main problem is that this is all so very new, with everyone struggling to learn new rules. 'Just think back at how short a time since outlet centres were considered a problem,' says Clarke. Leisure and retail warehousing went through the same learning curve.
'There are no rules,' says Ed Luker of Richard Ellis. The Red Book does not give figures about how to estimate potential voids after three or five years, so valuers have to make things up as they go along. The temptation is to be conservative - which creates tensions.
Americans are more comfortable with cashflow projections because they expect income to resume after a lease ends. UK banks tend to assume they will not. 'In the US there are reams of statistics so a valuer can take a view on the likelihood that space will remain void after a short lease ends,' says Luker. 'We need to do more research on this.'
As president of the Investment Property Forum he is also a champion of securitisation, which could be a solution to many of these problems. Short leases would lose their impact if spread across a large portfolio bundled up and sold off in shares. But the market cannot wait for that old chestnut to be roasted. Shorter leases will emerge because this is what some occupiers want. They will also help fill the 'black hole' of property investment - buildings which have only 10 years left on a conventional lease and are blighted by obsolescence, says Luker.
Perhaps Richard Baldwin, who struggled hard with this kind of conundrum when chairing the ASVB, deserves the last word. 'No matter what some people think, changes are happening,' he says. Whether this happens quickly enough to keep investors and valuers from civil war is another matter.