JLL offers solution to short lease valuations

Copyright: David Lawson– Property Week August 1999

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Tony Blair has found a soulmate in the heart of capitalism.  Jones Lang LaSalle is considering converting to the Third Way. The outing of this free enterprise paragon has little to do with politics, however. While the industry dozes through its annual summer lull, feverish work is under way deep inside the London HQ to create  a peace treaty in the war over short leases.

  The UK industry has grudgingly accepted  that shorter lease terms and break clauses are not just a residue  of the recession which would evaporate in the heat of recovery. But that has left occupiers and landlords arguing about how much extra rent should be paid.

 Jones Lang LaSalle polled occupiers and found a large majority  would in some situations pay a premium of between 10% and on rare occasions as much as 30% of rental value to gain the flexibility offered by short leases and break clauses. This is a wide range, however, leaving much ground for dispute. Some landlords are also reluctant to even consider changing, because they are unsure whether they will be getting sufficient compensation.

  Valuers are trapped in the middle when asked to advise investors. 'There is not enough market evidence of these leases to give definitive data,' says Barry Osilaja, associate director of Jones Lang LaSalle's investment advisory group. 'But investors have to respond to the demands of their customers.'

  Non-conventional methods such as discounted cashflows are tweaked to give both sides an estimate of where they stand. 'But this is not straightforward as every building is different,' says Ed Luker, a senior director with Richard Ellis St Quintin. 'There is no industry standard. Everyone has their own method of incorporating factors such as the likely value when a break clause comes into force.'

  Rosemary Feenan, head of JLL Research, believes there is a path which can be plotted between the conflicting demands of tenant and landlord. 'We call it the third way,' she says.

  The technique appears fiendishly complex, involving a computer technique based on what is known among statisticians as the Monte Carlo model. The  label was  applied because it calculates similar risks to gambling - which is the heart of the problem. It boils down to working out a compromise based on the risk to each side that they will gain or lose compared with the likely market rents at the time a break clause is enacted or a lease ends. The investor also has to calculate the risk of voids.

 'It has been a tradition that shorter leases are more risky for investors,' says Feenan. 'That is one reason why they are often reluctant to grant them. But occupiers want shorter terms  because of pressure from factors such as globalisation,  potential accounting changes and general need for more flexibility.'

 Some occupiers are now moving to an even more short-term position and  serviced offices are rapidly becoming a mainstream sector. These add yet another dimension to valuation demands.

 Finding a 'third way' involved pricing the  risk and finding a point which satisfies both sides. JLL asked the City University to  help develop a computer model.  The aim is to determine where rents will be at the time a break clause comes into force or a lease runs out. An occupier wants to be confident they will not be over-paying where rents do not rise. The investor does not wish to lose out if they do, or be left with voids.

 This is not simply projecting future rents along a graph, Feenan insists. It calculates the volatility of rents - in other words, the risk they will be  above or below a long-term trend. The key is using long-term volatility of rental growth to assess the probability that at the time of the break or lease end the  passing rent will be greater than estimated rental value, she says. That can be used to negotiate a compensation payment (premium rent) which satisfies both  tenant and landlord.

 She admits it is a very technical instrument, incorporating factors such as exit yields, interest rates voids and marketing costs. The crucial element, however, is past rental data. JLL managed to dig out information going back to the Seventies to act as a base for calculations.

  Tests on property held by clients and managed by JLL have confirmed that the model works well. 'We, the agents and the clients feel comfortable with the results,' says Feenan. Luker says it would be ideal to have an industry-standard method for valuing this new generation of leases. But he is sceptical that one can be created when so many factors are involved which require a subjective view.

  Reducing a lease from 25 to 15 years or introducing a 10-year break  involves estimating the difference in costs of renovation, releasing and voids a decade earlier, then discounting those back to today's values. A complicating factor is that a building may not require as much renovation after only 15 years and be easier to re-let. Each factor will be an estimate and  shorter breaks accentuate the problem. 'You have to calculate whether a tenant is likely to exercise a break clause after five years and leave,' says Luker. 'That becomes even more subjective.'

  The picture is also cloudy from the tenants' side, as occupiers rarely plan so far forward. They would have difficulty pricing the freedom to leave in five years rather than ten. Feenan says JLL is not punting an industry standard, however. 'We think it will be a useful tool for calculating risk and value in a changing market,' she says.

   The merger between Jones Lang Wootton and LaSalle has given her team new freedom to brainstorm ideas which may produce no immediate income. Pricing the risks in short leases is the first result, although a topic so close to the heart of the market may pay for itself quickly.