Are long-term leases coming to an end? LGIM's Head of Real Assets explains why there is a need for flexibility from tenants...
Ten years is around the weighted average lease length on a commercial property asset in the UK. In an era of fleet-of-foot tenants and channel-blind consumers, that is some commitment. To put it into context, it was 10 years ago in September that the Bank of England bailed out Northern Rock – so what a difference a decade makes.
Add in the forthcoming IFRS 16 accounting changes that mean operational leases will be very much on the balance Sheet and you can begin to understand why tenants can be reticent when it comes to signing on the dotted line.
The rate of changes taking place in the UK economy demands flexibility from both owners and tenants to ensure harmonious, rather than adversarial, relationships. For example, the evolution in operational models has created a structural, not cyclical, change towards shorter leases for some businesses. The increasing number of ‘pop-up’ shops and markets on our high streets and in our shopping centres are a recognisable manifestation of this trend, but so too are shared offices or even serviced apartments.
We have a situation where lease structures are not evolving at a fast enough rate to match the requirements of tenants. Property owners continue to focus on permanence – on the duration and stability of rental income streams – rather than on the benefits of flexibility. Instead they need to be freed up to be more versatile in responding to society evolving, including new shopping, living or working patterns.
This creates a number of problems. In a shopping centre, for example, income derived from sources such as promotions, communal areas and digital advertising can account for around a fifth of all revenue, and dramatically enhance customer experience, but they aren’t “leases”.
It comes back to fundamentals: in a core location, with a quality asset and sound business, both partners benefit from the security offered by a double-digit length lease. They also continue to be a vital part of the fiscal toolkit for corporate occupiers looking to free-up capital in the form of sale-and-leasebacks.
In principle, there is of course a robust argument that lease negotiations should encompass a breadth of options. However, in practice, property owners are hamstrung by the antiquated UK valuation system, where the answer to one simple question: what is this building worth if sold? has been made very complicated.
Occupier markets are changing but valuers are not reflecting this. The industry needs to adapt, to recognise and fairly value short-term income obtained from high occupancy, underpinned by high-quality asset management.
There are ways to de-risk flexible leasing; starting with improved product knowledge. Accounting changes shouldn’t change the way in which we look at leases or balance sheets, but they do mean you need to know what’s coming down the regulatory pipeline. Clever structuring, such as mandatory visibility of trading levels, assignment clauses and step-in rights also allow you to control the ‘controllables’ and be a responsible landlord.
At LGIM Real Assets, we have embraced the opportunity to offer our tenants and their customers what they really want from the built environment. Our market leading Build To Rent fund was one of the first to offer purpose-built rental accommodation with a professional level of service. We worked hard to ensure that our tenancy agreements met the demands and expectations of residents: leases from one to five years, no upfront fees and six-monthly breaks. Is it really that difficult to conceptualise how this might work within an office block?
Long leases are the sacred cows that suit passive property owners and complacent valuers but ultimately this failure to embrace economic innovation will erode values.
Historical concerns that flexible leasing will damage long-term investment are unfounded and we need to develop a new language for leasing that requires both parties to be articulate. This is an area ripe for positive disruption. For active managers, a progressive approach to recasting how we perceive ourselves as landlords will ultimately reward us, bringing about further collaboration with tenants that ignites a wealth of new ideas and possibilities.
Bill Hughes will speak about Private Rented Sector at MIPIM UK this October!
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