This month Sandaire Real Estate look at lease contracts that are linked to measures of inflation, typically the Retail Price Index (RPI) or Consumer Price Index (CPI), and which are still very popular. Within this update the team discuss how each lease contract has to be carefully appraised in order to quantify risks in the underlying long term asset value.
The team also take a look at Environmental, Social and Governance (ESG) and how it relates to Real Estate investments. At Sandaire, we believe ESG will become increasingly relevant across all asset classes and we are going to commence a long term research project in this area.
Inflation linked rent reviews – What are the risks?
UK Commercial Investment Property continues to attract investors who seek predictable income streams and the preservation of capital. Commercial (and Residential) real estate investment is seen as a good diversifier and natural hedge against inflation within an investment portfolio. There are multiple drivers that underpin a property’s performance, but the lease contract is the core driver of the contracted income stream.
Historically leases were granted for 25 years with 5 yearly rent reviews on an upwards only basis. Providing the tenant (covenant) was financially sound this arrangement guaranteed the landlord a predictable income stream and every 5 years any positive rental growth would be captured at the rent review. This rental increase could be as a result of many property and economic factors. Examples include increased competition from tenants for the location, economic growth and inflation. The contracted income was protected from any downward pressure on rents because of the “upwards only” element of the rent review clause. These leases were also generally drafted on a full repairing and insuring basis (FRI) which transferred all the associated costs and risks of property ownership, including obsolescence, onto the tenant. This left the landlord with what is referred to as triple net income stream which remained predictable as long as the tenant remained financially strong enough to pay the rent.
Fast forward to the present and lease lengths have dramatically reduced and the standard “long lease” is now just 10 years – more often than not with a tenant’s option to break at year 5. The FRI element has remained, but the shift to a shorter and much more tenant friendly lease term has been driven by the change in occupational requirements and the need for flexibility. Serviced Offices and co-working are becoming far more prevalent and sectors such as Student Accommodation and Leisure are now more akin to operational property with valuation based on Net Operating Income (NOI) and multiples rather than property yields.
This short lease environment has meant landlords have had to engage more with tenants and active asset management is now required to maintain the income stream. This can be viewed by both parties as very positive as it has forced much closer engagement and eliminated passive asset management.
The market has adjusted to this shift in leasing patterns but some tenants are still prepared to enter into long lease contracts especially in the retail and budget hotel sectors and for strategically important distribution warehouses. The principle driver for a tenant to do this is to lock into a location they consider important for their underlying business whilst retaining some predictability over the level of rent during that period. The leases are typically 15 to 25 years in length, FRI and have rent reviews every 5 years linked to the movement in RPI or CPI. Premier Inn, Iceland, NCP, Lidl and Aldi are all examples of tenants who have adopted this leasing pattern.
For investors there is a predictable income stream and a natural hedge against inflation and for the tenant predictable occupational costs and the knowledge they have secured their premises for the long term to the exclusion of competitors.
Some of these leases have been running now through their 3rd and 4th rent review and in some areas where the local dynamics have changed the rent has become substantially “over rented” whereby the local market rent is substantially lower than the “artificial” contracted rent that has increased in line with inflation. This disconnect between contracted rent and Market Rent has had some unforeseen consequences in respect to capital values, especially in the retail sector, whereby rents have in some locations reduced by as much as 50 percent whereas the RPI/CPI linked income streams have continued to grow apace.
These ‘long’ leasehold contracts have been sought after by both institutional and retail investors and new leases attract strong demand even in 2019. However, what is emerging as the older contract terms move closer to expiry is, quite often, a strong decline in capital values as investors price in the risk of the lease contract ending and the significant “froth” created by the artificial passing rent with a reversion to Market Rent. Many early investors into these RPI contracts did not foresee the material yield decompression that is now occurring whilst the weight of money and investors desire for income still sees strong demand for these types of lease especially to strong covenants.
A further relevant trend is the increased use of CVAs (Company Voluntary Arrangements) by retailers to reduce rental liabilities with the consent of 75% of creditors (by debt value).
Our in-house view is that these types of transaction are now fully priced and investors must consider very carefully the location and type of asset and rigorously assess the alternative uses that underpin the capital value when the lease expires. Evidence is emerging from recent transactions that the negative impact on capital values can far exceed the benefits of the contracted income returns. The Sandaire Real Estate team recommend a full professional appraisal is undertaken before these investments are acquired, or a new lease agreed, and that regular appraisals are undertaken throughout the life cycle of the lease to ensure that valuations are not going to be affected in the short, medium or long term by this factor. For further information on this topic please do contact us.
ESG – Impact on the built environment
Environmental, Social and Governance (ESG) are a set of values that have gained considerable traction across all asset classes. There are no global or regional set definitions, measures or criteria that can be applied generically or to specific asset classes, however considerable attention is being given to this subject across the financial services industry. This is driven by investors’ increasing desire to use socially responsible investing principles in their asset allocation decision process across their portfolios. This is becoming especially important for the next generation of investors. Sandaire is undertaking extensive research in this area and will provide regular updates on this subject we hope will be insightful, stimulating and part of our in-house investment process.
Real Estate within the UK has made progress within the environmental area, and in our next update we will consider the Minimum Energy Efficiency Regulations that affect both residential and commercial investment properties. Our research into ESG will also look at some of the less obvious ways property falls into the E, S and G categories. Environmental factors tend to be the more easily recognised such as improved energy efficiency and water consumption. The social and governance factors are, on face value, less easy to identify but buildings are part of the community and they have intrinsic social value. Part of any asset management plan for direct property investment should consider community, stewardship and supply chain factors but also be mindful of the impact of managing a property in a granular way, for example, by avoiding harmful chemicals in cleaning products.
Buildings have a direct impact on the environment. They are very energy intensive from the carbon used in making bricks, concrete and steel to the running costs of the building. Real Estate accounts for 40 percent of total carbon emissions (Organisation for Economic Cooperation and Development 2003). Modular construction in factories, use of sustainable materials, remediating contaminated land, and environmental improvements such as flood control all can have a substantial impact. Public transport links, charging points for electric cars, cycling facilities for staff are all ways to improve the ESG credentials of real estate.
Investment in farmland may also have a role in offsetting carbon emissions and the other negative consequences of urban real estate investment, as well as a helpful tax benefit in particular situations.
Finally, creating a good ESG policy for direct property investing will help manage risk and returns. This is a rapidly evolving subject area and it is too soon to entirely quantify the difference an ESG policy can have on returns. Inefficient or badly managed properties provide opportunities for improvement which must enhance overall value by increasing the attractiveness of the property to an occupier and enhance long term value and attract quality tenants.
The Sandaire ESG research project is envisaged to be long term, as this subject continues to gain momentum and the industry as a whole gets behind the values. By investing in best practice in every aspect of real estate management, a property will be more efficient, attractive and valuable.
It is a win-win situation for the investor, the occupier, the community and the environment.