Response to Options for Deterring or Outlawing the by jolinmilioncherie


									                      COMMERCIAL PROPERTY LEASES


                               SEPTEMBER 2004

Established in 1990, the British Council for Offices’ mission is to research,
develop and communicate best practice in all aspects of the office sector. It
delivers this by providing a forum for the discussion and debate of relevant
issues. The BCO has over 900 members, who are organisations and individuals
involved in creating, acquiring or occupying office space, both private and
public sector. The broad church nature of the BCO membership puts it in a
unique position to advance the collective understanding of its members, and
the industry more generally, facilitating the creation of more effective office

The BCO recognises the Government’s need to monitor the performance of
all sectors of the economy and therefore welcomes this opportunity to
highlight the significant changes seen in the commercial property sector over
the last decade. The emotional arguments used against Upward Only Rent
Reviews (UORRs), in particular comments on fairness and justice, do not
reflect the nature of the current property market and the changes made to
address past criticism.

Of fundamental importance to the issue of commercial property leases is the
fact that property must remain fully financed. By securing steady income
(through the construction and letting of property), the property industry is able
to raise finance at competitive rates. With secure finance the industry is able
to provide greater development, premises for business and an enhanced
built environment. Over the long-term, property becomes an attractive
investment, in particular for pension funds. It is important to remember that
36% of property is owned by pension funds (BPF figures). Property must remain
attractive to capital.        Private investment is essential for renewal,
redevelopment and regeneration, especially in the regions. Interruptions to
the renewal of stock will impact on productivity and efficiency.
               BCO response to UORR consultation (September 2004)

Drawing on a range of evidence, the following submission makes the case
against intervention. By stressing that change is happening, it will be argued
that any moves to introduce an element of downward review will increase
volatility in the market in terms of risk and return, decreasing the attractiveness
of property to capital, possibly restricting choice and fundamentally failing to
address the real issue that grieves business, that of long-leases.

              BCO response to UORR consultation (September 2004)


1. Why is the use of UORRs still prevalent in a very different business
   environment from the one in which they were first developed?

   UORRs have become established market practice, helping to underpin a
   less than liquid investment market by providing a minimum level of
   certainty to returns. Very few properties are developed or acquired as
   investments with equity alone. Commercial property requires substantial
   funding (e.g. little costs less than £1m) and the costs of funding do not vary
   with market levels of rents. Whilst it is fair to say the large corporate
   investors are sophisticated enough to operate in an environment without
   UORRs they are only part of the market. Substantial parts of the market
   are in the hands of small private investors and many assets are held to
   create effectively a ‘pension fund’.           The use of UORRs is a risk
   management tool for these later investors who are relatively risk averse.

   Arguably after a period without UORRs and a much greater ability for
   tenants to exit a property, the industry will see a greater rate of tenant
   turnover and possibly an increased ability to successfully attract new
   tenants. This increased ease of attracting new tenants may become the
   new underpinning of value. However, the industry is left with the
   conundrum that during the period between one state and the other the
   capital value of property will not be underpinned, resulting in fundamental
   instability. This is particularly serious in view of not only the investment that
   takes place directly in property but also the many financial transactions
   where capital assets (most notably property) are the guarantee of last
   recourse. No proposal to date has satisfactorily recognised this dilemma
   and/or put forward a method of resolution. Therefore, irrespective of the
   micro-economic situation it is the macro-economic which remains the
   same and works against change.

   In addition to underpinning the investment market and reducing financier
   risk occupiers have benefited from UORRs. The certainty and stability
   provided by fixed rents and costs enables occupiers to embark on
   investment programmes. By providing the certainty of no uplift in-
   between reviews, UORRs have often been the preference for those
   occupiers offered a choice. Furthermore, occupiers may in fact be the
   key beneficiaries of UORR provisions. Using IPD data from 1982-2001, a
   PWC study compared five-year UORRs relative to annual upward and
   downward rent reviews, and found that tenants to be the greater
   beneficiary, with landlords losing out to a greater extent (see PWC, Real
   Estates Directions Europe, Winter 2002/03).

2. Should the Government take statutory measures to prohibit or deter the
   use of UORR clauses in these circumstances?

   Legislative intervention in current circumstances would be inappropriate
   and unlikely to satisfy any of the interested parties. The legislative process
   risks proving protracted, uncertain, impractical, prohibitively complex and
   costly. Any attempt at statutory control will undoubtedly lead to a

              BCO response to UORR consultation (September 2004)

   distortion of the market and lead to a host of unforeseen problems. Whilst
   overtime a stable property market could develop, in the interim huge
   problems could occur as adjustments were made.

   Whilst recognising that not all interested voices may be shouting on this
   issue, evidence suggests demand for intervention is not as strong as
   perceived. Within the BCO’s occupier membership, calls for intervention
   are not strong, with other concerns more pressing. A CBI/GVA Grimley
   Survey (Summer 2004) indicates that over half of companies (54%) were
   against legislation setting out a detailed lease code. Furthermore, only
   26% were in favour of Government interference in the leasing market.
   Claims that UORRs constitute a major source of grievance to business
   apply to a very different property environment to today’s. The current
   property market has departed significantly from the one in which criticisms
   were originally expressed.

3. Would there be any viable alternatives to statutory intervention, bearing in
   mind the impact of the two successive voluntary Codes of Practice?

   It is important to note that the code was always about more than UORRs.
   The interim report from Reading outlines some of the positive impacts of
   the code, such as more effective dissemination, softening of landlord
   approach and more widespread practice of framing opening terms to
   match tenant needs.            Nonetheless, the report highlights how
   fundamentally the position of small businesses has largely remained
   unchanged, with knowledge of the code, and appropriate pricing, limited
   to professionals and larger tenants and landlords. However, a ban on
   UORRs would not change the fact that many small businesses are ill
   informed going into negotiations. The best solution has to be to ensure all
   small businesses are informed and are using professional advice.

   The consultation document does not make clear what alternatives would
   be allowed in place of UORRs. For example would indexing or fixed uplifts
   be considered? The brevity of the consultation paper provides little scope
   for debate on the pros and cons of such alternatives. For example both
   could leave occupiers worse off, with the real potential of paying more in
   the long-term, reflecting national and not local supply and demand in
   different market conditions. Such alternatives entail making calculations
   premised on amounts that cannot be quantified today. Such moves
   would have to encompass caps and collars.

   The most viable alternative to intervention, and to promote real flexibility
   and choice, is to allow market forces, in particular pricing, prevail.

4. How effective would statutory intervention be in addressing outstanding
   problems of inflexibility and lack of choice in the commercial property
   leasing market?

   The answer to this question would be that intervention would be
   ineffective. As stressed above change is happening and this submission
   would question the extent of inflexibility and lack of choice in the

              BCO response to UORR consultation (September 2004)

   commercial property leasing market. The property market of today is very
   different to that of the early 1990s, a fact masked by a number of
   misperceptions surrounding the operation of UORRs (see BPF submission).
   One of the key rationales behind action on UORRs is the need to protect
   small businesses. However, most small businesses will never face an UORR.
   The trend is towards shorter lease lengths, with the average now around 8
   years. Analysis by Drivers Jonas reveals that 78% of rents under £10,000 per
   annum are for five years or less, indeed looking at all leases, 50% are for
   five years or less. Therefore half of all leases are unlikely to contain a rent
   review. Consequently, it will only be larger occupiers that will be affected
   by any statutory intervention. The position of smaller businesses in regards
   to negotiations will remain unchanged.

   The market itself is the best vehicle to provide incentive for change.
   Market conditions and landlord/tenant demand dictate flexibility and
   choice. The market is delivering change. As well as the shift towards
   shorter leases, there has been an increase in the inclusion of break
   clauses, less restriction on sub-letting and the availability of new products,
   for example serviced offices, outsourcing and indexed linked and uplift
   provisions. Overtime this will have the effect that the Government is trying
   to achieve.

   It is important to consider comparison with other property markets and the
   policies that have evolved to encourage or discourage longer leases.
   Although comparison is inherently difficult, research indicates that except
   to a limited extent in Belgium and France, no country legislates against
   UORRs or specifies lease lengths (see research carried out by Lovells and
   Linklaters on behalf of the BPF).

5. Which of the five options for legislation would be preferable; are there any
   other legislative or non-legislative options that should be considered?

   Comments on the various options:

    i. Do nothing
       As expressed in answers to questions one to four, intervention is not an
       appropriate response and therefore this is the option we fully endorse.

   ii. Ban UORR clauses

      Such a move will substantially increase risk and uncertainty for all
      stakeholders. As will be expanded in the response to question 6, the
      effect could be to dramatically increase the cost and difficulty in
      securing funding, decreasing the value of property and increasing
      rents. This will impact on future development, including the possibility
      of deteriorating stock and decreased choice.

      The complexity of such intervention also raises the possibility of a new
      breed of professional advice, spawning a variety of schemes to bypass
      the legislation.

              BCO response to UORR consultation (September 2004)

  iii. Ban UORR subject to a floor of the initial rent
       Of all the options this is the most satisfactory because it secures the
       initial return. However it ultimately faces the same problems as a
       complete ban, i.e. it is likely to destabilise the property investment
       market place, leading to reduced values, investment and

  iv. Give tenants a right to break if the UORR produced a rent above
      market levels
      Again the problems with this option, in particular with regards to raising
      finance, are similar to a complete ban on UORRs. However, in terms of
      practicality and stability this could be more detrimental to creating a
      flexible market.     From the tenants’ point of view this option is
      impractical and for landlords’ it forms the worst option in terms of
      securing income.

   v. Limit lease length
      This option is unrealistic in terms of all stakeholders’ needs and the very
      different nature of building types and uses. A variety of lease lengths
      are already being delivered. Tenants should be free to negotiate
      whatever lease length they feel appropriate. For many tenants longer
      terms are necessary to budget for and justify ‘investment’ in their
      business. Crucially, moves to limit lease length would adversely impact
      on both flexibility and choice.

  vi. Require landlords to give prospective tenants priced options
      This may help to concentrate the minds of tenants but it is likely to be
      meaningless, with both side’s views likely to vary significantly. Although
      such pricing may prove helpful, without any fiscal driver a landlord
      would just price exorbitantly that option that he did not favour. Such a
      provision is likely to become a pointless bureaucratic exercise and will
      have little impact other than to increase landlords’ costs.

6. What would be the impact of the various options on the market: on rents,
   and on the development and funding of large-scale projects and those of
   marginal economic viability in particular?

   Any downward review would be associated not only with increased
   volatility in income streams, but also increased volatility in capital markets.
   The most significant impact is likely to be on small investors and landlords
   with knock on effect to pensions, banks, and lenders. Two separate
   pieces of research conducted by De Montford University and by Cass
   Business School and Jones Lang Lasalle, illustrate this impact.

   The following points from the De Montford research should be considered:
       Overall, lending organisations would prefer the Government not to
           intervene in a well-established market.
       The majority of lending organisations would continue to lend even
           with a variety of rent review clauses or break terms available,
           however they believe that the capital value of commercial

              BCO response to UORR consultation (September 2004)

          property will decline in the advent of altered rent review clauses or
          potential shorter lease lengths.
         By shortening the period of time during which the lender has
          security of a known income, a significant reduction occurs in the
          length of loan organisations are prepared to provide.
         64% of organisations would increase their required interest rate
          margin for loans secured by investment property where the leases
          did not contain UORRs.
         The investment performance of office property is expected to
          become more volatile and consequently more difficult to finance.
         Organisations would become more cautious in financing
          development resulting in lending lower proportions of development
          costs at a higher margin.
         47% of organisations believed that by outlawing UORRs, greater risk
          would attach to commercial property loans, increasing the capital
          base required to support those loans and so reducing the actual
          value of loans that could be made.

   The Cass/JLL research discusses the impact on institutional allocation,
   urban regeneration and on sales and leaseback.
       Institutional Allocation
            ▪ Downward rent reviews would lead to a cut in the
                 allocations to property in institutional portfolios of 2% to 5%,
                 and also to a significant increase in the overall portfolio risk
                 faced by investors.
            ▪ Because the impact of a ban on UORR would be uneven
                 across markets, there would also be substantial shifts in
                 allocations within property portfolios, with the primary impact
                 being a shift away from offices in London and the South East.
       Urban Regeneration - Severe impact due to:
            ▪ Layering of added risks to the income stream on top of
                 development and locational risk.
            ▪ Constraint on debt financing for development.
            ▪ High levels of risk and uncertainty associated with rental
                 value growth estimates for urban regeneration locations,
                 which would raise the rental premium desired by landlords in
                 exchange for downward rent reviews, or the fall in capital
                 values should markets fail to support that rental premium.
       Sale and Leaseback – downward reviews would impact on this
         important source of capital for businesses.

As stressed throughout the answers to these consultation questions, the BCO
believes intervention into the property lease market would be an
inappropriate solution to Government concerns about flexibility, fairness and
choice. Any moves to ban UORRs would increase volatility and insecurity in
the commercial property leasing market. Fundamentally, the criticism of
UORRs evolved in very different conditions to those that characterise the
market today.

             BCO response to UORR consultation (September 2004)

Jenny Mac Donnell
Research & Policy Officer
British Council for Offices
38 Lombard Street
Tel: 020 7283 4588
Tel: 020 7220 0443 (Direct)
Fax: 020 7626 2223


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