Article contributed by Michael Lever
Rent review to open market rent is at the heart of commercial property
Rent review to open market rent is at the heart of commercial property. On review and on renewal of the lease, a rent increase is a reflection of the direction that the property is taking. Falling rents are a proxy for deteriorating locations. An upward-only review whose outcome is an unchanged rent avoids declining market forces – temporarily. Index-linked reviews, whether or not with cap and collar, are akin to hanging on by a thread.
Property investment it is said is 50% finance, 50% property. It is said too that to not avail of the margin between low borrowing costs and investment yield is a no-brainer. Which perhaps is why a generation of investors, many for the first time into the commercial property investment market, have overpaid and continue to overpay for propositions that look good on ‘paper’ but which in reality fail to perform.
Overpayment can be symptomatic of auction fever, bidding carried away by enthusiasm. It is also the difference between fundamental value and ‘yield compression’. A product of interest rates, the price of an investment is influenced by the cost of borrowing. When interest rates fall, the price of the proposition goes up: conversely when rates rise the price falls.
Price is not the same as value. The value of a commercial property investment is objective. Price (or worth) is subjective; subjectivity can pay the price in more ways than one. That the commercial property market is unregulated is often forgotten. The desire for a store of value and transparent yield compared to the volatility of the stock market or political interference in residential buy-to-let can override prudence and due diligence. Cash buying does not equate to judicious choice.
Rock-bottom interest rates are unsustainable. It is not only yield expansion (also known as softening) that is leaving investors out of pocket. A property on lease is a depreciating asset whose rate of depreciation is counteracted by lease term duration and rental growth. Without at least some increase at rent review, depreciation wins. Come expiry of the lease and depending upon the type of property the likelihood of the tenant wanting to renew for the same term as previously is remote, particularly with shops where on renewal the tenant is also likely to want a break clause, together with a lower rent than before.
Tales abound of private investors devastated by substantial reductions in rent on renewal or whose corporate tenants go bust only for the administrator’s substitute to offer derisory terms for a new lease. And as for how long it can take for a lease inside the Landlord and Tenant Act 1954 to be renewed, not to mention added non-recoverable litigation costs in having to defend the tenant’s claim, more painful when rent is rebased, highlights how little or non-existent is the landlord’s knowledge of the process. In the context of the political policy for ‘levelling up’ the notion that could be done by reducing one’s net asset value is surely not what the landlord had in mind?
Anyone with money of their own or the ability to borrow can buy property. But money alone is not enough to buy wisely. Wisdom comes from a combination of know-how including what to do if something goes wrong. Objectively, the value of property let on a lease is affected by the terms and conditions of the lease in comparison with the terms and conditions of leases in the market for the type of property. In other words, the objective value of a particular property is affected by the subjectivity of other landlords. Other landlords are not obliged to grant leases that maximise the rental value of their own interests, let alone benefit the rental value of properties owned by others. The open market is not a level-playing field: it is a topsy-turvy chaotic arena which amongst professional investors is known as the “property game” for a reason. The rules of the game are simple: caveat emptor, read between the lines, do not only listen to what you want to hear. Rational acknowledgement versus emotional acceptance is not a recipe for success.
This being the season for predictions. as professional advisers, our task is to serve. Service is about help. instinctive, helping one another in some way and at some level of understanding enables us to progress. It is not only school-children that need proper guidance and education on how to manage their finances, but also adults that invest and/or borrow to invest in commercial property. Without an understanding of what commercial property investment is really all about and how to be successful, the risk is financially worse off and concluding never again.