Tenants are using the new buyer's market to their advantage; landlords focus on renewing existing leases. Andy Martin and Malcolm Frodsham report
Tenants' propensity to exercise lease break options fell sharply last year despite weakening rental values, according to the Strutt & Parker IPD Lease Events Review 2008.
The annual review, launched together with the IPF's research programme on the robustness of property income during downturns in the market, confirms break propensity fell from 43% in 2007, on a weighted basis, to 24% last year. The rate of renewals and new lettings rose last year while voids fell. But these statistics mask a series of complex influences on the UK real estate occupier market.
Anecdotal evidence from Strutt & Parker indicates that tenants are using break clause options as a powerful re-negotiation tool with landlords. Break clauses have helped to secure reduced rents as well as rent-free periods, one-off capital payments by landlords to buy out break clauses and even the offer of equity ownership in rented properties, enabling tenants to share in their offices' capital appreciation when the market recovers.
In addition, some tenants are choosing to wait until rental values fall further while others are looking to avoid relocation costs, which can be considerable even in company downsizing scenarios. The occupier market has already adjusted much more quickly than in previous cycles to lower rents due to a significant contraction in the marketplace - as tenants reduce the size of their workforce - and in particular to consolidation within the financial services sector.
The annual joint research paper is now in its seventh year and incorporates 11 years of historic data. The empirical analysis covers the likelihood of the different events which have an impact on property cash flows - including lease expiries, break clauses, void periods and defaults - which need to be assessed in evaluating commercial property income streams. The research is based on 3,709 leases which expired in 2008 with a total annual estimated rental value (ERV) of £219m (€257m).
In a shorter lease and income preservation environment, lease level analysis is crucial for underlying investors as well as property lending banks and debt buyers. As leases get shorter, lease events - such as defaults, expiries and breaks - have a much greater impact on overall property valuations. Shorter lease lengths are increasing the chance of landlords experiencing more frequent vacancy periods. When leases expire, a new tenant is more likely to pay a lower rent than if the existing tenant renewed. According to the review, 2008 saw a record high for the proportion of re-lets that resulted in a lower rent - at 56%.
With existing income levels under threat, as rental values have continued to decline over the first half of 2009, landlords are focusing on renewing existing leases rather than re-letting to new tenants. The Review corroborates this analysis.
The all property lease renewal rate held up last year, rising from 21% in 2007 to 35%, back in line with the 11-year average of 39%. On an unweighted basis, the rate of lease renewal in the calendar year was highest in units in retail properties in the South East, at 40%.
At the segment level, shopping centre lease renewals were highest, at 37% - more than double the rate achieved in 2007.
By contrast, the lowest rate of lease renewals last year were, unsurprisingly, among larger City office tenancies. By region, office renewal rates ranged from 35% in the South East to 29% in the West End, while the rate of new lettings ranged from 23% in the City to 14% in the South East.
Landlords try to minimise the risk of tenant default by carefully vetting the financial status of companies as part of the due diligence process when buying a property.Approximately 4,900 tenancies in the IPD databank entered liquidation/receivership in 2008, equal to 5.5% of rent passing. This is by far the highest it has been in the history of the series. The rate was highest in the retail sector, 6.5%, and lowest on tenants in the office sector, 4.2%.
About 55% of the total rent passing on which tenants defaulted was accounted for by the retail sector and roughly half of this proportion was attributed to shopping centres. Likewise, 26% was accounted for by the office sector and 15% by the industrial sector.
At segment level the rates of liquidation/receivership in 2008 ranged from 7.9% in shopping centres to 2.1% in offices situated in the rest of the UK. In fact each segment apart from offices in the rest of the UK registered a peak in default rates in 2008.
In the retail sector, excluding shopping centres default rates ranges from just 5.8% in retail units in the rest of the UK to 5.3% in the South East. The high shopping centre rate may reflect a greater willingness to let space to weaker tenants in multi-let buildings where the risk of default can be diversified.
In the office sector, default rates were highest in the rest of the South East, 6.5% and lowest in the rest of the UK, 2.1%. Offices located in the City and West End recorded default rates of 2.9% and 3.3% respectively. In the industrial sector the default rate in the South East was identical to that in the rest of the UK at 5.0%. The impact of the bankruptcies of Woolworths and Lehman Brothers last year was significant. Lehman Brothers accounted for 9.7% of the total rent passing of all tenancies that defaulted in 2008 and had a major influence on the high default rate experienced in offices in the South East as it accounted for approximately 63% of the total rent passing in this sector.
Twinned with the impact of default is the void period - strictly defined here as the period for which landlords are receiving no income and no tenant is occupying the space, excluding, therefore, empty or vacant units where rental payments are still being honoured or rent-free periods.
In 2008, the all property void rate peaked at 13.8%, by number and 8.4%, by ERV. The void rates by ERV varied from 6.3% on units in retail assets to 16.1% on units in industrial assets. Over last year, void rates were much higher on a weighted basis than on an unweighted basis in each sector.
On a weighted basis, void rates were highest in units in industrial assets and lowest on both a weighted and unweighted basis in units in predominantly retail assets. On an unweighted basis, void rates were highest in units in office assets.
Looking at the pattern of average void rates among sectors in 2008, offices once again reveal the widest spread, ranging from 7.2% in units in the West End to a high of 14.4% in the City. City offices recorded the biggest increase in void rates from the previous year, rising from 10.6% to 14.4%.
Overall, there was an increase in the average age of voids across all sectors last year with the largest rise in the office sector, reversing the trend in 2007. This is the first time there has been an increase in all three sectors since 2002, while each of the three main sectors, and the all property average as a consequence, were at record highs at the end of 2008.