To improve IRR keep your tenant in place as long as possible. Alec Emmott and Ronald Austin report
This article demonstrates that there is a clear relationship between the length of a lease and the rate of return: in the case of disputes, the revenue stream can be preserved by the parties having recourse to mediation to find a new basis for their relationship rather than litigation or arbitration.
Property is an atypical asset class whose valuation starts from the implicit financial hypothesis that a client will agree to continue to pay more over time (in either nominal or real terms) to house himself in ‘same shop' conditions. The duration of this engagement has however changed radically on both sides of the Channel.
During the post-war years UK Pension funds/actuaries started to look at property, with long fixed lease durations (20/25 years), full repairing and insuring covenants and regular upwards only rent reviews, as an alternative asset class (to bonds and equities) due to its qualities as an inflation hedge on the back of such occupational leases. In the event that the tenant wished to leave the property, it was he who was responsible for finding an occupier who inherited (as sub-tenant) the liabilities under the lease, of which the principal tenant remained nonetheless guarantor vis-à-vis the landlord for the unexpired period of the lease.
However as rent collectors have evolved into asset managers, and cross border investment developed, so the reciprocal engagements (of the supplier/landlord) and commitments (of the user/client) have evolved differently in both English and French markets.
Recent research by Investment Property Databank with Drivers Jonas in France (‘What is the Real Length of a French lease?'), and with the British Property Federation in the UK (‘BPF/IPD Annual Lease Review November 2007') contrasts lease duration in these two mature markets, and has underlined that the UK lease continues to get shorter - the average length of all new leases weighted by rent (including the first break clause where applicable) fell to 9.8 years in 2006/07 from 14.3 years in 1999.
So the myth that lower risk/yields in the UK can be attributed to longer leases and upward only reviews is up for examination.
The average real duration for new French office leases is now 6.5 years (UK offices 8.4 years). A small but increasing number of leases for large French space-users include fixed terms of six or nine years and, in some exceptional cases, up to 12 years. Sub-letting is still uncommon, and in the event the tenant leaves the property at a break, it is the landlord who is responsible for finding an occupier, who will generally sign a new lease on a renegotiated rent and conditions.
So the myth that commercial leases in France are ‘short but index-linked', the rent payable being linked to the yearly evolution of a building cost index,* is also up for examination.
It is a very unusual CEO who can plan his business/lodging needs and ability to pay beyond six/nine years, but it is simple to demonstrate that the landlord/investor has a real financial interest in maintaining his tenant/client in place as long as possible. The following examples are drawn from French practice but apply ceteris paribus to any commercial investment.
In a base case in which a property is yielding 5% in year 1, with a growth/inflation of the revenue of 3% per annum in perpetuity, with all expenses recovered, a cash-flow analysis will show a property (un-geared) IRR of 8%.
In the first variant the tenant leaves in year nine, obliging the landlord to take on the normal costs of refitting and re-letting, and re-lets after a year's down time to a new tenant at the same rent. Assuming an exit, always at the same income yield of 5%, the IRR falls to 6.8%. On the same assumptions as above a tenant leaving after three years will reduce the IRR to 6.6%.
The final ‘catastrophe' (but not unheard of) scenario has the tenant going to court at the end of a nine years' occupation and obtaining, after three years of litigation, a new rent which is 30% below the passing rent at the end of the previous lease. On the same underlying assumptions the property IIR falls to 5%.
A normally constituted property asset manager will thus have at heart the fact of life that knowing his client's requirements and adapting to them without the loss of cash-flow resulting from ‘wasted' down time, is now an integral part of his armoury - with a direct result on the financial viability of his investment. From the traditional landlord-tenant relationship we move inexorably towards a supplier-client relationship.
Mediation is a technique for maintaining good tenant relations that has not yet achieved general recognition in the real estate profession on either side of the Channel, whereas it is common in most other commercial relationships. Parties resorting to litigation or arbitration still tend to ‘go to war', thus seriously damaging a long-term relationship beyond repair, whereas those resorting to mediation have the aim of reaching a settlement creating a new basis for their business relationship.
The CEDR (Centre for Effective Dispute Resolution) has defined mediation as:
"A flexible process conducted confidentially in which a neutral person actively assists parties in working towards a negotiated agreement of a dispute or difference, with the parties in ultimate control of the decision to settle and the terms of the resolution."
The role of the mediator is to act as a facilitator or catalyst in assisting the parties throughout the process: the mediator manages the process while the parties control its outcome. A mediator need be neither a lawyer nor a specialist in the particular field: it is for the parties to choose The mediator must, however, have the confidence of the parties throughout the process.
The higher returns from building long-term client relationships can be destroyed by litigation, and preserved by mediation.
[* It is indeed tradition in the French market that rent payable under a ‘standard' office lease is indexed to the progression (but only the progression) of the ICC (a cost of construction index published quarterly by the government statistical office (INSEE). Over 20 years the ICC and the CPI (consumer price index) indices have tended to move roughly together. In recent years however the ICC has progressed at a rate well above the CPI - to the extent that a 2006 reform substituted a new weighted index for use in residential leases. There is some pressure already from retail users to adopt a weighted index in their sector.]