A focus on good tenant relations drives alpha. This might seem obvious enough, yet not all industry players are realising its potential as a competitive differentiator, say Howard Morgan and Paul Mitchell

As we write this article, the global financial system is in the eye of the storm - established names like HBOS, Lehman Brothers and Washington Mutual were some of
  the early casualties; business confidence at an all time low. An accountant we spoke to tells us that many of his clients are in ‘survival mode', with their planning horizons down to one month and their focus on funding next month's salary bill.

The short-term impact on real estate is clear, with expectations of returns of 12% or worse for UK commercial property this year, and vacancy rates predicted to increase in all sectors. This is a time for real estate investment managers to rethink their business models.

What is certain is that our understanding of the drivers of alpha - long-term consistent outperformance - will need to adjust to the new reality. In this article we look at some of the evidence to suggest that superior income returns will be generated by a service-focused approach to the landlord and tenant relationship.

Is there a link between a superior service culture and investment performance? While there is little information at hand in the UK and continental Europe, there are some indirect indications.

The income return - and, correspondingly, the yield - will partly reflect a fund manager's superior property management skills. With the landlord-tenant relationship central to this, a superior service culture should therefore be expected to deliver correspondingly superior investment performance.

There have long been anecdotes that the best performing fund managers have placed a heavy emphasis on superior income management. This was echoed in interviews undertaken for the Investment Property Forum's (IPF) study ‘Alpha and persistence in UK property fund management'.  Furthermore, a relatively high yield - as noted above, indicative of good income management - was a persistent predictor of superior fund performance in the IPF study.

Perhaps the greatest insight for the challenges ahead can be gained from the experiences of the early 1990s. There are two interesting observations. First, in every sector, the best performing properties maintained their returns from income better than the rest. Second, and consistent with the first observation, those fund managers with higher yielding portfolios, and therefore better income-producing properties, tended to outperform (see table 1).

Contrast this with the more recent boom years when yield and a focus on good income management would have put performance at a disadvantage to those following more risky strategies.We recall how in the early 1990s the US responded to the challenges of the last big economic downturn and development boom. The mantra everywhere was ‘tenant retention'. During this period, keeping the income flowing and improving customer service, while keeping operating costs under control, was the only effective strategy and source of competitive advantage.

In the first article in this series, ‘Time to embrace service', published in the May/June 2008 IPE Real Estate, we referred to two types of investors - those with an intuitive understanding of the link between service and performance, and those who will take a neutral or even negative stance, believing that customer service does not improve property returns.

The UK Occupier Satisfaction Index 2008 - sponsored by the Property Industry Alliance and CoreNet Global -  offers some hope for those investors that have taken the intuitive decision to invest in service. The latest research reveals that occupiers are beginning to say that they can see the larger landlords differentiate themselves from the rest of the pack and that this is having an impact on which landlords they prefer to do business with.

This suggests that property investors could achieve competitive advantage by tapping in to the benefits of consumer loyalty in exactly the same way as other mainstream businesses. Just imagine the power of being perceived as the Lexus or Apple of the real estate industry. This may be far-fetched for some but is exactly the strategy being followed by real estate innovators like ProLogis in the distribution sector and by Westfield in the retail sector.

What is the business case for tenant retention and actively encouraging loyalty? In his book ‘The loyalty effect - the hidden force behind growth, profits and lasting value', Frederick F Reichheld puts forward a helpful model for us to use.

Reichheld identifies five components of profit that can be attributed to customer loyalty. Applying these to real estate we see that revenue profit comprises:

Base profit -The difference between income return and cost. The longer you keep a customer, the longer the base profit will be earned; Per-customer revenue growth - In most businesses, customer spending and profitability increases over time. In simple terms, as customers become loyal they buy more services. In the real estate context this could mean package deals for multiple sites with a retailer or logistics operator; Operating costs - The cost of transacting business and after-sales support becomes less as the supplier and customer get to know each other better. Just imagine the cost benefits of a standard leasing and legal package with a loyal corporate occupier; Referrals and customer advocacy - The willingness of a customer to recommend their supplier is a powerful source of referrals in most businesses. Some landlords already give an incentive to occupiers who introduce their friends with good reason. In our experience, occupiers that are recommended are far more likely to convert from enquiry to letting; Price premium - The logic goes that older customers pay effectively higher prices than new ones. While underplayed in the property industry, most owners will tell you that occupiers on lease renewal tend to pay a higher rent than new businesses coming in that get the benefit of rent discounts, rent free periods and capital incentives.

In recent conversations with some leading real estate investment managers it is becoming evident that they are adopting strategies to differentiate themselves from the pack. Examples are the Hermes Real Estate initiatives on responsible property investment and monthly rental payments, and Legal and General Investment Management's sustainability programme.

We agree with Reichheld when he says "loyalty-based management is not a matter of investing blindly in your customers in the hope that somehow profits will grow". For real estate investors, this means calculating the benefits and being able to make an informed choice about where to invest resources in improving service skills and spending more time on occupier engagement.

This is an area where the availability of empirical data is poor and where more cross-industry research would be valuable.In the UK, some pioneering work in this area is being carried out by the Real Service benchmarking group of 35 leading property owners and managers.

The group has been working over the past four years to develop its understanding of best practice in customer focused property ownership and how this can impact business performance. The group has developed a simple model to show how best practice, service performance and financial performance are linked and is now gathering evidence to identify the inter-relationship between the three components (see figure 2).

The initial focus of the group has been to establish a standard way to measure and compare how far each organisation has adopted best practice. Each contributor commits to providing evidence of best practice in six building blocks and 25 criteria ranging from service strategy to business operations.

The portfolio of evidence is independently reviewed and a five-point assessment level agreed. When aggregated, this produces a Real Service Best Practice Index (RE BPI) which can be tracked over time. Since its launch in 2004 the RE BPI has increased from 56 to 77, reflecting the effort being taken to improve best practice by its members.

The focus of the group has turned to establishing consistent ways to measure service performance, including occupier satisfaction, recommendation rates, service charge compliance and tenant retention. The ultimate aim is to improve service standards for occupiers and to be able to identify how loyalty can benefit the profitability and reputation of the commercial and residential real estate industry.

Returning to hard evidence for the benefits of loyalty, the Strutt and Parker/IPD Lease Events Review suggests that losing a tenant at lease expiry opens up the possibility of void, and that on average this lasts around 15 months. This could reduce returns by the equivalent of about 0.5% per annum compared with a property where vacancy is avoided. 

The Strutt and Parker/IPD research also suggests that while a number (approximately 10%) will experience some very large rental uplifts following re-letting to a new tenant, the remainder of properties re-let to new tenants are at much greater risk of seeing a fall in rents than a property whose existing tenant renews. Therefore, other than the lucky few, a landlord who cannot keep their tenant at lease expiry is likely to suffer a rental penalty. If this is not made up during the new lease, investment performance will be further impacted.

Clearly better tenant relationships and management will not totally transform prospects. However, the various strands of evidence do indicate that a positive and proactive style will bring rewards. As one major corporate says in the UK Occupier Satisfaction Index (sponsored by the Property Industry Alliance and CoreNet Global):  "I want to build a longer-term relationship so I can do business with people I trust."

 This presents real estate investment managers with a strategic opportunity to secure sustainable competitive advantage through occupier loyalty and market-leadership in the active management and retention of cash flow.

This strategy is likely to prove most attrac tive to those investments managers that have the international reach and/or sector-specific skills to match the aspirations of the major global occupiers.Now that the froth of the credit boom has evaporated, this may be the only long-term strategy by which real estate investors will be able to generate alpha performance.

Howard Morgan is managing director, Kingsley Lipsey Morgan, Real Estate Performance Consulting
Paul Mitchell is founder of investment strategists, Paul Mitchell Real Estate Consultancy