The fundamental investment aim of commercial real estate is to generate a stable cash flow. For decades, the traditional long-term FRI lease has provided a safe and secure basis which has been relied upon by funders to make finance available, that in turn has encouraged investment and facilitated the development of modern commercial premises in the retail, leisure and office sector. Provided the tenant remained solvent and open for business, the rent and the service charge would continue to be paid and landlords could meet their funding covenants.
The Covid-19 crisis has, however, turned that concept on its head. There have been multiple reports involving familiar high street names feuding with their landlords over their inability to pay rents. Travelodge is the latest casualty and is set to use a CVA (the restructuring measure increasingly used by ailing retail and leisure operators) to slash rents in an attempt to end a fractious dispute between the hotel chain and its landlords. This all begs the question – is the current commercial leasing system fit for purpose?
It is difficult to predict what life post Covid-19 will look like, but there seems to be a growing call for more flexible, collaborative, partnership based arrangements between landlords and tenants. In that context, upward-only rents benefitting the landlord at the expense of the tenant, which have been at the heart of the British institutional commercial lease for decades, seems to be at odds with this collaborative sentiment. Rather, the reality is that upward-only rents have decimated the retail and leisure sector; tenants are burdened with rents that they can no longer afford to pay and owners burdened with properties that they are unable to let. Who then has the whip hand now?
During this crisis, there has been much comment that turnover rents offer some solution to this problem. These are certainly being considered more frequently and although there are numerous issues to be addressed (how to account for online sales, returns and now the ‘click and collect’ phenomenon), it is very likely that these will feature as part of the new way in which landlords and tenants operate in the future. Regarded suspiciously by landlords for years, communication between the parties will be key to overcoming landlords’ resistance to the use of turnover rents on a larger scale. Negotiation and compromise will, of course, come into its own in these new market conditions and so re-assessing business trajectories will be important – tenants could, for example, consider agreeing to a slightly longer lease thereby giving the landlord more security, or undertake to re-fit at the tenant’s own expense. For so long, tenants have been fixated on their businesses and possibly have not thought enough about the property that they are conducting their business from; time, perhaps, for a new outlook.
While e-commerce has changed the face of the high street, the success of remote working in this crisis has also caused many office occupiers to reconsider their actual occupational requirements; what is it that they actually need from their letting space? The standard British institutional commercial lease has encouraged investment in commercial real estate by building owners who are disconnected from the buildings they own and from the tenants in occupation – all that matters is a clear rental income each quarter. However, for a landlord that takes an active interest in its building portfolio and that wishes to ensure that its building remains attractive and lettable, this current pressure for change provides an interesting opportunity and every incentive to build flexibility into the design of new buildings, to ensure from the design stage that buildings throughout their intended lifecycle can easily and economically be maintained and repaired and if needed, upgraded to meet changing technological and communication needs of the potential occupiers.
For a landlord that is prepared to view commercial space “as a service” and not just a commodity, there are numerous benefits and potential profits to be had from offering its occupiers more flexible terms. For example, landlords could enhance the value of their investment by retaining a greater role in the management of its building. By retaining the responsibility for the repair and maintenance of the building, landlords would be able to factor in from the outset lifecycle costs of repair and maintenance, into a single “occupational charge” made to tenants for the right to occupy the building. Provided landlords maintain and repair the building, it will continue to remain attractive to potential tenants which who will be willing to pay a premium for flexible terms and the ability to vacate on short notice with no dilapidations liability.
Landlords and property funders might argue that such flexibility will destroy the commercial real estate investment industry and that any lack of long term certainty of income will mean that finance will no longer be made available to develop and invest in commercial real estate, but there is no reason for this to be the case. Many commercial property lenders have traditionally only been interested in (i) the location of the building (ii) the length of the lease (is it longer than the loan term?); and (iii) the identity of the tenant (is it likely to remain solvent?). If these changes take hold then these property lenders will have to become more sophisticated and will be required to examine more closely the “business” being operated by the landlord and apply relevant lending criteria to that business model.
So, what if 2020 is the year that the commercial property industry has been waiting for? What if it turns out to be the year we finally accept the need for change? What if 2020 becomes the most important year of them all?
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