Declining Lease Lengths in Commercial Properties - Literature review Example

?Topic: Declining Lease Lengths in Commercial Properties LITERATURE REVIEW Viewing the scenarios of commercial properties in some countries from academic perspective, a number of writers believe that leased premises suffer neglect as registering of lease agreements require costs. When property rights are distributed, the possibility of controversies arising among the interested stakeholders need to be reduced by entering into contractual arrangements. The literature on financial leases confirms the level of upkeep to be an economic factor. Researchers have not dwelt on the length of the lease except the reducing average lease lengths in the UK. A term structure of rental rates has been responsible for various lengths of the leases but it has been lacking in market reviews. A market review provides valuable knowledge into the relationship between rent and lease length, creating a balanced rent, depending on rent projections (Rowland, 2002). A lease length may depend on specific landlord needs such as redevelopment in the near future or for creating more space for another business tenant. Normally, landlords’ interests are served through long leases while tenants desire short leases with alternatives of renewal (Rowland, 2000). The possibility of such factors as cost of shifting and the cost of reletting could be crucial in deciding rents and lease lengths. Reletting costs may be borne by either the landlord, if the short lease expires or the tenant shifting premises before the expiry of the lease. These costs may not be transferable but can be reduced with mutual consent between the landlord and the tenant (Rowland, 2000). In a term lease there is no boost to reduce depreciation of the property, thus not securing the salvage value of the property (Miller and Upton 1976, p.766; and Flath 1980, p.253)). Smith and Wakeman (1985, p.903)) discuss how lease provisions may change the incentives for both parties, quoting the use of service leases (in which the lesser provides the maintenance) as a solution of avoiding the lessee’s inclination to ignore the property (Rowland, 2002). The deficiency of interest among tenants to take care of the property has been used randomly in the housing economics literature to state tenure choice (Henderson and Ioannides 1983, p.98)) and the observed reduced rents on lease renewal than new lettings (Hubert 1995, p.631)). Kanemoto (1990, p.7)) thinks that the problem comes in substantiating to a third party (typically a court) that the tenant has misused the property. Various types of contracts for maintenance of property change the possibility of not-suitable standards of maintenance (Rowland, 2002). Benjamin, de la Torre and Musumeci (1995, p.179)) present a model of under-maintenance by tenants, which compares the current values of owning and leasing property. The difference between the maintenance of property by owner-occupiers and by tenants shows the overexploitation by tenants during the lease, with bad outcomes for the residual value. The authors state different methods to improve upon the leases to reduce or eradicate the effects of the tenant’s provocation to misuse the property, like entering into contracts for maintenance by the owner, providing the tenant an alternative to purchase, deposit security or adjusting the rent as per usage needs (Benjamin, de la Torre and Musumeci 1995, p.184)) (Rowland, 2002). Interestingly, in the Northern Ireland, the private investors prefer long lease terms on properties situated in populous locations and depending on the area let properties on strong terms in the agreement (Crosby et al., 2002)). Property market was on the boom during 2002 in Northern Ireland, resulting in easy finance due to reduced interest rates realising greater syndicate transactions related to property. These inward investment initiatives like call centres for leading companies, including Halifax, Abbey National and Prudential and software development companies like Northbrook Technology and Fujitsu (Hamilton et al., 2005). Traditionally, property lease agreements had a span of 25 years with a trend of five yearly upward-only rent reviews and total repairing and insuring terms (Lizieri, 2003)). Commercial property leasing landscape has changed drastically in the UK since 1990s (see McAllister, 2001; Crosby et al., 2003; BPF/IPD, 2004; ODPM, 2004). The trend of short lease agreements in the UK commercial leasing market would prevail, as evidenced from the BPF/IPD Annual Lease Review (BPF/IPD, 2004)). The review pointed out that average lease lengths have reduced to 6.8 years in 2003 and 11.7 years on weighted basis. The unweighted average lease length for new office in 2003 was 5.3 years. Drivers Jonas (2004) noticed that for smaller properties (i.e. rent less than ?10,000 p.a.), the average lease length on an unweighted basis was 4.4 years, with 85 per cent of leases permitted being for less than ten years. The ODPM Interim Report (2004)) noticed that for properties carrying a rent of ?100,000 p.a. or more, the average lease length was 12.8 years and that 74 per cent of leases were being allowed for ten years or more (Hamilton et al., 2005). Changing lease structure in the UK within a market context Changes in the lease structure have been on the down side, as Lizieri et al. (1998)) stated that the institutional lease covering the 25-year tenure with full repairing and insuring lease with upward-only rent reviews that was the prevalent standard form in the 1970s and 1980s, seemed to be inelastic to fulfil the requirements of a volatile economic environment. The ever changing economic environment affected the occupiers’ propensity to earn profits from the business. The landlords practised a number of means to let their properties such as shorter leases, break clauses, capital payments, rent free periods and other motivations to let were identified as being common practice (IPF, 1993)), as cited by Hamilton et al. (2005). . In the past, lease terms before the 1990s seemed to be governed by the prevailing market conditions, the breakdown of the institutional lease and the influence of foreign tenants and investors not accustomed to the trend of long lease terms (Isaac, 1998)). But from 1995 onwards, the lettings market started gaining back the lost momentum and from 1996 to 1998, the leading commercial property market indicators hinted a period of long term real growth (DETR, 2000)). Market condition being the primary factor of lease terms, the hope of a recovery in the economy and the property market would have initiated a return to the bargaining power of landlords and tenants before the recession and a reversal to the terms of possession being practised before. Many researchers including Crosby et al. (2002)), Gibson and Lizieri (1999)) and DETR (2000)), have stated why the reversal back to the old trend of longer lease terms could not be brought back to practice. First, tenants fully understood the fact that their property holdings would impact on margins from their businesses and once offered elastic terms, argued and insisted on continuing of the softer terms in recuperating markets. Secondly, other shifts happened affecting the cost of doing business such as the new accounting methods, making it essential to enter the assets and liabilities by the landlords and the tenants. Tenants knew well that the pre-1990 lease terms were not favourable for the balance sheets and could cause revenue loss to their companies. Any changes in the leases could transfer the burden of repairs from tenants to the landlords, thus permitting tenants to look after their business interests first. Another influence related to leasing needs such as core and periphery had an impact on tenant leasing decisions depending on various business types. Finally, the impact of business styles like fast speed of transformation, management changes and internationalisation have alerted the tenants to the increasing needs of elastic terms of occupancy and the reality that the UK lease lengths have been comparatively longer than the rest of the world points to the reality of no reversal back to previous status of 25-years institutional lease and the time has finally arrived for shorter leases (McAllister, 2001; Crosby et al., 2003). Hoseli and MacGregor (2000) state how leases are a leading cause in differentiating property from the other major investment media. It is dissimilar to the other investment types for which income gain happens twice yearly in arrears, rents are paid quarterly in advance. Property income is similar to that of a traditional bond, rigid in nominal terms and tending to inflation. The “upward only” reviews means that if current market rents have increased, the rent will also increase but if they have come down, the rent won’t change. This denotes that the UK property income is associated with the levels of economic activity, that’s why the property has equity traits, but without the risk of a downfall in nominal income (Hoseli and MacGregor, 2000). Lizieri (2003) further states that long lease structures create a far off relationship for the landlord who holds the building as a pure financial asset, the source of a revenue stream and is least bothered for the upkeep of the physical and functional qualities of the property. The long lease creates a bond-like revenue stream, while presenting some possibility for future capital growth, making it a favourable investment instrument for institutional investors, pension funds and insurance companies. Assuming that most developers build structures for sale to institutional landlords, the treating of property as an investment instrument will create potent incentives to maintain the long lease structure. In fact, the over-riding impact of the property market and normal investment market by leading financial companies has led to the making of an “institutionally agreeable unitary product” (Lizieri, 2003). Hoseli and MacGregor (2000) present in detail the crucial attributes of leases by comparing UK lease terms with different other countries. Comparing the UK lease system with that of the USA, office leases are generally for five or ten years. The US accountancy law holds that companies were not eager on taking long leases, as this seemed to be burdensome. Most of the times the tenant pays a fixed base rent added to a matching share of the hike in building expenses. The base rent can be fixed for the complete lease term, hiked at pre-determined junctures or increased with the inflation. Retail leases normally include a part of the rent clause under which the tenant has to pay a part of the yearly total turnover beyond a fixed level. Such leases are also prevalent for retail property in France, where the portion of sales has to be given to the landlord, which is in the range of 5% to 7%. French commercial leases are normally for nine years with three-year break options provided to the tenants. Rents are determined either yearly or at the finish of every third year, normally for repairing work done on the building. Comparing the determination of rents with Germany, rents are normally fixed as per the cost-of-living index (Hoseli and MacGregor, 2000; Thomas and Turner, 2001a, b). The UK lease lengths have been based on traditional lease structures. Most of the quality bigger commercial establishments were let on the standard institutional lease (Crosby et al., 2002). The trend of shorter and varied leases started since 1990 with no specific length of the lease agreement (McAllister, 2001; Crosby et al., 2003). Lease lengths moved up and down as per the market conditions and that the reduction in lease lengths and the incentive packages were due to supply and demand functions in the marketplace. It was also stated that with the transformations in business processes or company structure, increased movement and innovation in products and services and with fast changing functional and location benefits, softer types of business occupation were needed. Gibson and Lizieri (1999)) contend that the institutional structure of the property market can function as a limitation, holding businesses from attaining the softer outcomes that they need. The example the UK’s trend of very long leases in commercial markets is given. A 20-25-year lease is totally unsuitable for a business with a planning view of just limited years (Hamilton et al., 2005). The average weighted office lease length in the UK in1990 was 23.5 years. The DETR (2000)) found that nearly 90 per cent (by value) of new tenancies in 1990 were on lease period of 20 years or more, the standard revision was done after five years and the great majority of leases were on FRI terms. However, by number of leases, it reduces to just over 50% of leases being for 20 years or more, and the average lease length was only 17.1 years. Crosby et al. (2002)) state that this gives the indication of two-tier market with bigger lettings more frequently on long leases, but smaller lettings on shorter leases even in 1990. In fact, it was found that shorter lease terms were prevalent in both prime and secondary markets and that lesser value properties also dictated shorter leases (Hamilton et al., 2006). The changes in the lease lengths started appearing drastically in 1990 but by 1992, the IPD rent-weighted average lease length decreased at slower pace to just above 20 years but after that the downfall in lease length was sharp to 13 years in 1994/1995. Saturation point came after 1995 and the DETR (2000)) indicated that data errors were rectified by the finish of 1998, bringing similarity in the average lease length to the 1995 averages. Just 18% (by value) of lettings within IPD data were on 20 year or beyond and number-wise this was only 6.5% (Hamilton et al. (2006). . Gibson (2000) undertook a survey of corporate properties and found that the average dimension of an office portfolio taken in each of the varied types of tenure contract (from a licence of less than one year to freehold) indicated that on average more than half the current portfolio was taken either freehold or on a lease of more than 15 years. In totality, there has been a crucial downfall in the number of properties held on leases of beyond 15 years (i.e. from 25 per cent to 5 per cent) and for leases above ten years tenure the figures indicate a similar design from 17% to 11%.Moreover, research by Cluttons and Pricewaterhouse Coopers (2004)) on Central London office tenancies normally supports Gibson’s (2000) and Crosby et al.’s (2003) outcomes. Some 46% of firms remarked that a lease of five years or less would be most desirable for their business requirements while 39% stated that tenure of six to ten years would be preferable to tem. The rest (15%) stated that tenure of more than ten years would better fulfil their needs. Actually, vast research has substantiated that economic signals like GDP, insolvencies, unemployment levels, office rental expansion and market condition were a leading cause that added to the changing lease structure within the UK (McAllister, 2001; Crosby et al., 2003).The UK economic condition has been a primary contributing reason to the change in lease structure; but it was just a catalyst to the long term shift away from the rigidity of the institutional lease. The UK Lease Market BPF (2004) has responded to ODPM’s consultative papers on the alternatives regarding withholding permission on upward only rent review clauses, pointing out that a small number of new leases have a rent review. It is a fact that commercial leasing market has totally changed in the past decade that the small businesses no more require a rent review. It is because lease lengths have gone shorter with the alternative of break for tenants reducing rent review to 63% of all leases and 80% of all leases are 10 years or below. The importance of 80% of the leases remaining for 10 years or below would not affect the tenants if the government follows alternative 3 of putting a ban on UORRs with floor to initial rent. In the case of SMEs, the average length is less than 5 years. As per the analysis report done by IPD on yearly lease data by business size based on Standard Government definitions of SMEs, the lease length has further reduced to just at 4.96 years, which is below the 5 years, which permits opting out of the 1954 Act. Thus, SME leases in the Office and industrial divisions are well below the mark up of 5 years, which brings the SME lease length to about half of the large businesses while comparing the years on averages between the two; the large businesses average lease length is 9.51 years. Offers 2 and 3 of the consultative papers offer nothing to the SMEs (BPF, 2004). Government data also indicates that leases of over 20 years, which used to be 60% of the market share have come down to 5%. The latest interim measurement of commercial lease code by the University of Reading has proved that by 2002 “…the number at 20 years or over had dropped to just over 5% and by rental value this had dropped to less than 25%” (BPF, 2004). As per the latest IPD data, the average lease length in the UK market has come down to 6.8 years. Such structural changes in the lease lengths are going to remain in the coming times as the trend is getting reinforced with the changes in stamp duty on leases and changes to be implemented to the International Financial Reporting Standards moving tenants towards reduction in leases. Legislation on leases would also boost this fashion but all businesses won’t be leveraging from shortened leases as lacking the security of long time lease arrangement and unable to write off their fit out costs in the long run. In such a cases, a ban on the UORRs can help such businesses in stead of offering alternatives to limit the lease length for some businesses (BPF, 2004). The UK Market Review Lease lengths in modern shopping centres have soft lease terms with lease lengths ranging between 5 years to 15 years. Retailers are better positioned to settle the terms as they desire, outweighing the benefits of longer-term leases. New locations have more chances of softer lease contracts for both the parties with some guarantee on the profitability of the centre (RSG Property, 2004). The British Property Federation (BPF) and the Investment Property Databank (IPD) have researched on the falling average lease lengths of lettings of 4 years or more from 14.7 years in 2001 to 13.9 in 2002-03. The retail sector was affected the most, seeing reduction in lease lengths from an average of 15.9 down to 14.8 years. This trend of shorter leases is not going to subdue in near future with Stamp Duty on leases (SDLT), an extra worrisome issue. Exemptions from SDLT to boost inward investments to reach government regeneration aims although distort the market view, set an example of policy aims. After a lapse of 15-20 years, refurbishment programme need to be implemented. In such a scenario, large scale shifts to tenant mix or functioning of the centre won’t be possible because of lease length and security provided to tenants (RSG Property, 2004). A comparison of leases between the Greater London with the rest of the UK, as found in the research, indicates that lease lengths were of shorter periods of 6.8 years in Greater London to nine years in the rest of the UK. The ODPM report has repeatedly stated that in the UK institutional property market, the average lease lengths for all property categories has been coming down since 1997 (ODPM, 2004)) as cited by Hamilton et al., 2006). RICS (2003) survey of commercial property market in all sectors also reveals the same trend of declining lease lengths and increasing incentives not only in London but all over the UK since 2002. Lease lengths started reducing in the 1st quarter of 2002 and this trend continued till the fourth quarter of 2004. Surveys also indicated the same trend; at least a net 26% of surveyors found the lease lengths reducing than the previous year in comparison to a net 25% reporting reduced lease lengths in the 4th quarter. Office property was foremost in reduced lease lengths particularly in London while industrial lease lengths were comparatively less reduced although the speed of reduction has been fast in comparison to the previous year in industrial leases. On the other hand, trend in retail property indicated a slight downward movement, continuing the trend of slower decrease in lease lengths throughout the region in the previous years of reducing somewhat lesser in some sectors and somewhat sharper in certain areas. The value of discount offers to new tenants increased in Q1 of 2002 and was there in the trends at the same rate in Q4 2002. A net 29% of survey reports indicated an increase in the value of discount offers. Such incentives were more prevalent and common in London especially for office property. In other areas, the values of lucrative offers also increased but at a slower pace. The South and Midlands saw only a moderate rise in office and industrial sectors primarily. North region saw reduced proof of incentives with only the retail segment registering any worth mentioning increase in the values of incentives (RICS, 2003). Lease lengths – offices The office lease lengths were comparatively less than the previous year in the 1st quarter of the year. 48% survey reports indicated reduced lease lengths from the last year. It was the same to net 50% as registered in the 4th quarter to be lower. Office lease lengths were equally reduced all over the region although London and South East areas registered the maximum decrease in lease lengths while other regions recorded smaller lease declines (RICS, 2003). Throughout quarter 1the incentives offered to hopeful occupants of the lease increased. 52% surveyors recorded an increase in the incentives while in quarter 4 2002, the reporting on incentive offerings was made by 57% surveyors. Incentive worth increased the maximum in London and the South East. In rest of the areas incentive worth indicated a comparatively reduced increase while in the North East and the North West, change was not worth mentioning (RICS, 2003). Lease lengths – retail The retail division of the property market has seen decline in lease length due to slow business activity and reduced fresh demand of property for retail purpose resulting in increase in the value of incentives offer to occupants although the pace of shortening lease lengths had been restrained. A comparison of decline in lease lengths as reported by surveyors indicates that Q1 saw 23% more surveyors recording increase in motivation values than a decrease over the quarter, which was 16% in Q4 2002. Retail sector increases in motivational offers has been more evident in London than in rest of the regions. In the South, motivation values have been moderate though over the quarter but increase nonetheless has been the strongest registered in 4 years of gathering similar data (RICS, 2003). Lease lengths declined further over the year than increased, as 9% more surveyors recorded a decrease. No change was noticed in lease lengths in Q4 as 8% more surveyors reported as such. Vey modest reduction in lease lengths was reported in a number of southern areas, in the North and in the Midlands. The Eastern region reported a small increase in lease lengths. London saw no change in lease lengths although other market factors indicated weak demand in retail market in Q1 (RICS, 2003). Lease lengths – industrial Industrial segment of commercial property lease lengths saw increased survey reporting on both incentives offered to tenants by property owners as well as reduction in lease lengths, indicating slow demand in the industrial segment of commercial property. Q1 saw 20% more surveyors reporting an increase in motivations than a decrease; it was at its peak in Q4 2002. Motivations were on the increase in southern areas and Midlands and minor changes seen in the North; the greatest increase was, however, recorded in London (RICS, 2003). Industrial lease lengths saw a speedier pace in their decline with 25% more surveyor recording a downfall in lease lengths than an increase. London saw the speed of reduced lease lengths quite evident; overall declines were centred in the southern areas, reducing in both the South East and the South West. A clear-cut decline was also visible in the northern areas, except the North East. Midlands and Wales, on the other hand, saw only a mild reduction in lease lengths (RICS, 2003). Comparison of Lease Lengths and Inducements If we compare the scenario of commercial property offices of 2003 with 2011 we find that demand for office space has reduced and the number of vacant properties has been increasing. The survey respondents have indicated that it has started to tail off with no new development projects in the offing. A number of deals materialised in the 1st quarter of 2011 in comparison to the last quarters but the number of enquiries was stabilised. It could have an impression on the number of deals to be realised in the 2nd quarter of 2011. The year 2010 saw weak demand for commercial property office space among investors and tenants, showing similar trends in the year 2011 indicating lack of confidence on the health of the economy. The value of motivations has decreased in the year 2010, which would be tracked minutely in the year 2011 (RICS, 2011). In retail segment sales and tenancies rush has been on the decline throughout 2010 and in 2011 too. The reason cited by survey respondents links the slow down in market condition with lack of straight forward policy on future road map of rent review clauses resulting in reduced enquiries and deal realisations in recent times. Lack of interest on the part of the consumers has affected the Irish retail market, which has depressed the new property dealings. Vacancy rate has been continuously increasing particularly outside Dublin and other areas where both lease lengths and motivations come down. Values for inducement had been increasing all over the first half of 2010 (RICS, 2011). Industrial section of commercial property off late has seen an increase in the number of enquiries but the impact has not been realised on materialisation of transactions. It indicates the presence of other factors such as finance coming in the way of sales realisations. Lease lengths are declining because more premises are getting vacated by those who have earlier taken them on rent. It is because of weak market condition. Tenants and investors have shown depressing sentiments throughout 2010 but it looks that in 2011 they are becoming firm (RICS, 2011). Performance-wise, the development land remains to be the weakest part of the market, and the current downward trend visible in 2010 seems to be going on in near future as well. Only a number of transactions have taken place on development land (RICS, 2011). Overall Commercial Property Market has got a respite from the general election with the issues of rent reviews and other policy decisions getting limelight. Activity in the property market was affected during election time with the prospective customers shying away from any property transactions. The ongoing depressing macro-economic environment has subdued the consumer sentiments but overseas investors’ enquiries have been increasing due to price cut and competitive Irish property market environment. Future of the property market seems to be dull with reduced domestic enquiries but it is a normal thing in the first quarter of the year. Election and the issuance of Programme for Government, it is expected hat market would be more hectic for overall business activity. References British property federation and investment property databank (BPF/IPD) (2004). Annual Lease Review, BPF/IPD, London. Available from: http://www.bpf.org.uk/en/files/bpf_documents/commercial/BPF_IPD_Annual_Lease_Review_2004.pdf [Accessed 19 May 2011]. Crosby, N. & Murdoch, S., 2000. Monitoring the UK Code of Practice: code, what code? Paper presented at RICS Cutting Edge Conference, 1 January, London. Available from: http://www.rics.org/site/scripts/download_info.aspx?fileID=1923&categoryID=450 [Accessed 19 May 2011]. Crosby, N., Gibson, V. and Murdoch, S. 2003. UK commercial property leases: landlord and tenant mismatch. Urban Studies, 40 ( 8), pp. 1487-516. Available from: http://usj.sagepub.com/ [Accessed 19 May 2011]. Gibson, V. and Lizieri, C., 1999. New business practices and the corporate property portfolio: how responsive is the UK property market? Journal of Property Research, 16 (3), pp. 201-18. Available from: http://www.informaworld.com/smpp/content~db=all~content=a713774734 [Accessed 19 May 2011]. Gibson, V.A. (2000), Evaluating office space needs and choices. Research Report by the University of Reading for MWB Business Exchange, Department of Land Management and Development, Reading. Available from: http://www.reading.ac.uk/rep/officespace.pdf [Accessed 19 May 2011]. Hamilton, Moira., Lim, Lay Cheng., McCluskey, William., 2006. The changing pattern of commercial lease terms: evidence from Birmingham, London, Manchester and Belfast. Property Management, 24 (1), pp. 31-46. Available from: www.emeraldinsight.com/0263-7472.htm [Accessed 19 May 2011]. Hoseli, M. & MacGregor, B.D., 2000. Property investment, principles and practices of portfolio management. Longman, London. Available from: http://usj.sagepub.com [Accessed 19 May 2011]. McAllister, P., 2001. Pricing short leases and break clauses using simulation methodology. Journal of Property Investment and Finance, 19 ( 4), pp. 361-74. Available from: http://www.emeraldinsight.com/journals.htm?articleid=845136 [Accessed 19 May 2011]. RICS, 2003. RICS commercial market survey: England and Wales. Available from: http://www.rics.org/site/download_feed.aspx?fileID=1330&fileExtension=PDF [Accessed 19 May 2011]. RICS, 2011. Quality commercial property review Q1 2011. The Society of Chartered Surveyors, Ireland. Available from: http://www.scsi.ie/publications/Downloadreport/commprop [Accessed 19 May 2011]. Rowland, P., 1999. Pricing lease covenants: turning theory into practice. International Real Estate Society Conference, Jan. 26-30, 1999. Available from: http://thankssjerseys.org/Papers/Rowland_Pricing_Lease_Covenants_Turning_Theory_Into_Practice.pdf ]Accessed 19 May 2011]. Rowland, P., 2000. Pricing lease clauses: the prospect of an art becoming science. Journal of Property Investment & Finance, 18 (2), pp. 177-195. Available from: http://www.emerald-library.com [Accessed 19 May 2011]. Rowland, P., 2002. Lease length and the care of properties. In: Refereed paper presented at 8th Pacific Rim Real Estate Society Conference on Jan. 21-23, 2002, Christchurch, New Zealand. Available from: http://www.prres.net/Papers/Rowland_Lease_length_and_the_care_of_properties.pdf [Accessed 19 May 2011]. RSG Property, 2004. The financing of retail property development in the UK: a report prepared for the Department of Trade and Industry. Available from: http://www.bis.gov.uk/files/file11002.pdf [Accessed 19 May 2011]. Read More