The second reading of the English Devolution & Community Empowerment Bill is moving through Parliament, with some in the real estate industry concerned its contentious proposals to ban upward-only rent reviews could profoundly harm markets. They suggest it is already holding back investment.
CoStar News recently caught up with senior practitioners at real estate adviser Hanover Green with expertise in different disciplines to explore how it might affect the industry, as well as reviewing a wide-ranging report on its financial implications from ratings agent KBRA.
The government took the market by surprise in July when it announced plans to ban upward-only rent reviews for commercial leases as part of the Bill. Upward-only reviews are common in UK commercial leases and mean the rent can only increase or stay the same at review.
The government has confirmed the change will not affect existing contracts but would ban the introduction of the clauses in new agreements. Landlords would have to choose between agreeing fixed rents or introducing a review clause that allows rents to fall as well as go up.
The government says: "The new rent will be determined by whatever methodology is specified in the lease, for example in line with changes to the retail price index. The new rent may be higher, lower or the same as the previous rent."
In a review of the implications, ratings agent KBRA says that landlords could face increased exposure to downwards rent adjustments, creating greater cash flow volatility and implications for property valuations, loan performance and refinancing risk. In turn this may present knock-on effects for commercial mortgage-backed securities transactions, where declining rental income can weaken debt service coverage, pressure credit ratings and increase refinancing challenges at maturity.
It points out that Ireland’s 2010 ban on upwards-only rent reviews created a two-tier lease market but had limited overall impact, as it coincided with a cyclical recovery. It adds that the UK reform mirrors many Irish features but adds stronger anti-avoidance protections.
KBRA finds that a ban on upwards-only rent reviews would increase downside risk in weaker sectors like secondary offices and retail, but in what it terms the "resilient growth markets" such as industrial and prime retail the impact is likely to be less pronounced. But event here it would be likely to reduce income certainty, with future rents driven by market conditions, lease timing and tenant negotiations.
Colette Williamson, principal, lease advisory, Hanover Green, says the announcement was a surprise, "a bolt out of the blue with no consultation seemingly with the British Council for Offices or Royal Institution of Chartered Surveyors".
Williamson says there are clear reasons the government is pursuing the change that, at first glance, appear rational, but it appears not to have thought about the wider connotations for real estate and business.
"It has been positioned as part of the government's levelling-up ambitions and a way of bolstering the high street and secondary retail and it seems the retail industry has lobbied powerfully with government. The question is, will it do what it intends to do and what are the wider repercussions for the property industry? Often where businesses have not grown or their property is over-rented, the capital could be redeployed away from rents to help that business, and there would be an upside but the legislation could have serious consequences elsewhere."
Williamson says it is important to point out there have been examples of rent reviews moving downwards.
"Examples here include Westminster City Hall's rent review with Landsec, for instance. It does happen but the normal is it is upward only or flat at review, and the market dictates what the price of that is at negotiation.
"In terms of the second reading of the legislation in Parliament at present there has been no change to the proposals so far as we know."
Jonathan Webb, principal, investment, at Hanover Green says there is an impact on local government and councils given their property holdings for investment income and their own pensions.
"Interestingly, it seems that, again, landlords are seen as greedy and wanting to keep upping rents, but much of UK property is owned by pension funds or local authorities. The legislation has huge implications for them and for the likes of L&G advising Local Government Pension Schemes as the government drives to increase investment in infrastructure and regeneration. The point that is missed is being a landlord is not an easy game. It requires a lot of capex that has to be spent ensuring buildings are kept in good order and that money needs to come from somewhere.
"It is not crazy to consider upwards and downwards rent reviews – they have been more prevalent in Ireland and Europe. But the government just went out with it without consultation, and the blanket nature of it is the problem. It is not necessarily wrong across the board but it needs more intelligent thought."
Stuart Barron, partner, lease advisory, says importantly the legislation will not necessarily help the tenant, even if that is the aim. "It will exacerbate the trend for shorter and shorter leases being signed outside the [Landlord and Tenant] Act with no protection, no right of renewal. In that context is it going to be of benefit to tenants?"
James Shillabeer, a partner and South East office agency expert, says: "Since Covid development has been very rare in offices. In the South East there has really only been three new major developments – Tempo, Station Hill and Clarendon Works. That's a response to construction costs, the cost of fit-outs, the uncertainty over office tenants and business decisions. If you then as a landlord think your appraised rent could go down there is a real problem. And ultimately if it is not commercially viable it will not be delivered."
Shillabeer says that if levelling-up is the driving factor behind the plans then it could have the reverse effect to the intended.
"It would be better to be specific and focus on specific regions and sector, and also size. The notion is it protects smaller tenants but there are unintended consequences that the space may not be delivered for these tenants. And there could be a massive push to shorter leases, outside the Act and no '54 Act assessment – is this what the legislation is trying to achieve?"
Martin Thomas, a principal and founder of Hanover Green Retail, says that in the current market, most deals are agreed with much shorter leases than has traditionally been the case, and tenant break clauses are common. Therefore the market dictates the negotiations, and it works.
"In 2017-2018 our work in the professional sector was 75% rent reviews and 25% renewals but now it is skewed the other way. In today’s market a 10 to 15-year lease is increasingly unheard of. There are of course exceptions like on Bond Street where retailers may want 20 to 25 year leases but they are putting millions into a shop fit out and have total commitment to the location.
"We acted for a major high street retailer recently who renewed a lease and committed to a 10-year lease extension because the rent went down on renewal, and because it could agree a rent-free period and a capital contribution from the landlord in return for committing to 10 years. This sort of deal would not happen now, if the legislation was to go through, but the parties by negotiation were both happy with the deal. The retailer would never have done this without the landlord’s capital contribution and the rent-free element. For the landlord of course the tenant's covenant is key. Taking away the ability to negotiate this way will have huge implications.
"For the food and beverage sector these changes could be a lot worse. For the tenant the valuation of their businesses is created via the [earnings before interest, taxes, depreciation and amortisation] multiplied by the length of the lease. This valuation is vital when leisure operators are seeking capital and wanting to undertake fit-outs. If the legislation stops long leases being signed the restaurant sector will suffer. Shaftesbury Capital's Kingly Court asset is a great example of where short term leases can work but many restaurants will seek 20-year leases and I can see many landlords refusing if the rent can drop.”
Tom Wildash, principal, central London office agency, says the office market is already under pressure and this will not help.
"Leases are getting shorter due to economic uncertainty and business uncertainty over how much space occupiers need. Fit-out costs are increasingly expensive, which is driving the demand for tenants wanting landlord-fitted space and in that market there is expectation that leases will only be three to five years with no rent reviews. In general, rent reviews are rarely mentioned in negotiations as a reason not to do a deal. Ultimately, when looking into the future the change in rent at review is a small factor in terms of the opex costs for occupiers to consider – £10 on £100 per square foot for instance. The problem will come if the tenant does want a longer lease – what will that look like? Is it a stepped rent, or RPI indexed - arguably that is a worse problem as an upward only rent review is basically what someone is prepared to pay."
Capital markets specialist Webb adds: "If you look at the system it is much like the bond market where you commit to pay a coupon. That does not go down, it is fixed. Why should rent reviews be different as an investor class?"
He also believes the government has bigger and better levers to pull for levelling up. "The worse thing though is the Budget delay - that is giving businesses reasons to delay decisions and causing uncertainty. Also, if government wanted to regenerate the country than reforming business rates would be a better place to start."
Shillabeer agrees: "The rise in national insurance contributions has also been the real blow for business."
Williamson says when looking at larger occupiers taking 50,000 square feet or more the reality is they are often agreeing long rent-free periods under current negotiations. "It is a small cost to be in the right building."
Barron adds that if it is RPI-linked rents that are agreed instead, the tenant "could really get stung where it is not getting capped".
Williamson adds: "Instrinsically the system seems fair and there has not been enough consideration of the wider economic implications. It is fair if the tenant is paying the market rent and the entire structure is the market rent. If there is a change in the structure there would be less rent frees and higher rents all outside the Act."
As Webb adds, the fear is that in its current form the legislation, if it passes, could paralyse development. "Ultimately it has be commercially viable to deliver space – the other option is nothing happens."