The British Lease Is Dead. Long Live The British Lease!
When the UK government threatened to ban upward-only rent reviews in 2004, then-British Land chief executive Sir John Ritblat mounted a defence of the practice that appealed to an English past of noble lords and humble rustic swains.
“The government should leave it alone,” the FT reported him as saying. “The property investment world has been built up over 1,000 years, dating from the feudal system, and it works extremely well.”
Ritblat was actually pulling the age-old rhetorical trick of appealing to a glorious past that never really existed, to justify a purely commercial motive. The truth about the origin of the modern British lease is much more recent, and arguably more interesting. It was born in Britain’s post-war economic boom, a time of fish fingers and fast food, and pioneered by an unlikely source: the Church of England.
For more than half a century, the British lease, with its upward-only rent review structure that meant rents could never go down, was like gold dust for landlords and investors in UK property. But today, long leases with upward-only rents are killing the UK retail and leisure sector, burdening tenants with rents they can no longer afford to pay, and owners with properties they are unable to rent.
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Turnover leases, long mistrusted by landlords and also some tenants, are being touted as a new way forward for retail and leisure, but they are more complicated, and they will require a fundamental change in the way property in the UK is valued and funded. It is the kind of change the slow-moving real estate sector has resisted for decades. But with the coronavirus pandemic turning the industry on its head, that resistance is now futile. Change that was happening gradually has now accelerated to a sprint.
"Upward-only rent reviews might have worked 30 years ago, but retail has changed, as it has many times before, and will continue to do so long as people gather to buy things,” Benson Elliot Senior Partner Joseph de Leo said.
Inflation, Inflation, Inflation
The UK has historically had longer lease lengths than other parts of the world, and it is pretty much the only country that has upward-only rent reviews. The roots of this go back not to feudal times, but to 1955 — that is when University of Reading academic Peter Scott found the first reference to a rent review, as detailed in his book The Property Masters.
Consumerism and prosperity started to take hold in Britain in 1955. Unemployment was at a low that has still never been matched — 1% — and the pound was strong because it was pegged to the dollar, and thus the booming U.S. economy. Post-war rationing had finally ended a year earlier, as had a ban on leasing consumer goods like cars and televisions. Birds Eye launched its frozen fish finger, Wimpy opened the first fast-food restaurant in the UK and commercial television arrived with the launch of ITV.
Consumer spending soared, and along with a strong currency the UK experienced something never before seen in peace time: inflation. For hundreds of years, except in periods of scarcity created by war, inflation had been virtually nonexistent in economies across the world. But from the mid 1950s it spiked, and hit unthinkable levels of 10% or more during the oil crises of the 1970s.
And landlords wanted a piece of it, Scott said. At the start of the 1950s, the average lease length for commercial property was more than 70 years with no rent reviews, according to data from Scott and the Investment Property Forum. If the rent was unlikely to go up, why bother to review it? But with the arrival of inflation, there was something to play for, and in 1955, institutional investors started putting rent reviews into leases, albeit only after 50 years.
But by 1960 the average length to the first rent review had dropped to 21 years, by 1970 it was seven years, and by the time the 1980s arrived, it was down to the five years common today. But the key was that leases were still long, more than 20 years on average, and that rent could never go down.
One pioneer of this system was the Church of England. That might seem surprising, given the church isn’t noted for being a bleeding edge commercial innovator. But perhaps it is not as unlikely as at first glance: The Church of England has been collecting rents from tenants and parishioners for 500 years, and its establishment under Henry VIII was a big real estate play, with the king confiscating the land and property of England’s Catholic monasteries.
In 1948, the Church of England established a body called the Church Commissioners, which managed the church’s investments and used the income to pay a chunk of the salaries of clergymen. It went big into commercial property in the 1950s, building on land it owned in London and beyond, buying assets and selling off some of its agricultural land in the process. It has traditionally been the second biggest landowner in Britain after the crown.
And when, alongside insurance companies like Legal & General, the Church Commissioners started putting rent reviews into its leases, it specified in the contracts that when rents were reviewed, they could only go up, according to Scott. This quickly became ubiquitous and thus the unique modern British lease was born.
For a long time it was a system that worked well for landlord and tenant alike.
“The upward-only rent review gave both the owner and the banker security of income, and that increased the value of the asset,” The Lorenz Consultancy Managing Director Tony Lorenz said. “And if the landlord didn’t have that security then they would have to charge a higher rent to maintain the value of the asset. There would also be less incentive to redevelop assets, as there would be less certainty about the profit you would make.”
It helped turn the UK into an investment destination that has historically punched above its weight in terms of global investor interest, as the institutional lease with guaranteed cashflow proved highly appealing to investors from near and far.
The New World Order
For retail, in the pre-internet world where sales were steady and you were likely to stay in a store for decades, the system suited all parties. But fast forward from 1955 to 2015, and the picture was very different. After a mini revival post-global financial crisis, the retail sector entered the most difficult period in its history.
The penetration of online sales has now surpassed 15% in the UK, and it is forecast to keep growing to as much as 30% by some estimates. In 2018 and 2019, 210,000 jobs were lost in retail, according to the British Retail Consortium and the Centre for Retail Research, as retailers went into insolvency or shut stores.
In order to unburden themselves of onerous upward-only leases, retailers have begun utilising the legal company voluntary arrangement process, which allows them to break leases and leave landlords with empty units. In many cases, cost-burdened retailers still end up going bust even when they have shed stores, leaving even more voids.
Then along came the coronavirus, and turned the problems for retailers and property owners up to 11. In March, all but essential stores and restaurants were ordered to close by the government, dropping retail and leisure operators’ revenue to zero overnight. Retailers have furloughed staff to save costs, but the largest fixed payment these companies have — rent — has now become central to the debate about whether firms survive.
In the short term, landlords and tenants are negotiating over rent holidays to see companies through the crisis. But thoughts are also turning to the fundamental overhaul of the way leases work, which many feel is needed to ensure the long-term health of the sector.
“What has become obvious is that the current system is not fit for purpose,” Alterx Director Bert Broadhead said.
Alterx bought a struggling town centre retail scheme in Chesterfield last year, and as part of its bid to revive it, has been bringing in new types of leases based around sales income in order to ensure retailers are paying what they can actually afford.
“The market was already moving towards having a larger number of flexible leases, but the current situation has accelerated this.”
From the point of view of tenants in sectors like retail and leisure, the situation is clear. Long leases with upward-only rents were in many cases hindering their businesses even before the coronavirus. Given the new uncertainty over revenue, this kind of lease is a tightening noose.
“When we first reopen, we have no idea where our revenue will be, but it might be 30% of pre-crisis levels, and that means our business isn’t sustainable,” Harts Group founder James Hart said.
The company runs a chain of restaurants across London including the famous Barrafina tapas bars.
“I strongly believe that landlords and tenants will have to work together so that they can both survive this. I think we’re going to have to look at rents being a percentage of turnover so that the business is given a chance to survive quieter times.”
If There, Why Not Here?
Turnover leases are the norm in other markets, including Continental Europe and Canada. Sometimes retailers pay a low base rent and then a percentage of their sales revenue on top of this, sometimes the rent is entirely based on the tenant’s turnover. The percentage of turnover paid to the landlord differs according to the type of business: A jewellery store can afford to pay a higher proportion than a discount retailer, because its margins are typically higher.
“I’ve been building and buying shopping centres for 25 years, and when we first started looking at the sector in the UK in 2012, I was astonished that you don’t get sales data from the retailers,” Benson Elliot’s de Leo said. “Your job as a landlord is to create a mix of retailers that drives footfall, which drives sales, which means that you can increase rents. If you don’t have visibility on sales data, how can you possibly know if the rent you are getting is sustainable?”
He said the visibility over sales gives both landlords and tenants the scope to negotiate with better information and less hostility. If a retailer is struggling, it could ask for a rent cut, and the landlord could make an informed decision about whether to give this, or bring in another retailer that might provide better footfall and pay higher rents.
An argument in favour of longer leases with upward-only reviews has typically been that it protects the value of an investment, making it easier to secure bank finance or a high price when the asset is sold: Cashflows are long-dated and secure, giving valuers the confidence to put a high value on a property.
Valuing a turnover lease is more complex. In the UK, valuers typically don’t assign a value to the turnover portion of the lease until there is three years of data showing average sales for a store. The uncertainty around rental income means a higher yield might be put on an asset.
But the property industry manages to put a value on such leases in other parts of the world. A valuer would look at a store, say a fashion retailer, take the amount of rent such retailers typically pay at similar stores in a similar shopping centre, and then presume it would pay that rent in this scheme.
And in a world of declining revenue for retailers and leisure operators, where leases can be broken through CVAs or operators are going to the wall, what value does a long lease with upward-only rent reviews have anyway?
“You are almost getting to the point where valuers are caveating their appraisals to such an extent that banks can’t rely on them anyway,” Broadhead said. “Just because you have a tenant paying a certain amount on a long lease, with the current system, no one has visibility on whether that is sustainable.”
For a long time, while both sides were doing well and making healthy profits, the lack of transparency between landlords and tenants was not a problem. Indeed, the two sides withheld information from each other to try and gain a competitive advantage.
“It is surprising how many retailers still think, it is our data, we don’t want to share it,” Broadhead said.
The adversarial nature of the relationship in the UK is highlighted by the fact that pan-European retailers who are happy to share sales data with landlords on the Continent won’t do so in the UK, de Leo said.
And this goes both ways. According to a recent Colliers International survey, 80% of landlords thought the way property is leased needs to change, and 40% were willing to consider leases where payments are linked to sales turnover or footfall. But only 37% of landlords were prepared to share relevant footfall data with tenants.
“If we are going to move to a more flexible type of leasing, then that figure has to change,” Colliers Head of Retail Strategy Matthew Thompson said. “Landlords and tenants need to share insight and share risk.”
He pointed to the outlet village sector, where these practices have long been common, and which has significantly outperformed its rivals in traditional retail sectors.
In that sense, the crisis brought about by the coronavirus can have a positive effect.
“If a retailer is coming to you asking to renegotiate their lease, then that is the moment when you can turn around to them and say, OK, but we want to see your sales data,” Broadhead said.
And the reverse is true, as Colliers’ survey showed: Faced with a prospect of a lease based on turnover, where income can go up or down, or no income at all, landlords might have little choice.
“People have started to grasp the nettle,” Broadhead said.
The new world of retail leasing will be a lot more complex, for landlords and tenants alike. Thompson argued that leases should be based on numerous data points, potentially including footfall in a shopping centre overall, footfall in stores and sales turnover.
Online retail brings additional complexity to the idea of the turnover lease. In a multi-channel world, a storefront for a big brand is a form of advertising, so leases may also attempt to capture the value of that advertising.
“The big issue everyone is wrestling with is how do you account for the impact of a store on online sales, and how do you account for returns?” Broadhead said.
No one has yet cracked this conundrum, but the increasing amount of data about whether people have visited a store before purchasing, and how online sales improve when there is a store nearby, is making it increasingly possible.
“In reality people are experimenting every day with this,” Broadhead said. “There will be no one-size-fits-all lease anymore.”
He added that property industry bodies like the Royal Institute of Chartered Surveyors and British Property Federation would need to work with counterparts like the British Retail Consortium about standard definitions of what constitutes footfall, or an online sale or return linked to a store, as standardised definitions would need to be in place to allow leases to capture this new data.
When Ritblat argued in favour of upward-only rent reviews at the start of the century, he was lamenting the potential death of a system that he said went back hundreds of years. From the vantage point of 2020, he was both right and wrong. Something is dying, but it isn’t a tradition spanning centuries. It is a leasing practice born at the birth of modern consumerism, but which is dying as that kind of simple consumerism is itself becoming a thing of the past.
Today, the way we consume is complex, multifaceted and fast-moving. The way shops are leased is none of those things. It needs to catch up, or retailers and the people that own the stores from which they operate will go the way of the feudal system.