UK: LEASES - IN SEARCH OF THE GOLDEN LEASE. - Tenants demanding reform of the commercial lease are locked in battle with property companies intent on protecting their investments.

by Andrew Yates.
Last Updated: 31 Aug 2010

Tenants demanding reform of the commercial lease are locked in battle with property companies intent on protecting their investments.

An increasingly persistent lobby has emerged during the recession, demanding reform in an area of the property market hitherto regarded as sacrosanct. It is bent on radical reform of the commercial lease. Members of the lobby are mostly tenants. They say the lease structure has become untenable; they agree that it is inflexible; and that the lack of flexibility results in financial hardship and stops companies from moving premises.

The antagonists are predominantly the property companies or investors in property. They say they have invested because the returns from bricks and mortar are guaranteed by the existing lease structure. Reform is unnecessary and there is no justification for interfering with the lease, they say - for that interference could jeopardise the market as a whole and their investments in particular.

The reform that is demanded hits for six one of the most cherished principles of the UK property market: that rents should move only upwards after the five-yearly rent reviews. Among other things suggested is the abolition of what is termed 'privity of contract', a legally binding contract, considered by many to be a mainstay of the standard 25-year commercial lease.

What the property industry regards as the 'standard institutional lease' is not enshrined in law. But at the insistence of property investors, by far the bulk of leases taken out in the last two decades have been of 25-year duration and all but a handful have upwards-only rent reviews. As a result of the weakness of the market recently, investors and landlords have been more flexible than previously and agreed to shorter leases with break clauses, giving tenants the chance to opt out of their commitment after, say, five years. But tenants have been unable to persuade them to give up the upwards-only rent review.

'It's their guarantee of inflation-hedged income and they will do anything but give it up,' explains one agent. And as the market improves, investors and landlords appear once again to be gaining the upper hand in negotiations. Break clauses are less easy to come by than they were just 12 months ago and upwards-only rent review clauses are unbreachable. Reformers are demanding their prohibition, through legalisation, for all future leases.

Last year, those demanding reform were thoroughly encouraged when the Bank of England threw its weight behind their cause. 'Upwards-only rent review clauses seem designed for a world which had the certainty of upwards-only property values,' said the then governor, Robin Leigh-Pemberton. 'This pattern is not in the interest of the economy as a whole, and the thrust of our anti-inflationary policy is intended to make it obsolete.' Leigh-Pemberton also criticised privity of contract and its 'apparently absurd outcomes'. Privity of contract means that tenants who assign their lease when they cease to occupy a building remain liable for rent if a subsequent tenant defaults. The idea is nonsensical according to Leigh-Pemberton who labelled it a ridiculous system of 'responsibility without power'.

The Bank's view has changed little since Leigh-Pemberton made his speech; it says that anything inflationary, such as upwards-only rent reviews, should be abandoned. And since the famous speech, the clamour for change has become deafening.

Only this summer, Sir James Blyth, director and chief executive of Boots plc, which pays some £125 million a year to external landlords, made his views clear. 'Investors and developers need to recognise their tenants, the users of property, as their customers. They must become much more customer-driven,' he commented. 'The industry has allowed itself to become too finance-driven, indeed finance-dominated, over the last couple of decades, which has led to a greater rigidity and uniformity in occupational arrangements.'

Blyth argues for changes: 'Why is there one standard issue, the Institutional Lease, albeit expressed in different legal phrases, irrespective of a multitude of different tenants, whose need surely cannot be standard in all cases? Why are rents reviewed only on the basis of "comparables" that frequently are not comparable at all?'

He questions the present lease arrangements which have seen rents increase while many a tenant's income decreases. 'What about the ability to pay or the importance of maintaining an attractive tenant mix? Why are rent reviews just once every five years, and then usually upwards only, when such an arrangement simply delays market adjustment?'

Blyth is not alone among shopkeepers who want change. Keith Miles, finance director of Etam, which has 220 stores across Britain, actually blames the lease structure for the extreme nature of the boom and bust cycle witnessed so dramatically within the last few years. 'We tend in the UK to have a much more extreme boom and bust situation than other countries,' he says. 'By having upwards-only, five-year rent reviews you delay the effect of the market. In the end the market will out and when it happens, it does not occur gradually, it occurs dramatically. The result is often bankruptcy and collapse; first among tenants and then the property companies themselves. OK, the rents adjust in the end, but if a tenant is hit by an upwards-only review just as his income is under pressure, it can force him out of business. And once you are bankrupt, adjustments a few years down the line aren't much help.'

The British Retail Consortium has become heavily involved in the campaign. 'Upwards-only rent reviews should be abolished for future issues,' says the consortium's Mark Bradshaw. With the help of MPs such as Angela Browning, who recently took over from Nicholas Soames as Minister for Food, and Peter Thurnham, the Conservative member for Bolton North East, the pressure for change has been building. The Department of the Environment has been reviewing upwards-only rent reviews, arbitration procedures for disputes between tenant and landlord, and the thorny issue of confidentiality and of how much information about actual rent levels should be disclosed. Just before the parliamentary recess, the Department announced plans for a voluntary code of conduct.

Many tenants and property experts see the question of confidentiality as crucial. Landlords base rent levels for each tenant on comparable settlements in the locality of their shop or office. And tenants say they tend to obscure the real facts behind each deal in order to give the impression of maintaining higher rents than those actually achieved.

Many landlords, for example, have been inducing tenants into office buildings in London with 'rent free' periods of up to five years. Canary Wharf is full of tenants enjoying a year or two free of rent.

In the recent, weak market, these rent-free periods have been offered by landlords and property investors as bargaining chips to secure the continuance of upwards-only rent reviews.

Yet the 'headline' rent - that which the tenant agrees to pay after the rent-free period - is still used as a comparable from which to work out settlements in the neighbourhood. And landlords are blamed by tenants for preventing information about rent-free periods, free fit-out and decorating, and other such discounts from being released.

'It would be far better if more information about the property market was made available,' says Keith Miles. 'People should be able to find out more about the amount of empty property, about rent-free periods, and about what the headline rent is in comparison to the real rent after all these discounts.'

Angela Browning is just as adamant. 'Upwards-only does not reflect market conditions, and with things like free refit packages and rent-free periods, the average rent appears higher than it actually is. There is no transparency or information about how the rent is assessed. Transparency is an important factor and its introduction would be helpful.'

While the Department of the Environment was pondering these aspects of the commercial lease, the Lord Chancellor has been deliberating on privity of contract. And not before time, says Angela Browning. Speaking before she was appointed to the Ministry of Agriculture, she talked of constituents who had suddenly been landed with enormous bills from landlords because tenants in properties where they had been perhaps 20 years earlier had gone bankrupt. 'I first got involved in this because one of my constituents was having to sell his home to pay the debts on a property where he had been a tenant many years before,' she said. In this case, the individual was collared by his landlord simply because he had been the original tenant on the property. And no matter how many times the lease had been assigned after he left, he could still be held responsible if any of the subsequent tenants failed to pay their bills.

Like the Department of Environment, the Lord Chancellor is taking time with his deliberations on privity, and the Royal Institute of Chartered Surveyors is beginning to lose patience. 'Our attitude is that we would like this matter to be finally resolved,' says Richard Lay, chairman of DTZ Debenhams Thorp and RICS spokesman on such matters. 'Some two years ago, the Lord Chancellor indicated that there would be legislation which would remove privity of contract. This would mean that when a tenant assigns a lease, he will remain responsible in the event of the assignee going bankrupt. But if there is a further assignment, then he is absolved of responsibility. On this particular issue, we have not come down on either side of the argument. But what we do want is for it to be resolved.'

Some landlords, however, are set against changes to privity which, in contrast to upwards-only rent reviews, is enshrined in the 1954 Landlord Tenant Act. They say that privity guarantees income and safeguards them against a steady erosion, each time the lease is assigned, in the quality and reliability of tenants. In Scotland and Northern Ireland, there is no privity of contract and tenants have no continuing liability when they assign their leases. But investors enjoy protection which they regard as essential, having the right to stop a lease passing to financially weaker tenants.

While Lay will not commit himself on privity, he is far from ambivalent about the reforms that are demanded in other areas of the commercial lease: 'We do not accept that upwards-only reviews are inflationary and this is something with which the Government should not interfere.'

Lay believes the current system allows the market to react sensibly to prevailing conditions. 'In the 1980s, it was a landlord's market with demand that was greater than supply. But more recently, it has been a tenant's market and occupiers have been able to negotiate favourably.'

Landlords, too, remain entrenched. John Ritblat, chairman of property company British Land, responded after Leigh-Pemberton's speech: 'It was an uninformed, impoverished statement that was greatly damaging to the industry.' Michael Mallinson, a past president of the British Property Federation, representing investors in property, was also condemnatory: 'The Bank appears to be sweeping the carpet from under our feet.'

More recently, The British Property Federation has gone to considerable lengths to show that upwards-only rent reviews are far from inflationary. The Federation published a report saying that the current method of rent reviews in fact exerted a deflationary influence on the market. William McKee, director general of the Federation, says tenants are far from disadvantaged. 'Upwards-only reviews are in the interest of the tenant and occupier. We had some research conducted comparing rental increases under the standard lease with the levels that rents would have been had they been adjusted for inflation. One conclusion we came to was that rents have been running below inflation over the past 20 years or so.'

Investors in property say that any change could severely reduce property values: the impact would go beyond their own industry and damage the entire economy. First of all, any uncertainty caused by the changes could well result in a loss of appetite for property investment among the institutions. The banks, already concerned about how the record £39 billion they have lent to property companies over the last few years will be repaid, would have even less chance of seeing their money.

Secondly, there is a danger that the erosion of companies' asset values could hamper their capacity to borrow, thereby stifling the growth that would spur economic recovery. Commercial property, it should be remembered, accounts on average for 30-40% of a company's assets. Landlords make much of the importance of their security of income. If it is jeopardised by interference with the lease structure, the institutions will be less willing to invest in property and there can only be one conclusion: the supply of property would dwindle and, inevitably, rents for tenants would rise. 'If the laments of tenants win the day, they will actually be shooting themselves in the foot, doing more harm to themselves than good,' remarked one institutional investor.

The arguments cut little ice with tenants who, with few exceptions, view the landlord's interest as incompatible with their own. Already, many leases signed in the past couple of years involve concessions by landlords - such as giving the tenant the right to break the lease after, say, five years - which would have been unimaginable in a stronger property market. But, without the Government's intervention, any reforms are likely to be part of a slow process since, on average, just 4% of leases expire a year. The tenants' best hope is that the property market remains weak enough, for long enough, to force lasting changes on to Britain's commercial lease structure.

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