UK: PROPERTY INDUSTRY FEELS A TREMOR. - The property industry is too big and too important a part of the UK economy to be left alone. This was the implication of two recent government statements - making the sector feel on decidedly shaky ground.

by Erik Brown.
Last Updated: 31 Aug 2010

The property industry is too big and too important a part of the UK economy to be left alone. This was the implication of two recent government statements - making the sector feel on decidedly shaky ground.

The UK property industry is still kicking over the traces of the most spectacular crash in its history. Companies once considered invulnerable have gone bust, commercial property values have slumped by 30%, fee income for surveyors and architects has dropped to breadline levels and there is a glut of product: with 32 million sq ft of empty office space in London alone. But there are those who fear that the worst is yet to come.

Commercial property in the UK is bought, sold, traded and leased in a free market. The risk of failure is significant, but it is balanced by the possibility of enormous return. Real estate companies may still be going under at the rate of four a week, but that is the price they have to pay for playing in a market that can make millionaires overnight. We can cope, the industry says, we always have.

The question now is whether it will be allowed to get on with the business of coping. For those at the top of the industry, the clearly-perceived threat of government intervention has suddenly become a frightening reality.

On 31 March, two statements were issued: one by the Lord Chancellor, Lord MacKay of Clashfern, the other by environment secretary Michael Howard. Both attacked what senior property players regard as the principal mechanism by which property investors secure their returns: the commercial property lease.

The announcements followed weeks of lobbying by the British Property Federation (BPF), which represents landlords, and the Royal Institution of Chartered Surveyors (RICS), which represents the largest body of professional advisers. Concessions were made - retrospective changes to existing leases were ruled out, much to the relief of landlords - but underlying the detail of the two statements was the clear implication that the property industry is too important in the economic structure of the UK to be left alone. The real issue is one of control.

The importance of commercial property to the national economy is undeniable. In 1989, the total value of property assets in Britain was £1,280 billion. Commercial property - shops, offices, warehouses, factories - accounted for about £250 billion of that figure. Researchers employed by the RICS reckoned that property accounted for between six and ten per cent of gross domestic product, depending on the breadth of definitions used. They also said that commercial property accounted for 40% of all corporate assets in the UK. Other studies suggest that 70% of all corporate borrowing in this country is secured against commercial property. Any shift in values has a direct impact on the capacity of industry to raise investment finance to fuel growth.

In the current debate, that is both a weakness and a strength: a weakness because it may have suggested to the Government a need to impose controls; a strength because any controls imposed will have a dramatic and, as yet, incalculable effect on values and on the economy.

By way of example, the RICS says that a 10% fall in values would result in a £10-billion drop in corporate borrowing over the next two years. This would have a knock-on effect on GDP, cutting it by 1.5 % - or £9.7 billion over the same period. The industry asks, Can the Government afford to make mistakes on this scale?

Well, perhaps not. But neither, the Government believes, can the impact of the boom and bust cycles in the property market be entirely ignored. Commercial property has a direct impact on the health of the banking sector, for instance. And despite warnings from the Governor of the Bank of England, Sir Robin Leigh-Pemberton, bank lending to property companies rose to a peak of £40 billion before the crash.

Sir Robin was due to address the BPF annual conference in January, but a bout of flu kept him away. His speech was read, instead, by one of the Bank's associate directors, Pen Kent, who suggested that the investment qualities of property had been driven by distortions in the market and pronounced cyclical demand, with the result that 'we have lost sight of the more fundamental productive role of commercial property in the economy'.

It was a chill message for an industry already anxious. 'That speech by the Governor was clearly deliberately placed to start the debate going,' says John Parry, MD of the Hammerson Group and president of the BPF. And it did. Within weeks Parry had fixed a meeting with Pen Kent at the Bank of England to state the industry's case.

The property industry's stance is fairly simple. Businesses need property. The industry exists to supply it. Because British industry and commerce prefers to pour money back into its own business, rather than to tie it up in property development and ownership, property is provided for rent. Somebody other than the occupier then has to build it and finance it and that is an expensive, long-term risk business in which timing is crucial. Investors can be found to provide the finance for development, but they have a right to demand a reasonable rate of return - otherwise they will take their money elsewhere. If they do, values will fall and rents may go up as the investors left in the market seek other ways of getting a return from failing investments. The standard commercial lease was developed as the best way of balancing the interests of investor, developer, owner and occupier, the property lobby says. Any attempt to interfere with it would produce dangerous distortions in a free market business.

The corollary to this argument is that since property is a free market, it has already corrected itself and there is no need for further interference. For the time being, those elements in the commercial lease that have been heavily criticised have already been written out of new leases because tenants can have whatever they want in this market - including long, rent-free periods with a right to quit at the end of even that concession.

Peter Hunt, chairman and MD of Britain's biggest property company, Land Securities, sums it up with force: 'We have created this mess, this industry. It's our fault for creating oversupply. There are reasons for it, but that's not the point. The tenant is entitled to exploit his position in the market place and he is jolly well doing it.

If he doesn't like 25-year leases, if he doesn't like upward-only rent reviews, if he wants his rights to break the lease, he negotiates it. He has his position in the market and it will be dealt with through the market. There is no need for statutory intervention. What politicians don't realise is that statutory intervention in the market can cause the most unforeseen and unfortunate upsets.' The frustration the property industry feels is under-written by a suspicion that politicians and Treasury officials have only a vague understanding of the way the property market works. 'Over time,' says Christopher Jonas, current president of the RICS, 'we do not think the country's economic management has taken account of the movements in capital in the property market, and the values that follow those movements sufficiently.' There is a kind of banana effect, he says, in which the Government introduces a policy without understanding the impact it is likely to have on the property industry; the industry swings upwards or downwards in a long curve as a result, pulling other parts of the economy with it.

Jonas, a man respected for his intelligent analysis and keen perceptions, recites a new litany: 'Changes in house prices affect retail spending. Changes in retail spending affect company profits. Company profits affect demand for commercial property space. Demand for space affects rental values and investment yields. Yields affect investors' interest in property. That affects values and companies' ability to borrow for industrial activity. That affects GDP. Which affects the exchange rate. Which affects interest rates. Which affects house prices.' The cycle is larger than that, of course, since the investors in property include life and pension funds - and, in a direct way, property performance affects savings and pensions. In fact, there are cycles within the cycles. Hugh Jenkins, chief executive of Prudential Portfolio Managers, which holds £3.5 billion-worth of property in its life fund, points out that the British property system is very attractive to overseas investors. Hunt mentioned one English institution that had recently sold £350 million-worth of property to the Germans, but the buyers had demanded the security of property let to blue chip firms on traditional leases; and Parry says at least three transactions by foreign investors had been stalled by rumours of UK government intervention. 'If people are going to be attracted into the market to finance the next generation of building,' says Jenkins, 'then it has to be on terms which provide certainty, security, and wealth for the longer term. And it has got to be free from the anxiety that external forces are going to change the rules again.' There are, inevitably, those radicals who point out that pension funds have reduced their exposure to the market until their presence is almost negligible in real terms and that the industry could probably do without the institutions. Perhaps, some suggest, this really is the time for a restructuring and repricing.

The idea infuriates Hunt: 'It could have an alarming effect on the economy. Look around London and the rest of the country and pick out those buildings that are owner-occupied and those that aren't, which are rented. First of all, you imagine commerce and industry just raising the money to buy them in. How would it affect their balance sheets? Where would the money come from? I mean, the value of rented property throughout the UK is colossal. It would make industrial and commercial organisations less efficient: there is a limit to the amount of borrowings that they can raise relative to gearing ratios, interest cover and God knows what.' Property in the economy may be the subject of the debate. But, so far, the attack has been on key elements of the institutional lease: in particular, upward only rent reviews - which the Bank of England suggests is inflationary - and privity of contract. Privity of contract operates only in England and, in simple terms, makes the original tenant responsible for the rent paid by an occupier he has sold or passed his lease on to. In boom times, it hardly figures: but in the recession, companies that assigned their leases to other tenants who went bust have found themselves facing hefty and unexpected bills. The Lord Chancellor has promised that the law of privity will be reformed as soon as Parliamentary time allows.

Environment secretary Michael Howard, on the other hand, has promised government scrutiny of upward-only rent reviews, confidentiality clauses and the procedures for settling disputes. A consultation paper will be published soon. The BPF says bluntly that reform of the privity law will hit values and discourage investors, while Howard's announcement will 'inject uncertainty' into a market already deeply affected by recession.

One might expect tenants to be gleeful at any criticism of lease structures. And so they are, especially in the retail sector where landlord/tenant relationships are at an all time low. But not all tenants share the same view. Malcolm Ablett, associate director in charge of property at the Hanson Group, has a dual role. Hanson has 600 surplus properties but it is also a tenant and as a tenant Ablett argues: 'I think the property market is best left alone. It's best to let the tenants, investors and the developers to sort the thing out among themselves... Currently it's a tenants' market - and those companies wishing to take professional advice will find that there is plenty of it around. There is no excuse of ignorance. Companies who are not making the most of the current market have themselves to blame, and if they are public companies they should be held responsible for their actions to their shareholders. It's a self-regulating business and I can see no reason for the government to take the side of either developer, investor or tenant.' So, are members of the BPF really frightened for their future? 'Well,' says Parry, 'that's a very emotive phrase. But do people feel under threat? Yes, certainly that is the impression I get from the membership of the federation. They feel that there is a government out there that is out of empathy with the aims of the property industry. A government that is engineering change; change that strikes at the root of our current industry structures.' Whatever the size of the economic problem, politics may still be a determining factor in what happens next. The property industry traditionally votes Conservative, but criticism of John Major's team is growing in the sector. The Government is going to have a difficult job balancing the interests of landlords with those of tenants without losing votes one way or another. The debate continues.

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