In preparing its window display to attract cross-frontier investment flows, the one thing the UK real estate industry has lacked in recent years is evidence of growth. The development of property derivatives and other types of financial engineering in property could never prove a total substitute for this essential element.
Now Investment Property Databank (IPD), which monitors the performance of more than £50bn ($80m) worth of institutionally owned commercial property in the UK, has revealed that rental values rose last year for the first time since 1990. Rents are the motor of growth in commercial property. Though the rise was comparatively modest, at 3.1%, the best of it came in the latter part of the year, perhaps paving the way for rising capital values.
There is evidence that funds from outside the UK were ahead of the game. Direct overseas investment in UK commercial property rose to £2.16bn ($3.4bn) in 1996 according to London agents DTZ Debenham Thorpe. If one large and untypical transaction that distorted the 1995 figures is ignored, this represented a more than doubling of the inflow between 1995 and 1996.
Investment from Germany was by far the largest single constituent, accounting for £1bn ($1.6bn) of the total. The German open-ended funds were again the major players. Other European countries accounted for £312m ($500m), with Sweden significantly stepping up its activity.
The cross-border investment flows suggest that UK commercial property practitioners may have been worrying unduly about some of the market changes brought about by the collapse in rents and values in the early years of the decade. For the UK property market is a very different animal from what it was 10 years ago and direct comparisons of rents and yields with those of a decade back need treating with caution.
One of the strengths of commercial real estate in the UK was the traditional institutional” lease pattern. The domestic life assurance companies and pension funds liked to invest in buildings let to a single tenant for a term of 25 years. Rents would probably be reviewed only every five years, but the review was usually “upwards only”. In other words, the rent could rise at the review point but it could never fall during the term of the lease - always provided that the tenant remained solvent. UK property thus offered a one-way bet that was generally unobtainable elsewhere. Rents would rise to reflect growth in market rates. They would not, as elsewhere, fall if the market rate fell.
This lease pattern came under attack in the 1990s property market slump, which saw rental values fall by over a quarter on average across the board and by about half for City of London offices. Many office tenants who had agreed rents near the peak of the market in the late 1980s thus found themselves committed to paying almost double what they would have had to pay if they had been free to go out into the market and sign up another building from scratch. This gave rise to the phenomenon of the “overrented” property: a property let at a rent above the market rate, where the landlord risked a significant fall in his income if the building became vacant and had to be relet at a market rate: either because the lease came to an end or the tenant became insolvent. Such properties offered high initial yields to investors but also significant risks and restricted prospects of growth. The German funds were, however, significant buyers of this type of property.
The other main area of concern during the market collapse was the principle of “privity of contract” under English law. This meant that tenants who assigned their leases to others remained ultimately responsible for observing the terms of the lease - including paying the rent - if subsequent tenants defaulted during the term of the lease. The principle increased the property-owner’s security of income, but in the market collapse it proved a heavy burden on some former occupiers who found themselves saddled with paying the rent on a building long since vacated.
Abolish the traditional features of the UK property market, the domestic property industry argued, and the flow of funds into the business would be curtailed. In practice, the UK government declined to outlaw the “upwards only” provision in rent reviews, though it abolished the “privity of contract” principle for new leases signed after the beginning of 1996. However, landlords could still insist that a tenant who assigned a lease provided a guarantee for the immediate assignee, though not for subsequent assignees down the line. The greater bargaining power of prospective tenants during the slump saw lease terms reduce from 25 years, with shorter leases and break clauses becoming common, but the principle of “upward only” rent reviews was vigorously defended.
Thus it can be argued that there has been some reduction in the security of income offered by UK property leased under the new conditions, though there are still many properties subject to the older pattern of lease. A 7% yield on a property in 1985, with a 25-year lease, upward only rent reviews and the protection of the privity of contract principle is not the same thing as a 7% yield today on a building leased for only 10 years and with no privity of contract protection.
But markets can adapt. Buyers may reasonably expect a higher initial yield from a building leased for 10 years than one leased for 25 years because of the different security of income. They would certainly expect a higher initial yield from an overrented property than from one let at today’s market rate. Distinctions between rent (what the tenant is paying) and rental value (what a new tenant might expect to pay) have acquired a new significance.
It is reassuring for the UK property industry that overseas funds do not appear to have been discouraged. Rather the opposite. And DTZ points out that German open-ended funds that were earlier buying overrented offices for the yield - almost a bond-substitute - are now buying more for growth and diversifying into shopping centres and other types of property. Overall, UK commercial property values edged up by a mere 1.6% last year according to IPD, to give total returns of just over 10%, which were still comfortably beaten by equities. But the tide could at last be moving in property’s favour. Certainly, some continental European funds seem to think so.
Michael Brett is a freelance journalist and author of “Property and Money”.”