Walls come tumbling down
Mark Preston compares the UK’s commercial property section with the rest of the Continent, where differences are lessening
A traditional image of UK commercial leases as opposed to those in Continental Europe would show them to be so divergent as to be different types of legal instrument entirely. An overview of the property markets would also show more differences than similarities. After reviewing these different pictures and their implications, we will describe how some convergence between the two is happening more rapidly than might have been imagined a few years ago – and because of very different, though allied, pressures.
A typical UK commercial lease – at least until a few years ago – was of 25 years’ duration with regular market rent reviews, upwards only, every five years. It was on full repairing and insuring (FRI) terms, putting the onus for the upkeep of the building effectively entirely in the tenant’s hands. Counteracting this cost, there would be relative security of tenure at the conclusion of 25 years. UK leases were designed to offer a long period of security to the tenant and a high degree of profitability to the landlord or investor who could foresee rents increasing above inflation for very little capital investment, once the freehold of the building had been secured.
The Continental European-style lease – and all the major European markets for these purposes are closer to each other than the UK – could not have been more different. A three to five-year “term certain” lease was the norm in these markets. It offered no security of tenure, fixed or index-linked rents were standard, and the burden of repair and maintenance fell almost entirely on the landlord, although recovery was partially possible through the ubiquitous service charge. This model was very attractive to tenants, perhaps less so to investors.
The paradox is that the UK lease model has given the UK investment market a greater degree of elasticity. The reason is only partly provided by the attractions of the bond-like characteristics of these leases. Transparency, liquidity, high turnover volumes, relatively benevolent taxation and the sheer size of the London market have conspired to achieve this also. In doing so, the UK has attracted larger volumes and a greater range of foreign capital over a more sustained period than any other European market. This in turn has led to even greater liquidity and so on, in a virtuous circle. The result is that the UK is an easy and flexible market to enter.
Even five years ago this could not be said of a market as sizeable and sophisticated as France, which has a great metropolis at its core. French property investment was mainly for French institutions, with some exceptions, notably the Dutch and, in the late 1980s and the early 1990s, the Scandinavians. The most sophisticated and largest European market, Paris, commands rents a third lower than central London. Speculative office starts are mainly confined to the suburbs, and typically have run at an annual total level of between 390,000m2–500,000m2 across the Paris conurbation. Central London alone saw a total 1,200,000m2 in 1998. Volumes of investment turnover are considerably lower on average in Europe, and transparency is widely believed to be lacking.
Aside from these issues, one of the biggest differences between Continental Europe and the UK has been their tax regimes. The UK transfer tax (or stamp duty) is at an historic high at 3.5% currently, matched only by Germany. French rates by contrast have only fallen to a favourable rate of 4.8% this year from their more normal level of 18.6%. The rates of transfer tax in other major European markets range from Spain, 6%, to Belgium, 12.5%. All these figures seem to represent an extra disincentive to invest and an extra barrier to market liquidity. However, corporate transactions are far more prevalent on the continent to avoid the need to transfer property titles and, increasingly, the need to di-versify has overridden such obstacles.
In summary, when they turn to continental commercial property markets, international investors such as ourselves typically faced low volume, smaller markets with somewhat less transparency than in northern Europe. This has been fed by – and been a cause of – a dominance of a local investor base and a smaller overall market leading to a greater risk, particularly in southern Europe. On balance, attractive returns have offset this risk in recent years.
Yet ironically, UK tenants’ desire for greater flexibility has already led to a shortening of the 25-year term described earlier (it is more typically 15 years now), and to a booming demand for serviced office space and even shorter-term accommodation. In a world of globalisation and ever -fiercer competition, the typical UK lease is being driven closer to the European model, at least regarding leases.
At the same time, a relaxation of prohibitive tax regimes led by France and Germany, a move to consultancy culture (fed in part by a tradition of professional advising in Britain) has led to a greater willingness to invest, more joint venture activity and a more transparent commercial property regime in Europe.
Ironically, the very same global concerns and more febrile international business picture has led to these changes. For investors such as Grosvenor looking to coinvest with institutional capital in markets that they understand and in which they have management experience, there are some bright prospects as this cross-border investment intensifies.
Are we then seeing a period of convergence of these two distinctive lease patterns which have sprung from two quite different legal traditions? The differences, although not as bald as the traditional picture outlined at the opening of this piece, are still very apparent. For some, the UK – and the London market in particular – remains one of the most attractive destinations for European institutional investors.
But the more competitive tax and operational structure now emerging in Europe is making it a more attractive destination for institutional investment. It may not be convergence yet, but in an increasingly globalised economy, it does represent cross fertilisation on a scale and of a kind never seen before. Also, as perceived risks converge, so will return expectations.
Mark Preston is director of asset management at Grosvenor Investments, part of Grosvenor Estate Holdings