The decision to ban upwards-only rent reviews will have implications for NAMA, amongst many others, writes ADRIAN TRUEICK.
THE DECISION to introduce legislation banning the provision of upwards-only rent reviews in all commercial leases will have a significant impact on the property market.
The proposed ban will apply to all leases of business premises, including retail, office and industrial. This decision to legislate against a provision that has been standard in commercial leases since the 1960s, in response to what is hopefully a short-term economic downturn, appears shortsighted and will have significant unintended consequences.
The existing lease structure allows developers to secure competitively priced finance and to sell the completed building to long-term investors, including insurance companies and pension funds. Without the security of a stable rent, bank financing will be considerably more expensive and property will be less attractive to passive investors, particularly the pension funds who make up a significant proportion of the market. These changes will impact on the viability of development, reducing the future supply of new buildings.
An adequate provision of new properties is necessary for a developing economy. Many occupiers, particularly the overseas multi-nationals, require buildings that provide the latest developments in technology. Such companies increasingly demand buildings that use sustainable materials, reducing their long term running costs. With few of these occupiers willing to commit their own resources to building their own property, there is a need for a vibrant development community.
Although rents, with or without upwards-only reviews, are likely to increase in line with inflation, potential investors will generally assume a worst case scenario, heavily discounting the value of properties that are subject to “market rent” leases.
It is impossible to calculate the likely discount arising from the proposed change but a 10 per cent reduction in value would be regarded as conservative. More importantly, many of the investors that were attracted to property because of its guaranteed rental stream will exit this market, reducing the number of potential purchasers and damaging values.
The upwards-only lease has long been regarded as a trade-off with tenants for the five-year review pattern. Tenants benefit from a fixed rent for five years, with the landlord forgoing any growth in rents between the reviews. For example, a landlord with a lease that last reviewed in 2004 has missed out on most of the growth in rents during the boom. This may be compared with many European markets where commercial rents are increased annually.
In times of economic growth, tenants benefit significantly from the five-year reviews. Tenants, whose rent has been fixed for five years during periods of growth, have been able to sell their leases for considerable sums. Leases on Grafton Street have routinely sold for premiums of over €1 million, with much of the value attributed to the rent saving up to the next review date.
The proposed change in legislation will particularly impact on developers who have entered into existing agreements for lease. Many such developers have agreed significant compensation packages with their proposed tenants in return for a higher rent.
Such incentive packages can be worth several multiples of the initial rent and were negotiated with the tenant on the assumption that the landlord would have a minimum rental flow for the period of the lease. Without the security of upwards-only rent reviews, developers will find it impossible to finance these payments to the tenant.
The proposed change will also preclude this type of deal in the future. Tenants will no longer be able to secure large inducements in return for agreeing to pay a higher rent as the rent may be reduced at first review.
Even though the proposed change will not be retrospectively applied to existing leases, it will affect all properties. At review, tenants will argue that leases which include upwards-only provisions are penal and that market rents should be reduced. This may lead to a two-tier market, with properties let on conventional leases underperforming newer leases.
The proposed changes will have a negative effect on all developers and investors but the greatest loss will be suffered by the taxpayer. Under the proposed NAMA legislation, the taxpayer is set to become the largest owner of partially developed buildings and sites. Without the ability to let buildings on an upwards-only basis, the value of all of NAMA’s development portfolio will be considerably lower.
Assuming that at least 60 per cent of the €80 billion in property loans to be taken in by NAMA is not subject to an existing lease, the reduction in value to the portfolio will be around €4.8 billion.
In addition, with the likelihood that there will be fewer investors, NAMA’s ability to sell property out of State ownership will be restricted and the timescale for NAMA will have to be extended.
The proposed legislation is a long term solution to a short term problem. No one can doubt that the current economic crisis has severely affected a large number of retail tenants but the proposed change in legislation will not have any immediate effect on these traders. In addition, the proposed change will apply in future to both office and industrial leases, few of whom have had any issue with upwards-only rents.
Economic conditions will improve, leaving us with legislation that has a disproportionately negative effect on the whole property market. The issue of upwards-only rent reviews was never an issue when businesses were doing well and will cease to be an issue when the market recovers.
If the Government is to intervene in the market it should be on the basis of a short term, targeted measure. The cost of doing business is a combination of many factors, like rates, salaries, energy costs, insurance, refuse charges and rents. Many landlords have reached an accommodation with tenants, reducing rents, providing rent holidays and writing off arrears. Many private sector landlords are under the same pressures as their tenants, with many facing higher bank funding costs. Any solution to the problem will have to include the banks.
Adrian Trueick is a director of HT Meagher O’Reilly
