May 10, 2020

Time to end the abuse of tenants

written by Lisa Eason

The coronavirus crisis is likely to mark a defining moment in the relationship between commercial landlords and their tenants. Historically, in this crowded country, property owners have held the upper hand, and their dysfunctional connection with tenants has resembled a master/servant arrangement. For example, no other supplier of a product or service receives payment three months in advance, as landlords do; no other supplier has a contractual right to upwards-only reviews in pricing; and no other supplier typically serves a winding-up petition within a few days of the non-payment of a bill.

Tenants have been supplicants: often busy fools making no profits but still having to pay their bullying landlords, come what may. Unquestionably, the relationship has been an abusive one, where the tenant — the one creating jobs and paying most of the tax — is the victim. “More fool they!” cry property owners. Too many tenants, meanwhile, have accepted inducements such as rent holidays and contributions to fit-out costs, without accepting that these goodies will lead to harsher lease terms.

But without occupiers, the property owned by landlords becomes a liability rather than an asset, for the owner then has to pay rates and insurance. Now the tide is turning. In future, there are likely to be new rules of engagement.

The first earthquake has been the structural change in retailing brought about by e-commerce. This technology-driven shift has seen at least a third of overall sales move online, devastating many categories of store-based retail.

Dozens of chains have closed or gone through some form of insolvency — including CVAs, a special procedure that essentially shaves off unaffordable shops. Hence the two biggest shopping-centre landlords, Intu and Hammerson, have seen their shares collapse by 95% and almost 80% respectively in recent months. Investors have recognised that valuations, and old shopping habits and facilities, are broken.

The economics are stark. A typical leisure business might occupy 10 sites and pay a total of £1m in annual rent. That capitalised income stream has an investment value to the freehold owners of perhaps £20m, generating a 5% yield to a buyer. In the desolate market for new tenants that landlords now face, if the operator goes bust the value of those 10 sites, left vacant, might be 40% less than if they were occupied, valuing the assets at £8m less.

In such circumstances, it is definitely in landlords’ interests to make rental concessions and help tenants to survive this tumultuous period. Retail and leisure rents are likely to fall by 25%-50% in the new world of social distancing, consumer timidity and recession.

Sadly, many landlords are simply too mean, cynical, lazy or unimaginative to see the bigger picture. They also frequently fail to do enough homework on the financials of their prospective tenants. Operating metrics matter. Similarly, agents are stuck in their ways, and cannot see that the old operating models and calculations no longer apply.

The property industry needs to realise now more than ever that the landlord/tenant contract must be seen as a proper partnership — one with a degree of mutual dependence. All retail and hospitality leases in future should be focused on rent as a percentage of a tenant’s revenue, so that success (and disappointment) in the underlying operation’s performance is shared. The traditional upwards-only lease is wholly unfit for purpose and should be scrapped. Rent review mechanisms are inappropriate and biased in favour of landlords, who game the system.

Unfortunately, many retailers and restaurateurs think too much about their businesses and not enough about the property they are conducting it from. Landlords think only about property, so out-negotiate tenants much of the time.

The difficulties for landlords do not just concern retail property. The office market, too, will change after the end of the lockdown, because many companies have realised staff can, and indeed may prefer, to work from home. Demand for office space is bound to fall, so rents will need to decline. Companies such as WeWork helped create a bubble — one that I suspect will have a bad ending.

Commercial property owners generally have enjoyed a wonderful decade or more of falling borrowing costs, rising rents and reasonable tenant demand, leading to stellar returns. That boom has died. Sudden structural changes mean landlords must work constructively as partners with their tenants, or face a bleak future of vacant sites and no one to pay the rent.