Week 35 Lecture

Tenant Incentives

What is an incentive?

Leases are often created in a simple form - a defined number of years at an agreed rent, often with upwards only reviews to Market Rent at predetermined intervals.  However, in the UK, letting practice has become more complex for two principle reasons:

1. The UK property market has entered a period of sharp decline (driven by economic recession), and tenants now have the upper hand in lease negotiations extracting concessions from landlords known as lease inducements or incentives.

1. Commercial occupiers have become more mobile, and their business models require flexible leases to facilitate fast paced business development in response to competition, product innovation and cost reductions.

Lease incentives can take many forms, but amongst the most common are:

·           Rent free periods in excess of the 6 months normally allowed for fitting out

·           Cash payments (or reverse premiums) by landlords to incoming tenants

·           Payments in kind to the tenant e.g. fitting out works

·           Break clauses in favour of the tenant

·           Staggered or stepped rents e.g. pre-agreed increases in rent at future dates

·           Caps on future rent reviews

·           Taking over existing lease liabilities for tenants

Landlords prefer to grant concessions (such as prolonged rent free periods) rather than simply accept a reduced rent, for several reasons:

a)        Agreement to pay the artificially high rent or headline rent is a long term commitment by the tenant.  Under a standard upwards only rent review clause, the tenant is locked into paying the inflated rent for the duration of the lease, or until Market Rent grows to overtake it.  In contrast, the landlord only has to pay the incentive once.

b)        The landlord, rather than letting at a low rent, achieves apparently high rental evidence which may influence the rent reviews of other property he owns in the locality.  Such lease inducements are often clouded in secrecy with only the headline figure being made available.

c)         Many landlords believe that the building has a higher Market Value (even net of incentive payments) than if it were let at the lower 'true' Market Rent.  Certainly the Market Value will be higher once the initial inducement has passed. 

It is worth noting that any property let at a headline rent, in excess of its Market Rent is immediately an over-rented property and needs to be valued accordingly.

Net Effective Rent

In a market such as that of today, or in the early 1990’s in the City of London (where office rents fell by more than 50%), most new lettings are at headline rents subject to some sort of incentive.  Valuers involved in rent reviews or valuations in these markets need to analyse headline rents and incentive packages in order to find comparable evidence for Market Rents.

The question is, what rent would have been agreed by the parties to the lease if the letting had not been subjected to incentives?  This rent is known as the net effective rent.

There are several different methods of analysing transactions to ascertain a net effective rent, and four approaches are identified by the RICS in Valuation Information Paper 8 (RICS, 2006):

1. Rent and value apportionment not assuming the time value of cash flows (straight line or simple method of analysis)

1. Rent and value apportionment assuming the time value of cash flows (discounted analysis)

1. Comparison by reference to effect on investment value (the assumption that market evidence for similar properties will also be over-rented in a weak market, and therefore evidence will already reflect the market’s perception of risk)

1. A DCF approach (assumptions are explicitly stated and different prospective cash flows mapped out)

Some of these methods can be approached from two sides, particularly when the objective is to analyse a comparable letting to inform a rent review negotiation:

·           Landlord’s perspective - where the valuer will seek a method of analysis which gives a high net effective rent, near to the headline rent

·           Tenant’s perspective – where the valuer will seek a method of analysis which gives the lowest net effective rent possible

On the other hand, when the objective of rental analysis is to estimate Market Rent for the purposes of valuing a similar property, the valuer needs an unbiased method.

Simple Analysis of Net Effective Rent (Straight Line Approach)

We will examine the various methods of valuation recommended by RICS Valuation Paper 8 (2006), starting with an example of the simple analysis of net effective rent:   

We need to start by analysing the comparable fourth floor letting from the landlord’s perspective.  He wants to produce a high net effective rent to support his stance in negotiating a rent review on another office building in Charlotte Square.  He can argue that the inducement is to persuade the tenant to pay the headline rent for the whole of the 15 year lease, through the mechanism of the upwards only rent review.  Therefore the effect of the inducement should be spread over the entire lease:

The tenant, however, will suggest the value of the rent free should be analysed only over the period to the first rent review i.e. 5 years:

These two opposed ways of analysing the net effective rent give two very different outcomes.  They serve the needs of the landlord’s and the tenant’s surveyors in arguing a rent review on a similar building, but are not helpful to a valuer wishing to find evidence of Market Rent.  In this situation, the valuer will have to arrive at a view of the appropriate figure somewhere within this range, based on evaluation of the circumstances.

Problems with the simple approach

Whether analysing from the landlord or the tenant’s perspective, the simple method is inadequate for two reasons:

i.           The simple approach ignores the time value of money i.e. £1 received today is worth more than £1 received in the future

1. The simple approach ignores the fact that Market Rent will grow and eventually overtake the headline rent.  Quite when this will happen depends on several factors:

­        The magnitude of the inducements - larger inducements mean that Market Rent is well below the headline rent and so will take longer to catch up

­        The supply and demand imbalance in the submarket

­        The level of future economic growth and its result on tenant demand and ‘take up’ rate

Discounted Analysis of Net Effective Rent

Lettings with inducements can also be analysed using the same principle as the simple approach, but this time including discounting to allow for the timing of rents:

Instead of simply multiplying the rent by the number of years it is paid, we can replace this with Years Purchase Single Rate to account for the timing of the rents:

As before, the tenant will suggest the value of the rent free should be analysed only over the period to the first rent review i.e. 5 years:

Problems with the discounted approach

In Example 2, we use an All Risks Yield to discount the rental amounts, but it can be argued that the rent is certainly going to be fixed until the first review and could indeed be fixed for much longer, depending on the degree of over-renting.  Since the incomes being discounted are therefore more in the nature of a fixed income bond than a growth property-style income, it can be argued that they should be valued at an equated yield: a bond yield adjusted upwards to reflect the additional risk of property investment.

Using DCF to Analyse Net Effective Rent

In some cases, a valuer will analyse a headline rent to find net effective rent so that it can be used to estimate Market Rent for another property being valued to Market Value.  In such cases an unbiased estimate of Market Rent is required, and the valuer may resort to using the extreme landlord and tenant perspectives to arrive at a compromise figure.

This is effectively a recognition that both extreme views (i.e. writing off the inducement over the whole lease or writing it off over the period to the first review) are incorrect. It recognises that the headline rent should be written off for some period in between the two, where the headline rent is likely to be overtaken by the growing Market Rent.  In that case, the compromise is justified in theory, but is inexactly calculated.

Advocates of the DCF growth explicit approach to analysing net effective rent, seek to investigate exactly when Market Rent will break through headline rent, and the effect of choosing it as the basis for writing off the inducements.

We will apply the DCF approach to the Charlotte Square office letting:

Initially, we need to estimate a point at which the Market Rent will pass through the headline rent.  In this example, we could trial the breakthrough point at the second rent review.

We assume that the landlord is indifferent whether he receives

Scenario A:  Market Rent on standard lease terms from Day 1

or

Scenario B:  Headline Rent of £130,000 per annum with 2 years rent free

Therefore, the value of the two scenarios should be the same and we can calculate the value of each scenario and put the two values together in order to find the Market Rent:

Scenario A

Market Rent                                                      £MR per annum

YP in Perp @ ARY of 8%                                 12.5

Market Value                                                    12.5MR

Scenario B

On the basis that both scenarios are worth the same to the landlord:

£573,139 + 6.1685MR (Scenario B) is equal to £12.5MR (Scenario A)

£573,139                              =             12.5MR – 6.1685MR

£573,139                              =             6.3315MR

MR                                         =             £573,139 ÷ 6.3315MR

Market Rent                                      £90,522 per annum

However, the assumption that the Market Rent, growing at 2.5% per annum, breaks through the headline rent by the second rent review must be double checked.  Does it cross, if it starts at £90,522 and grows at 2.5% per annum?

(1.025)¹⁰ x £90,522 per annum = £115,876 per annum

The Market Rent would only grow to £115,876 per annum by the second rent review so it would not exceed the headline rent of £130,000 per annum, and it’s clear the trial assumption regarding breakthrough was wrong.

We must try again with the crossover rather later, say, when the lease ends in Year 15.  This involves modifying the valuation of Scenario B (Scenario A’s value remains unchanged):

Scenario B

On the basis that both scenarios are worth the same to the landlord:

£763,132 + 4.3340MR (Scenario B) is equal to £12.5MR (Scenario A)

£763,132                              =             12.5MR – 4.3340MR

£763,132                              =             8.1660MR

MR                                         =             £763,132 ÷ £8.1660MR

Market Rent                                      £93,452 per annum

Checking that the new breakthrough assumption is correct:

(1.025)¹⁵ x £93,452 per annum = £135,346

This accords with the assumption that breakthrough occurs at the end of the lease.  The result does, as expected, fall between the extreme landlord and tenant views.

DCF methods can be used in this way to arrive at an unbiased analysis of net effective rent, theoretically suitable as the basis for deriving Market Rent.  The DCF method is rather cumbersome and although one version of it is demonstrated in RICS UK Guidance Note 6 -  Analysis of Lease Transactions in reality it is probably little used in the profession outside the realm of the more sophisticated investment markets.