The Only Way Is Up, Summer 2012

Report Summary:

Offices

Since 1992, there have only been a few occasions when office rental value growth over a five year period has consistently been higher than RPI inflation. Constraints on supply due to a more restrictive planning regime have seen West End rents outstrip inflation over the five year periods to 2008 and 2009 respectively but the subsequent economic downturn means that the net increase in rental values by 2015 will be small. In the current office market, in the City and outside of London in the secondary market in particular, there is very little business sense for an occupier to agree to RPI linked rent reviews given the likely movement of average rental values. If a tenant is on these terms, there is an increased risk of break clauses being taken where available, especially as it makes assignment or subletting even more difficult if the occupier finds itself in difficulty.

Retail

Problems on the high street and retailers going into administration are attributed in part to the leasing agreements in place. With the possible exception of retail warehouses where average rents are set to rise by 9% in the five years to 2017, RPI inflation linked rent reviews are unsuitable for standard retail and shopping centres. By moving to a system of upwards or downwards open market rent reviews or a system based on turnover, the risk of defaults on rent payments decreases, whilst maintaining income for the investor that will increase in line with any upturn.

Industrial

In the past 25 years, average rental values in this sector have risen 60%, compared to 140% for RPI inflation. Even on closer inspection, five year average growth has consistently been below RPI inflation with a few minor exceptions. Headline rents have remained subdued as a result of over supply in many markets, whilst the increased use of inducements has also kept average rental values down. Many leases signed on an UORR basis in the early 1990s will have seen rental commitments change very little, having been over rented until the late 2000s, a problem now affecting recently signed leases on RPI inflation linked reviews.

Conclusion

At face value, investors always look to create maximum value for their asset and our analysis supports the theory that an investor should insist on RPI inflation linked rent reviews to do this. Yet to do so would be disadvantageous for any occupier. Many investment decisions are being taken on the basis of covenant strength yet a tenant in an over rented property subject to RPI inflation linked rent reviews will encounter greater difficulties than a competitor on an alternative measure. With the greater prevalence of shorter leases and rental values still below peak highs, it could be argued that a true UORR no longer exists. For many leases granted in the current market, the tenant can effectively incorporate an upwards/downwards rent review by negotiating a lease term of less than five years. The use of short leases, particularly in secondary properties across all sectors, negates the need for a tenant to commit to UORR or RPI inflation linked increases.

About the Author:

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