Consulting » COMMERCIAL PROPERTY – Property on a new footing.

Recession … what recession? Property developers and their advisers are talking down the impact of a possible downturn. But you can still sense their unease. Recession in the early nineties knocked the wind out of the property business for five years or more. Some say it has still not fully recovered. Any kind of downturn shifts the balance of power between property owners and occupiers. Add to that some new thinking among occupiers about how they should handle their property portfolios, and it is quite easy to see why the developers’ smiles are not entirely genuine. Yet look at the latest figures, and there are no signs that occupiers are divesting themselves of property. The CBI/GVA Grimley winter 1998/99 survey of property trends reported stability in the market – a slight rise in property occupation, if utilities are excluded. The survey expects a net increase in property holdings over the coming six months. But Jim Whelan, an associate in Grimley’s research department, admits the next survey, due out in June, could prove a watershed. If the downturn is going to feed through into property, that is when it could start to show. So many property developers burnt their fingers in the early nineties recession, that office development slowed for most of the rest of the decade. As a result, there is not the over-capacity of a few years ago. Even so, because occupiers are becoming more cautious when it comes to property holdings, developers are trimming back their expectations of the rents the market can bear. “There is a nervousness and some of the demands have dropped away,” says Adrian White, national director of agency at Chesterton. “The forecast is for flat or very gently rising rents rather than decline.” But the key point is that the property landscape has changed – and not just through the impact of the last recession. As Keith Blake, chairman of property consultants Fuller Peiser, points out, a combination of low inflation and low interest rates has created a new mindset among developers and occupiers. “We are going to see a fundamental change in the way the property market behaves in future years,” he says. “We have seen historically low interest rates over a more sustained period than for any time since most of us started working in the UK economy.” He points out that a sophisticated property market only developed during the past 25 years – the years of boom and bust. Consequently, the way the property market traditionally operates takes account of that. With boom and bust gone, it will take time for both occupiers and investors to work out how to gain advantage from the new circumstances. Blake says: “If you have sustained low inflation and interest rates, rents will not go up at the same rates. In the past, rents have gone out of control, perhaps doubling every five years. Now, rents will be more subject to the laws of supply and demand.” One consequence of low interest rates is to make investing in property more attractive than it was, argues Martin Francis, a partner at chartered surveyors Weatherall Green & Smith. “Although we are notionally in a recession, finance is relatively cheap,” he says. “So investors and property companies can borrow at low rates and buy properties that might give them a positive cash flow after debt service. One of the big opportunities in a recession, if you are cash rich or can raise finance, is to buy in a weak market at a competitive price. In the last recession, I knew of companies that bought a vacant building, entered a lease and then sold the building with the benefit of a leaseback.” While some companies will remain wedded to the idea of freeholds or long leases, most FDs increasingly look for more financial flexibility in their property portfolio. The idea of being locked into a typical 25-year full-repairing lease with stiff upward rent reviews every five years is becoming increasingly unattractive. And with the need to make all assets sweat during a downturn, property is a good place to start – particularly given that it accounts for anything between 10% and 20% of outgoings in a listed company. FDs and chief executives increasingly recognise that property is a cost area that ought to be subject to as much scrutiny and imaginative thinking as the rest of the business. No wonder one chief executive is said to have called property costs the “next frontier” for efficiency improvement. One idea is to get property off the balance sheet so that assets as a whole are seen to work harder (see box, overleaf). But new changes in accounting rules, such as FRS 12 (see box, right), mean that the costs of property can now inflict painful hits on the balance sheet. Indeed, a suggestion from the Accounting Standards Board that capitalisation of lease commitments should be reflected in the balance sheet could have a major effect on many companies. As Chesterton’s White points out, FDs and chief executives should be using the time now to plan ways to reduce the impact this could inflict. One way, says White, is to try to restructure leases either with an existing landlord or with a new investment or finance partner. “If you are putting property into the hands of a property partner, you may be passing it to an organisation that better understands it,” he says. Alongside the property’s underlying financing, services such as facilities management may control operating costs and help to use the space more efficiently. Another issue for FDs is what to do about FRS 15, which applies to all tangible fixed assets except investment properties. According to David Tuckett, head of corporate appraisal at Fuller Peiser: “Companies must decide whether to revalue or not. If not, they use the cost of the asset and then depreciate it. If a company elects to revalue, it will have to do a full valuation every five years with an interim review at year three and further reviews in years one, two and four.” Tuckett suggests that companies which choose not to revalue may, over time, seem less attractive to investors than those that do. He says: “There will be an increased incentive for companies with extensive freehold property to take these assets off the balance sheet by leasing and finance transactions.” Fuller Peiser’s Blake says that companies should not be afraid of selling property. “There are certainly indications that companies feel uncomfortable having large portfolios of property on their balance sheet. They need to address the issue because the bottom line will demand they address it.” He adds: “A company in, say, manufacturing, doesn’t need to own property because that is not its core business activity.” He points out there are a growing number of ways of raising capital against a property that can also strengthen the company’s balance sheet, and cites structured finance transactions – another piece of financial engineering being imported from the States. The principle is to loan money against a property, based on the credit-worthiness of the owner. Yet Blake also warns about one danger of losing control of a freehold or long lease. For example, if the area in which a factory is situated changes character – perhaps it develops more retail space – the site your factory is on could suddenly become more valuable for a different use. The question of ownership comes down to balancing a range of factors. The question of making property work harder does not only revolve around finance. There is also the question of making sure the property serves the business’s operational needs. Blake notes a trend among occupiers and investors to work more closely together than in the past to ensure that a building is designed for the occupier. “I wouldn’t say it is necessarily bespoke, but it is tailored to the needs of a particular sector,” he says. White agrees that property can have a “material impact on the operational efficiency of a company”. He says: “I know a number of companies that are reinventing themselves by putting people into new premises to help create culture change and introduce new working methods. If they tried to introduce those changes within their existing property, they would find it a lot more difficult.” This is a key point. For all the fancy new financial engineering likely to appear around property in the next few years, the critical point is that the buildings ought to be an effective – even attractive – place to work. FRS 12 HITS THE BALANCE SHEET New accounting standard FRS 12 could clobber smaller and medium-sized companies planning to move property. The standard says companies which are legally or constructively committed to a course of action that is likely to give rise to liabilities must make provision. The knock-out blow is this: vacant or property sub-let at less than cost may require large provisions, all taken in the year the liability is acquired. The result is that some companies could find their profit wiped out, according to Mike Harvey, a director of DTZ Pieda Consulting, who has studied the issue. He explains: “In the past, the effective loss on holding property, whether vacant or sub-let, could be spread over a number of years rather than hitting the profit and loss account on day one. “The new standard requires an up-front provision for the future costs of a lease on a vacant or sub-let property. Once management has committed to vacating a building, it must estimate the liability from an onerous lease.” Because many companies own leases negotiated in the boom days of the late eighties, they are expensive by today’s rent levels. Harvey reckons FRS 12 could increase pressure from occupiers for shorter leases. He points out that in the US, which has had a similar accounting standard for years, leases of five or ten years are common. LEARNING FROM THE DSS When it comes to property management, could the Department of Social Security have something to teach the private sector? In the Prime Contract, which was set up under the Private Finance Initiative, the DSS has shifted the financial risk and management of its 827 properties to Trillium, a serviced office and property investment group, run by Martin Myers and Manish Chande. The DSS is claiming that its annual occupancy costs have been cut from £350m to £275m a year, and that it is reaping other benefits such as not facing the hassle of keeping the properties up to scratch. The DSS does not even have to change a light bulb – employees just ring Trillium. Not surprisingly, Chande believes the DSS’s approach is “extremely relevant” to the private sector. He points out that property assets represent 44% of aggregate net book value of top FTS^E100 companies. Shifting some of that off the balance sheet could achieve two objectives. First, it would release capital that could be applied in the core business. As property traditionally produces a poor return on capital employed (ROCE), redirecting the cash could improve the overall performance of this measure in the company. Secondly, it could turn the uncertain costs of property ownership into the more predictable expense of property occupancy. Chande also says that because Trillium is a specialist, it can manage an estate more effectively. A key benefit – especially during an economic downturn – might be disposing of surplus property. For example, the DSS identified that only 60% of its property was core, 31% fell into a vague “may or may not be needed in the future” category, and 9% was definitely surplus. The deal was structured so that Trillium could dispose of the surplus property immediately and the DSS could vacate a further 2% of the estate a year without penalty. If it does not quit, that space is shunted into a “flexible space” category, which it can leave at any time in the future. And while this happens, monthly payments by the DSS to Trillium are adjusted accordingly. Chande reckons this certainty with flexibility could appeal to the private sector. “Wouldn’t you like to plan one of your major overheads and know exactly how much you are spending? Wouldn’t you like to hand over surplus property and leave somebody else with the problem of dealing with it?” It sounds attractive, but there are a couple of reasons why only a few large companies may be knocking on Chande’s door. First, private sector companies are more likely to have an eclectic range of property – from factories to depots – as well as offices. So far, Trillium has only made this approach work on offices. Secondly, the culture of property ownership runs as deep in corporates as it does among householders. Owning title to the bricks and mortar creates a feeling of security. Changing that could prove tough.