Changing rent reviews will have serious consequences

 

Moving to end upward-only reviews for existing leases must be fully debated

THE PREVIOUS government abolished upward-only rent reviews (UORRs) in new contracts but left existing ones untouched upon advice from the Attorney General that interference with them would be unconstitutional.

This Government proposes to go further, and has committed, in the programme for government, to “legislate to end upward-only rent reviews for existing leases”.

Draft legislation is due shortly, and the general expectation is that commercial property tenants will be allowed break contracts and reduce their annual rent bill.

Such legislation would be among the most radical ever introduced in this country, yet has had little or no debate or analysis. It has potential to transfer a huge amount of money from taxpayers to people who do not need it.

The basic issue is similar to mortgage debt forgiveness – to distinguish between those who need and do not need rent relief.

Economic consultants DKM undertook a study for the Irish Association of Investment Managers (IAIM), but its contents are more guarded than the third secret of Fatima and the major property interests have been silent, in public at least.

A report by Colm McCarthy for Retail Excellence Ireland argued all costs and rents need to fall as Ireland seeks to regain competitiveness, and noted the Government, a major renter, would gain. So far, the running has been made by a small number of high-profile Grafton Street retailers and retail bodies which have taken out newspaper ads reminding the Government of its commitments.

A brief look at the background helps to contextualise the debate.

Retail property values rose six-fold between the mid-1990s and 2007 – see Chart 1.

Since that year they have fallen by two-thirds, reversing all gains since 1999, and with a further 20 per cent decline in prospect if UORRs are banned. The latter calculation is by Investment Property Databank (IPD), which produces global property indices.

Movements in retail rents have been less extreme – they merely tripled – but have since fallen by 36 per cent. If they, too, were to fall by another 20 per cent, values and rents would have merely matched inflation over the past decade and a half, with no rise in the real value of retail property, a remarkable rollercoaster ride.

The McCarthy report opens by saying prime Dublin rents rose by 240 per cent between 2000 and 2007 – this is based on CBRE data for prime quoting rents for Grafton Street, which is not representative of the country. IPD data show an average 71 per cent rise in retail rents in that period.

The experience of the other commercial sectors has been less extreme. Office rents increased by less during the boom but have fallen by more and are now unchanged in inflation-adjusted terms by comparison with the mid-1990s. Industrial rents rose least, fell the most, and are now back where they were in 1995, a 50 per cent fall in real terms. The problem, if there is one, seems to be in the retail sector only – the Government’s intention is to ban UORRs in all three sectors.

Rents in the retail sector have fallen sharply, but this will only be reflected in new contracts as existing ones may have years to run and will have UORR clauses which will prevent reductions in the absence of agreement between the landlord and tenant and/or a decision to quit.

The most controversial claim so far has been the Retail Excellence Ireland contention that altering existing UORR retail contracts could create 20,000 jobs and/or save 30,000 jobs.

Chart 2 shows trends in retail sales and employment since 1998. It is obvious that one tracks the other and that the fall in retail employment – 15 per cent, or 38,000 jobs – is fully explained by the decline in turnover.

That employment should track sales is no surprise, particularly as rents are a small percentage of turnover – McCarthy quotes 15 per cent, employers’ group Ibec say up to 20 per cent, but industry sources put it at 3 to 7 per cent.

The impact of rents on employment is not discernible at the overall industry level, though undoubtedly they were important in some reported cases, notably Carluccio’s restaurant in Dublin, which had to close briefly before the landlords realised a lower rent is better than none at all.

It is fantasy to suppose the proposed changes could offset the bulk of the job losses recorded to date in the absence of a recovery in turnover to previous levels.

The costs associated with the proposal are major. Some years ago, unguarded comments from Michael McDowell on stamp duties caused a freeze in sales in residential property. Something similar has now happened to commercial property.

The number of transactions bottomed out at 13 in 2009 – see Chart 3 – but recovered to 29 in 2010 as investors perceived value.

Many of these were foreign, in contrast to earlier years when purchasers were exclusively Irish – in 2010, foreign purchasers accounted for almost one-third of the spend. The uncertainty due to the proposed legislation snuffed out the recovery, and the first half of 2011 saw three transactions – with two being tenants purchasing the premises they rented.

The biggest known casualty so far has been the Liffey Valley Shopping Centre deal. UK investors were bidding €350 million, but it fell through because of the prospect of lower rental income. There were others.

Retrospective changes to contract law are controversial. Differing legal opinions are no great surprise, but amendment of UORRs is so radical and potentially costly that it would be challenged in the courts, thereby engendering further delay.

It is by no means certain the Government would win such a case. If it failed, it would have to compensate landlords for lost rent, exposing it to a €1 billion to €2 billion annual cost. I am not sure whether claims for loss of capital would be entertained; if they were the hit could be much greater – one report suggests the total fall in values could be as high as €14 billion.

Whether the Government won or lost, there would still be huge costs for taxpayers because of further falls in the value of what is effectively State-owned property.

In May 2010, the chief executive of the National Asset Management Agency (Nama) wrote to the then minister for finance pointing out a change in the law would mean they had overpaid banks for assets bought. It has been reported a further 20 per cent fall in Irish property prices would cost Nama, and therefore taxpayers, another €2 billion to €2.5 billion.

Also, Anglo and the other State-owned banks have large exposure to Irish property, which could cost several billion more. The stress tests have allowed for extra falls in commercial property prices, any generalised scheme could quickly erode existing capital buffers in the banks to the ultimate detriment of taxpayers.

Pension funds and insurance firms are big property investors. Pension funds have €5.5 billion in Irish property. Their assets would fall by more than €1 billion in value and their annual income by a few hundred million euro.

Nobody would argue with McCarthy’s contention that costs should fall in the interests of competitiveness. However, his argument is diluted by the fact retail is the least internationally exposed sector, and his view that Government would gain from a lower rent bill is overwhelmed by the vastly greater costs incurred.

The consequences are so extreme that a retrospective amendment of existing UORRs should only be entertained if it is necessary on hardship grounds. Yet the retail industry lobby has ignored this matter, focusing instead on unrealistic job claims.

I did find one attempt to shed light on this area. CBRE surveyed 136 retail properties in Wexford, a typical country town. It is a pity they did not do Grafton Street as well. They found 45 per cent of businesses were owner-occupied, so for them the UORR debate was in one respect irrelevant. In another respect, a ban would reduce the value of their property by another 20 per cent.

Another 25 per cent were on new leases, at open market rent, while a further 13 per cent had not sought rent reviews.

Wexford is atypical in that few multinational retailers are located there. This is another category, size unknown, but substantial, that does not need rent relief.

The second finding by CBRE was that 80 per cent of the tenants who sought relief had been given it, with only three cases, 2 per cent of total retail units, refused.

This indicates landlords are taking a pragmatic approach, irrespective of the law. It has been reported that Nama also found rents had been reduced on the properties transferred to them.

So, the only, evidence available indicates some tenants are having difficulty with fixed rents but the percentage is in low single digits.

What is needed is a mechanism to quickly bring recalcitrant landlords to their senses and, failing this, an effective appeals/arbitration scheme.

General provisions that would have the effects of benefiting a majority of tenants not requiring such support, that would damage pension funds and insurance companies, expose the legislation to constitutional challenge, further damage the reputation of Ireland as a place to do business and expose the taxpayer to large potential bills should be avoided.