"Effectively, up until now, a major attraction of the UK real estate market has been that the revenue generated is relatively certain. With UORRs, it is not possible for rents to go down, which, depending on market conditions, can introduce volatility and reduce income certainty from leases, an important factor for long-term investors and lenders"
- Oliver Spero and Jack Thompson - Hartnell Taylor Cook
The Government’s English Devolution and Community Empowerment Bill sparked concern in the commercial property sector with its proposition to ban upwards-only rent reviews (UORRs) earlier this year. While previous attempts have been made to make such proposals law, the Bill’s recent progression to the committee stage brings it one step closer to reality.
The immediate knee-jerk reaction from the sector has been negative, with many heralding the potential ban as the end of the stability of commercial property as an investment.
But while prospects might look bleak, it’s also important to recognise the inherent strengths of the UK market and its resilience in dealing with such blows. Although some issues are likely to arise, in the short term at least, the market’s adaptability and stability mean that in the end, the ban is not likely to bring the upheaval some predict, and in actual fact, may present opportunities for innovative landlords.
Short-term pain
In the short- and medium-term, the greatest impact of the UORR ban is likely to be its indirect effect on the value of property in the commercial market. The lack of consultation before the ban was announced has created some alarm among investors, and if implemented, this will likely lead to a greater perception of risk. Given the high levels of uncertainty in the market at present, the prevailing feeling among many investors is likely to be anxiety about the impact the ban might have.
We may also see changes in lease terms as landlords increase initial rents in response, shorten lease lengths or opt for fixed or stepped rent increases instead of reviews to protect income. Such adaptations might reduce long-term flexibility or market appeal, influencing investment returns.
Effectively, up until now, a major attraction of the UK real estate market has been that the revenue generated is relatively certain. With UORRs, it is not possible for rents to go down, which, depending on market conditions, can introduce volatility and reduce income certainty from leases, an important factor for long-term investors and lenders. Should investors continue in their grim perception of the market, spurred on by anxiety of the ban’s impact, then property values may well be reduced in the short term.
Long-term gain
Nevertheless, while the initial impact might be a negative effect on property values, the strength of the UK market means it is unlikely that this downturn would last for long. The major pillars of the UK market that make it so attractive to investors, namely its transparency, fluidity, and the rule of law, will continue to be a draw to investors in this sector.
Equally, it’s important to remember that although the ban makes it possible for rents to decrease, it does not make it a certainty. Prime markets such as London, for example, will likely remain popular both for longer-term investors and short-term trophy buyers. In these markets, the unrelenting demand for property, combined with the constraints on available stock, will serve to keep competition, and therefore rents, high.
The perception of a value fall due to the risk will probably be secondary to the UK’s economic performance and other drivers, such as bond yields and availability of debt.
Similarly, it’s likely that other aspects of the UK market will also serve to further mitigate the effects of the ban. For example, it is already common practice across many areas of the market to arrange lease structures to avoid rent reviews, making them much less common than they were previously.
In some cases, this means leases stipulate reviews should only occur once every 3-5 years, while for some specialist properties, like supermarkets, for example, it can be as long as 10 or even 15 years. The prevalence of lease arrangements such as these will also lessen the impact of the ban, should it occur.
Potential opportunities
As much as the current market is, at least in places, strong enough to withstand any changes that the ban might bring, it is also a significant opportunity for landlords and tenants who are willing to innovate and experiment with their lease structures.
At present, for example, stepped lease structures are relatively commonplace for retail property such as shopping centres, but are not much used elsewhere. These structures set pre-agreed milestones across the lease tenure at which the rent will increase by a predetermined amount.
Essentially, such structures hash out rental terms in advance rather than relying on negotiations at a rent review. In the case of a ban on UORRs, such structures could prove popular for landlords and tenants beyond the retail sector by removing the uncertainty of waiting to see whether market conditions will make the rent go up or down.
The certainty that stepped leases provide could make them a useful tool and a good opportunity for both sides, giving the landlord a steady income and removing the guesswork of relying on market conditions.
A lengthy process?
Another consideration that has arisen due to the prospective ban is that the process of transition from old lease agreements that allow UORRs to new ones that ban them might drag on, creating a two-tier market.
This has led to fears that there will be a flurry of activity in the build-up to the ban’s implementation, as landlords strive to get leases over the line before it comes into force. While it’s true that, at least in some sectors, leases allowing UORRs may be seen as more valuable, there are also many reasons why the market will be able to adapt to the challenge.
Ultimately, despite the panic the government’s out-of-the-blue announcement caused, exacerbated by a lack of industry consultation, the UK market has always been resilient. Rather like when authorised guarantee agreements were introduced, there are bound to be teething problems as the new system comes into force.
However, as new solutions, like those discussed above, are found and innovations made, it’s likely that the issue will subside and the market will continue in its strong position.
