The short answer to the question how to appraise a shop investment is that everything about the proposition is reflected in the level of Zone A rent. But, because people generally like to have things spelled out, if only to ensure nothing much has been overlooked, here is the long version.
Shop investments are valued by reference to specifics, rather than generalities: namely, the nature of the particular town and importance of the particular trading position in that town. Towns and cities are ranked in terms of national and regional importance, according to multiple retailer representation and associated criteria, such as customer spending-power. The era of local and catchment population only shopping in the town where they live and/or work is long gone. Nowadays, spending-power, drive-time, parking facilities and the customer experience overall are determining factors. While each town will have its own trading positions, more important for investment potential is the relationship between one particular town and another, together with any wider influences that could affect that importance, such as new developments in the offing.
Towns vary in character, heritage, population (resident and catchment) and other socio-economic demographics. Each town has its own trading positions: in-town, the best position is the prime position, which might include a purpose-built shopping centre or mall at the heart of the town centre; everything else is classified as secondary. Secondary comprises secondary, tertiary, local, and neighbourhood. Out-of-town (including edge-of-town) shopping centres, malls, precincts, outlet centres and supermarkets are in a league of their own and depending upon the overall shopping experience may be the dominant shopping location for the whole town.
Over time, sometimes almost overnight in the case of a new shopping development, in-town trading positions can change. What used to be the prime position may become secondary, and vice versa. The presence of multiple retailers does not itself define a prime position: many multiple retailers prefer secondary positions.
Unlike town centre ‘high streets’ including secondary positions where the ownership of shop property comprises different landlords and owner-occupiers, purpose-built shopping centres, whether in- or out-of-town, are usually owned by a single landlord able to control tenant-mix. Shopping centre management is directed toward maximising the trading potential for both the centre’s owner and the centre’s tenants, whereas with fragmented ownerships, different landlords and so on, each individual landlord is likely to have their own investment policy, tenants having to fend for themselves.
Purpose-built shopping centres, being privately-owned, can be managed to a marketing plan, but investing in individual properties in the ‘high street’ is riskier. In the firing line of day-to-day trading reality, retailers fall into two categories: those that actively support and contribute to community initiatives to generate custom, and those that don’t. Those that don’t are sometimes criticised by those that do but only because those that do resent the freely cashing-in on community initiatives. It’s not that those that don’t are anti-social, so much as a difference in approach to attracting custom.
Some retailers are destinations in their own right, others rely far more on passing trade. Ideologically, a town centre might be presented as a community but, in practice, it is not a level playing field: business is not an extension of social services. Ultimately, some retailers are better at attracting profitable trade than others. Generally, the least capable are prone to bleating, the more successful adjust and adapt.
Amongst the factors affecting asset management and investment potential is not just the relationship between each particular building and its trading position, but also the relationship between that trading position and other trading positions in the town and other towns elsewhere. In the absence of a united front involving all interested parties, competing interests between (1) owners and their tenants in single ownership shopping centres and (2) the relatively dysfunctional policies of different landlords and tenants in ‘high streets’ can result in the ‘high street’ interests losing out.
Unlike single-ownership shopping centres where rent levels are geared to positioning of the tenant mix, with all leases generally containing more or less the same terms and conditions, other than rent, there is no obligation on a landlord of an individual shop property in ‘high street’ trading position to want the highest rent and/or to pursue rent review so, for example, rent reviews might remain outstanding. Consequently, rental levels even in the same street do not have to be consistent. Furthermore, since transactions are particular landlord-tenant specific, a tenant is not obliged to agree the lowest rent and many retailers are rumoured to ingratiate themselves with landlords in exchange for preferential treatment elsewhere. Establishing a surveyor-acceptable common denominator for the level of rents is a matter for informed opinion. The adage ‘one swallow does not make a summer’ is cited whenever a transaction is thought to be out of line.
For decades, it’s been said there are too many shops. The polarisation of the retail market over the past twenty years or so suggests there may now be too many towns. To evaluate prospects for a town, thinking that it’s nice place to live in may not be the correct criterion. It also has to be a nice place for most people to shop compared to whatever else is nearby. To avoid being subjective the definition of “a nice place to shop” must allow for different tastes and spending-power. A busy-looking town centre might suggest popularity but is not necessarily indicative of a growth area for investment.
Having decided whether the town itself would be worthwhile investing in, the next decision is to select the trading position in that town. As well as monitoring footfall, (passers-by, where do they come from, where are they going), the question is what influences if any could affect the potential for that trading position. Depending upon the location, influences are numerous, ranging from tourist attractions and public transport facilities to proposed redevelopments. Successful retailers have it within their power to make or break the popularity of a trading position. Unless one is privy to the facts, it is difficult if not impossible to assess whether a particular tenant or other retailers nearby are doing well. A shop that looks busy isn’t necessarily a profitable business. The stability of a trading position and its attraction for new tenants will depend upon whether the established tenants are trading profitably as defined by the established retailers’ particular requirements. It is possible to buy a service that assesses tenant-covenant, financial standing and so on – in my opinion the sort of information for gauging rental security that is readily available on-line if you know where to look – but rarely will an investor get the sort of information that is vital. It’s all very well paying to be told that ‘x plc’ has for example 300 branches, a turnover of £xM, net profit £yM and net assets of £zM but what’s equally if not more important is whether that particular retailer intends to remain in occupation in a particular trading position and for how long. In the absence of procuring confidential commercially-sensitive information, including whether the shop lease is on the market, the experienced-eye becomes the reliant factor.
The best properties rarely come on to the market so generally investors will have to be content with second-best and within their affordable price range. Property dealers trade on opportunity, but private investors like to buy for long term hold, often the life of a mortgage of say 20 years. The prospects for the investment should be assessed by reference to the envisaged period of ownership. Using the 20 years example, how likely is is that the proposition will perform as investment over 20 years? I reckon towns that provide a ready supply of propositions available on the market tend to be unstable and lacking investment prospects. Many properties do the rounds, cropping up for sale over the years, sometimes via the same auctioneers or agencies. At present, I’m advising on a shop property that’s been sold in 5 different auctions since 1999, on each occasion at a different price.
The proposition is a particular property so the nature of the property itself is important. Generally, investors prefer to own complete buildings (shop and upper part) rather buy piecemeal (shop only, upper part sold off). For residential investors looking for bargains, there is a lot to be said for a shop and upper part. It may be possible to convert the upper part into one or more flats, and/or to sell any existing flat separately should the opportunity arise. Where the shop premises includes a flat above, all let on a business tenancy, and where the shop tenant is not in occupation of the flat, there is potential within the Landlord & Tenant Act 1954 for opposing renewal of the whole on expiry or denying the shop tenant the right to renew of the flat as well and getting the flat back for a relatively low amount of compensation.
Having selected the property, the next point to consider is the rental value. The benchmark is the open market rent for the premises. The open market rent differs from the closed market. The closed market is where the tenant has negotiating rights and a dispute resolution procedure. The practical distinction is whether the landlord is in control and the tenant’s only choice to take or leave it.
When the shop property is let already, the starting point for comparison with the benchmark is the rent currently payable (the ‘passing’ rent). When the shop is vacant and to let, the starting point is the estimated rental that would be obtainable on the grant of a new lease. The passing rent is certain. The estimated rental is uncertain.
The first question is whether the passing rent is correct, or too high or too low. To answer, first establish the type of occupancy: is it a tenancy (popularly a lease), a periodic tenancy, a tenancy-at-will, or a bare licence? The passing rent would have been agreed on some basis: the question upon what basis includes what rights, if any, does the the tenant have. It is also necessary to read the existing documentation.
The basis for the rent is important. Rent does not exist in isolation: rent is the product of the terms and conditions of the lease upon which the premises are let and would be let. One cannot state categorically “this is the rent for the premises” without also defining the terms and conditions in the lease. That surveyors generally do say ‘this is the rent for the premises’ includes, by implication, assumptions regarding the terms and conditions of the lease granted or to be granted. Anyone that answers the question ‘what is the estimated rent?’ for premises that are let already without taking into account the terms and conditions of the lease or the nature of the occupancy that is in force is likely to come up with the wrong answer. For example, if the existing lease contained a restricted user clause then the passing rent might be lower than if there were no restriction. Similarly, if tenant has carried out structural alterations to the property then the effect on rent of those improvements might have been disregarded at the last rent review; the question then is whether and when the rental value of those improvements would revert to the landlord.
(On renewal of an existing tenancy where Landlord and Tenant Act 1954 case-management procedure is underway, a draft lease for the uncontentious terms and conditions will be agreed between the respective parties’ lawyers before the respective parties’ expert witness surveyor reports on rental value are prepared and exchanged. To value a rent, the surveyors must have something tangible and agreed in principle to go on. With a brand new letting, it is rare for the draft lease to be submitted before the tenant makes an acceptable offer of rent. Usually, the draft lease is submitted after outline terms and conditions are agreed in principle (heads of terms, subject to contract, etc). Since rent is a product of the terms and conditions of the actual lease, the test of integrity when drafting the lease is whether if there were a rent review on the same day as completion of the lease the rent would then be the same as the initial rent.)
To compare the passing rent with the estimated open market rent, the passing rent is devalued. Depending upon the type and size of the premises, shop rents are normally devalued to the Zone A rate. Zoning is a measuring methodology for comparing shops of different sizes and layouts to arrive at a common denominator. Having calculated the area in terms of Zone A (known as “ITZA”) and deducted values for non-zoned parts of the premises including, for example, any residential accommodation, the net rent for the shop is divided by ITZA and the result is the Zone A rent. You can find out more about zoning on my website at ITZA (if the link doesn’t work then http://www.michaellever.co.uk then Rent Review Matters then ITZA).
To make a comparison with the estimated open market rent, it is necessary to devalue the evidence, preferably of open market lettings but if not available then the next best thing, according to the hierarchy of evidence. Evidence generally is what other landlords and tenants have agreed or had ascertained for similar types of premises. However, evidence is not only of other rents agreed but also the terms and conditions of the leases and other types of occupancy. For that you would need to know precisely or as near as possible exactly what has been agreed by others.
For the do-it-yourself investor/landlord, sourcing comparable evidence is not straightforward. Rents and agreements are confidential to the parties concerned. There is no public register. The nearest to a national resource is to buy copy leases that are registered with the Land Registry. However, having a copy of someone else’s lease isn’t going to get you very far if you don’t have the rental devaluation. Rateable value could be a clue: rating areas on-line are freely accessible but rating areas, as well as being notoriously unreliable (arithmetical inaccuracies, also it depends when the premises were last referenced (measured) for rating), often differ from valuation areas for actual rent so can only provide a rough guide and should not be relied upon. Other quasi-public domain sources include shop agents’ websites, auction catalogues, and stock exchange public property company results and announcements. For surveyors, our sources include subscriber-databases (generally a mishmash of agents particulars, auction catalogues, and industry press-releases), information that we obtain direct from landlords, tenants, and other surveyors, our experience from work undertaken and in-hand, and our own record systems. Created in 1975 for my own use, I own possibly one of the largest computerised databases of shop rents; at the touch of a button, I can access information in seconds and whilst I don’t profess to know about everything happening in the places I monitor, it doesn’t take me long to familiarise and gather evidence.
An important point to remember about comparable evidence is that transactions are confidential and the information, often of considerable value, is guarded jealously. The commercial property market thrives on the free circulation of comparable evidence but it’s not ‘free’ in the true sense: it comes with the implied understanding to not misuse it. Arguably, Data Protection Act limitations apply; it is suggested that either or both parties’ permission should be obtained before facts are released. In any event, it is not compulsory for either landlord or tenant and/or their respective surveyors to cooperate with requests for evidence. Since shop tenants tend to close ranks over disclosure of rental agreements, unless it suits them to co-operate, it can be difficult if not impossible for a landlord wanting to establish the facts if you don’t have the contacts.
The reason surveyors are more likely to be able to procure evidence is that landlords and tenants come and go, whereas surveyors endure, so are likely to come into contact with one another sufficiently regularly to want to reciprocate. The shop property market comprises thousands of different landlords and tenants, (approximately 400,000 trading fascias have been identified) but there are only about 4,000 multiple retailers (including banks) which narrows things down a bit, and since fewer surveyors deal with shop property rents on a regular basis and reliably so, knowing whom to ask comes from experience.
Having devalued the evidence and compared the Zone A level with the passing rent Zone A, any other differences must be considered carefully. Apart from any technical adjustments and allowances, the effective date of the evidence is important. Evidence can be historic and the definition of historic varies. Generally, evidence within the same year or so, unless 2008 when before August that year predated the downturn, is preferred but where there is no recent evidence it becomes a matter of informed opinion which is where surveyors come into their own: informed opinion may also be used as evidence.
Particulars for the sale or auction catalogues of shop investments often mention Zone A rents nearby. Such mentions should be treated with caution. As I’ve said, it’s not just extrapolating the Zone A rent from one transaction and applying it to the shop premises under scrutiny: the terms and conditions of the respective leases are also vital.
After ascertaining the Zone A relationship between the passing rent and open market rent, the next question is how to value the investment. Where the passing and open market Zone A rents are about the same, the question is why or whether the rent should increase at the next opportunity, normally a review or lease expiry/renewal. In my last missive, I’ve already said that ‘upward-only’ rent review doesn’t mean the rent necessarily has to increase. Why is about the future direction of the market for the premises, also known as supply and demand. A change in ownership of an existing property does not increase the supply so the question is whether there is any demand for the premises. If there’s no likelihood of any increase then the investment is not going to perform, except in the context of the buyer’s subjective reasons for wanting the proposition.
Historically, a rule-of-thumb yield for non-growth propositions was at least 10% but since the early 1970s – when for reasons, if you’re interested, you can read about on my website >News and Views>Valuation (Valuation and Overpaying) – the traditional demarcation of the market into non-growth and growth is virtually non-existent. Based upon the cost of borrowing, the same nationwide, yield rather than ‘location, location, location’ has become the determining factor for most buyers.
Assessing risk by reference to yield depends upon the tenant’s covenant. National companies, multiple retailers and banks, all considered more secure propositions tend to fetch higher prices than shops let to independent retailers and local shopkeepers. The fact that larger companies can up-sticks or go broke without warning doesn’t seem to have altered a view amongst some investors that a shop let to a multiple retailer is likely to relet to another multiple retailer. That view is based on no evidence whatsoever: one reason many trading positions (including numerous ‘high streets’) are not as primary as they were is that multiple retailers have relocated to better locations.
When the passing Zone A rent exceeds the open market Zone A rent, the question is for how long is the passing rent secure. Assuming the tenant does not go bust in the meantime, the over-renting will expire on renewal of the lease when the market rent will apply.
When the passing Zone A rent is below the open market rent, the investment is reversionary. Reversionary implies growth because the reversionary rent is the rental value of the property if it were let now at the estimated open market rental. Since the estimated rental would not be known for certain, either agreed or ascertained, until sometime in the future, the reversionary value is deferred by the number of years to the reversion. (I’ve emphasised ‘implies’ because growth is not certain merely because of differences in the respective Zone A levels. The next rent review date may be years off by which time what is now the latest open market letting could be historic; in the meantime, the market might have changed.)
The starting point for the valuation of a shop investment ought to be the valuation of the property if vacant, but invariably it is not. Vacant possession value could be more than or less than or the same as the investment value, depending upon the location and trading position.
Shop property let already is generally valued subject to the benefit of the existing lease (occupancy) so the two elements get muddled and the proposition (property plus investment) treated as one. Since the tenant’s covenant (identity of the tenant) often makes a difference to the value of the investment, it can be difficult to distinguish the separate elements.
The muddling of values (where the shop premises are let already) tends to be linked to sentiment. Generally, sentiment is a better driver of market momentum than technical valuation. Hence, depending upon the degree of sentiment in the market, the same shop property investment could, for example, be valued at anything between about 1% and 15%+ which means that the timing of the purchase becomes critical if you want to avoid overpaying, and the timing of selling if you want to avoid becoming lumbered.
The property industry has debated at length the difference between price, worth and value. In outline, price is what the seller asks and buyer agrees and the amount that the proposition fetches is what the proposition is worth to the actual buyer. In other words, worth is subjective. Value is objective: what the property would fetch generally, regardless of whether anyone would pay more. Anyone who has agreed a price with a buyer only to have the property down-valued by a surveyor for the bank will have their own views, but thinking that value must surely be what the particular buyer pays is wrong because that view makes no allowance for the actual circumstances.
There is a school of thought that will only buy where a profit can be had from the difference between the cost of borrowing and the starting yield from the property. There is nothing wrong with that, provided it is not confused with property investment. The cost of borrowing, interest rates generally, is nothing to do with the value of property, but that doesn’t stop countless investors believing there is. Consequently, prices vary according to prevailing interest rates and market sentiment. Strong demand, combined with easy borrowing, generally results in lower yields.
When price is sentiment-oriented, the technical value can be difficult to gauge. Arguably, the best indication is the forced-sale valuation that banks and lenders require. The challenge of sentiment is that it is subjective to the buyer and geared to market-momentum. It may sound bizarre for a proposition to be priced at 3%, 7%, 10% or whatever depending upon the instability of market momentum, but that’s sentiment for you. Sentiment distorts underlying value. When you buy priced on sentiment, you are taking a risk that the market would be at least equally sentimental when you want to sell the investment. One reason guide prices for auction lots often bear no relationship to the result is not a consequence of the auctioneer or seller underpricing, but of underestimating the degree of sentiment. Auction reserves are normally based on technical valuation considerations.
When you buy on valuation, as distinct from sentiment, you are also taking a risk that the valuation is correct. Since valuation is only an opinion, albeit an informed opinion, the question is whether the opinion would prove correct when tested in the market. The beauty of opinion, at least from the surveyor’s perspective, is that the valuation is at a certain date. It is not possible to value in advance – that’s prediction – so it’s anyone guess whether the opinion would stand the test of time. There are valuation criteria that surveyors have to respect, also a duty of care, but a margin for error is permissible. Study case-law on negligence claims and you’ll find they tend to be circumstances-specific.
Capital value is expressed as percentage or years’ purchase (‘YP’). Whether % or YP, each is another way of saying the same. Yield is the income return on capital and is calculated by multiplying the required return by the passing rent plus the estimated rental value deferred. (Some landlords and surveyors prefer discounted cash flow (‘DCF’) analysis, which is a method of valuing using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values —the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.)
YP is a similar calculation but instead of percentage yield is expressed as a number of years. For example, a property let at £100,000 a year yielding 10% would be priced at £1M. 10% = 10 YP. (100/10=10). One advantage of thinking years’ purchase is not just to have an instant calculation of the number of years to get your money back, as much as to increase awareness of the potential. For example, at present 7% yield sounds better than 1 or 2% interest from cash on deposit but it’ll take 14.28 years (ignoring tax, etc) to get your money back by which time anything could happen to the particular property and/or the tenant and/or the location you’re buying into.
In conclusion, to appraise a shop investment properly requires a technical approach and a thorough understanding of business tenancy law and and valuation, which is why it’s advisable to consult an experienced retail property surveyor. If you don’t want to pay for what might be perceived common sense, instead perhaps taking comfort from what others are paying for similar propositions, then at the very least, in my opinion, you really ought, with respect, be giving more credence to whether (1) the town and (2) the trading position will endure, (3) the passing rent would reasonably be expected to increase during the remainder of the term and on renewal, and (4) for how long the tenant’s covenant (for which you may be paying a premium) at the property will last. If you skip all that and simply focus on the yield and tenant covenant then more than likely you’ll come unstuck.