‘Are Headline Rents still Relevant for Asset Evaluation?’ – Column by Steve Jude, CEO on Estates Gazette23/01/2015
The world of work has changed forever. A combination of technology and globalisation has forced most businesses to become more agile in order to compete for customers. In the commercial office sector, change in occupier behaviour has gradually instigated a requirement for more flexible real estate. We are experiencing a quiet revolution in the economics of offices. So while we are accepting change to lease lengths, isn’t it about time we also reassessed the relevance of headline rents when it comes to valuing commercial property?
The perceived importance of headline rents has ensured that some landlords are increasingly willing to sweeten the commercial terms of a new lease by including longer rent-free periods and capital contributions, whilst upping rental levels across the later the years of the lease. This deal structure is partly based on the traditional assumption that the headline rent will become the new baseline rent when the building is re-let. Arguably, this assumption could however have a distorting effect on the real, underlying value of commercial property, even more so than in the past. This is primarily because once a long term occupier leaves, it is now becoming more difficult to replace like for like, due to the increasingly flexible requirements of the modern occupier.
In other industries, take retail as a good example, the full costs and revenues of a commercial contract are applied to the profitability of the business. The recent turbulence at Tesco highlights exactly what happens when revenues and costs are not aligned correctly. Why then, as an industry, do we still attach such relevance to a headline rent that does not reflect the full cost of the lease?
Of course, it is worth bearing in mind that traditional valuation models continue to work well for a particular part of the market that values certainty of tenure over flexibility. The rising headline rents for Grade A office space in central London indicate that there is more demand than supply and in this rising, niche market, the traditional model of valuation works well and sturdily underpins the current high levels of investment.
However, unfortunately, the majority of the UK commercial office occupiers are not in the market for long term leases, in Grade A space, in central London. Most UK businesses are in a constant cycle of driving down their operating costs, increasing the quality of their products and services and matching their fixed costs with their guaranteed income. As the ‘Facebook Generation’ assumes decision-making roles in business and as mobile technology continues to force change into the workplace, it is inconceivable that the commercial office market will do anything but become more and more flexible.
Traditional long-term leases can provide a strong valuation, but they do not provide sufficient flexibility for the majority of modern occupiers. Consequently, these businesses have done what customers do in all sectors and have voted with their itchy feet. The inexorable decline in the length of leases has been matched by the explosive growth in flexible working patterns and subsequently, the serviced office sector. In a free market, customers eventually find a way to get what they want.
Ultimately, all businesses, including property businesses, only have true value if there is demand for their product from their clientele. If a business does not provide the products and services required by its customers, then they, and their income, will disappear. The majority of commercial office occupiers require a level of flexibility which puts pressure on the traditional model of valuation and which therefore needs to be addressed.
It is now more important than ever to value flexible short term lets and a regular income. There is no quick and easy answer as to how to change the valuation model, but accommodating this mega trend within an amended model will become one of the most important roles of industry professionals in the coming years.
Steve Jude is the CEO of business centre provider Citibase and works with landlords to utilise second-hand office space for short term occupancy.