Two-tier marketplace, with some leases upward only and others not, is absurd
EUROPEAN COMMERCIAL leases differ from Irish ones in three ways. Firstly, lease contracts do not exceed 10 years. Secondly, there are break clauses; and thirdly, the mechanism for rent determination is linked directly to the cost-of-living index.
We need to adopt this more competitive model.
Half a century ago, there were no upward-only rent review leases in Ireland. They owe their origin to our nearest neighbour, the UK. Back then, when large British institutional investors bought prime commercial properties here, they began to insist tenants sign up for long (35-year) leases, without a break clause, subject to periodic reviews where rents could only ever rise.
The logic behind this was to protect pension funds and insurance companies from the potential ravages of inflation.
In time, these leases became the industry standard.
The philosophy in Europe was always on the quality of your building; here it became the quality of your tenant and this signposts why huge mistakes were made by Irish banks during the boom, as lending was backed by the financial obligations of the lessor as opposed to the collateral of the property itself.
During the 2002-2007 credit bubble, access to cheap capital was uniform in the euro zone, yet French or German banks did not expand their lending to commercial property as aggressively as Irish ones. Why?
Well, the Irish valuation model was very different, for one. This was acknowledged by former Anglo boss Seán FitzPatrick, quoted in The FitzPatrick Tapes: “Our exposure is not to the building, it’s to the money that comes from the leasing of it. If the value of the property goes down, it doesn’t matter. We still get our loan repaid.”
Some may believe that easy credit was the issue, but banks can only engage in secured lending when they have something to secure against.
The Irish commercial property loan model also affected the more traditional residential property market in an insidious way. The preponderance of “mixed-use” developments during the boom was the modus operandi of the developer. Here, it was the commercial component that was seen as the “jewel in the crown”, because positive rental growth was assured – a one-way bet!
Developers saw these commercial leases as a way to leverage-up their property bets.
Today, these uneconomic leases no longer apply to new tenants signing a brand new lease, since the last government banned them in March 2010.
However, prospective tenants can only opt for a brand new lease on more attractive rental terms providing they can find such a unit in the right locations.
Many vacant units still have leases that are effectively no longer assignable. A tenant in arrears still has an unexpired leasehold contract, even after vacating their buildings. This is why so many commercial properties are vacant.
Since the abolition of upward only 25- and 35-year leases, the market has moved to a situation where 10- to 15-year contracts are the norm, but this has created a two-tier marketplace. Andrew Muckian, a property partner at law firm William Fry, Dublin, writing in a recent Property Week UK, said: “Because of the current state of the market, banning upward-only rent reviews has not had as big an impact as it might otherwise have had.”
He added: “Investors who buy shopping centres will get a mix of leases. Some will be upward-only and some with no guarantee of income – and that will lead to a completely different valuation model. Chances of rental growth may be limited, and we think that this will create a two-tier investment market.”
It has.
In short, the current situation is an absurdity. There are those who might say why not let these existing leases wash through the system. But should we wait until 2030 for this problem to disappear and in the meantime just muddle along? What sort of policy strategy would that be?
UCD economist Colm McCarthy has summarised the problem by highlighting the three key areas where Ireland differs from the UK on this issue: we’re locked into a common currency zone; price inflation is much lower here; and an oversupply of new un-let commercial properties exists, and there is an overhang of vacant older ones due to the recession. McCarthy argues that we need to reduce all costs as a matter of economic urgency.
Let us now see the new Government deliver on its manifesto pledge and allow market rents to prevail in all commercial leases.
Derek Brawn was head of research at the property company Savills Ireland and is now an independent property commentator. He is author of Ireland’s House Party (Gill and Macmillan, 2009)