How do lease terms affect value?
Updated: Oct 2
A lease in its basic form is a contract between a landlord and tenant. It sets out how much rent will be paid, for how long and what the obligations are on each party. In this article we will explore how different terms influence value – both from the investor (landlord) and business (tenant) perspective. Better understanding your counterparty helps both parties reach an amicable position quicker.
How can it influence value so much?
Two identical buildings let to the same business can be worth materially different amounts depending on the lease.
Imagine if one building had a lease paying £100k per year with a lease expiry in 2 years time. The repair of the structure sits with the landlord and there is no obligation on the tenant to keep the rest of the property in repair.
Compare this to its identical neighbour – the lease runs for 10 years at a rent of £120k per annum and all costs associated with the building belong to the tenant – in effect they have the same obligations as if they owned it other than they pay rent.
An investor will pay materially more for the second building and there may not even be investor interest in the first one. An occupier may like the pared down responsibilities of the first scenario but if they are looking to undertake a sale and leaseback to release capital then they may be jeopardising this for some ‘nice-to-haves’.
Fundamentally, a lease needs to work for a business operationally and for an investor to offer a risk adjusted return. It is about balance and compromise.
The key lease terms for value and why they are important:
Principal terms
Rent
Term
Review basis
Tenant centric terms
Security of tenure
Landlord centric terms
Guarantees
Other terms
Break options
Repairing obligation
Alienation
Dilapidations
Rent – put simply, how much rent the tenant will pay and the landlord will receive. Both parties will want to know how this relates to the Market Rent (as we discuss in what influences the value of property). Above Market and the tenant and tenant will both be concerned about overpaying. Under Market and the landlord may feel they are not getting full value for their property and the tenant may have left value on the table if they’ve undertaken a sale and leaseback. Rent of its own is not the most important piece, rather it is how it interplays with the next two.
Term – the longer the lease, the more certainty a landlord has that they will have an interrupted income stream and hence lower the risk. Lower risk equals a higher price in a sale and leaseback. For a tenant, a longer lease gives more certainty for operations on site. A long lease will put more focus on the credit quality of the tenant whilst a shorter lease puts the focus on the real estate fundamentals – how quickly can this be re-let if it becomes vacant and how much needs to spend to do so. A longer lease coupled with a good credit story is key for releasing capital from bespoke or secondary properties.
Review basis – an investor will work out how much they can pay by looking at a cashflow of the rent and how long it is certain for. Because of the wide inflationary environment in which we live, a key driver for pricing is the ability to grow the income stream. Reviews are typically done on a 1, 3 or 5 yearly basis depending on the mechanism - fixed increases or indexation to a local inflationary measure is usually 1 or 3 years. If linked to Market Rental levels then 5 yearly is more common. Rent reviews are always upwards only (except where prohibited in certain European jurisdictions) – this gives businesses access to the most competitive capital who can price this type of product. For a business, an annual link to CPI or similar is likely to match their wider cost profile. To manage risk, it is typical to have a cap (restricting how high an inflation linked rent can go - typically 3, 4 or 5%) and a quid pro quo of a collar (typically at 0%, 1% or 2%).
The interplay of these three items has a material impact on value and understanding what a business wants to do and what investors will accept is a key part of Capcore’s advice.
Security of Tenure – a key consideration for a tenant is the protection that the lease and statutory provisions give them to stay in their building and renew their lease at the end of the term (if they so wish). Passing the control of this to a landlord hands over a key lever for negotiation. This changes by jurisdiction - in the UK for instance there are statutory protections in England and Wales but not in Scotland - so it is key to understand your local market.
Parent Company Guarantees – put simply, the stronger the business that is on the line to pay the rent, the better the pricing that can be achieved as part of a sale and leaseback. Adding a PCG may be a necessity if the tenant entity is weak but it may also be a credit enhancement and should not be given away for free.
Break options – a tenant break option provides flexibility but at the cost of certainty to the investor which will inevitably lead to weaker pricing. An investor prices the certainty of their income stream. If you think that a tenant break option is needed at year 5 or 10, question whether you have the conviction that this building is a good candidate for sale and leaseback.
Repairing obligations – a sale and leaseback should be thought of as a financial tool not a risk transfer device. The capital that is interested in sale and leasebacks is known as ‘Net Lease’ or ‘Triple Net Lease’ and this refers to the fact that all costs associated with the property remain the tenants. In fact, nothing should change between Day0 and Day1 other than the payment of rent (and receipt of proceeds). Attempts to push some repairing obligations onto a landlord will remove any liquidity from the sales process. This is of particular relevance for assets in France where the market is somewhat different and stricter laws governing the responsibility for repairing structural elements of the building exists.. This rehighlights the necessity to know your jurisdiction.
Alienation – businesses change and markets move. If a business is entering into a long term lease commitment then it is important to know that they can exit the building and allow someone else to take occupation. A landlord has the certainty of income for the duration of the lease and wants to make sure that the tenant covenant is kept to a similar standard as this impacts value. There should always be some form of assignment or sub-lease provision and this is typically on a landlord’s consent basis. The consent should be not unreasonably withheld and there is substantial case law surrounding this in most jurisdictions.
What This Means for a Business
The practical implication: a business negotiating a leaseback is setting the value of its own property while it negotiates. These are not administrative details settled after the price is agreed, they largely determine the price.
The waterfall below shows how different elements can combine to create or reduce value:
The highest possible valuation usually means meeting the investor’s ideal requirements for lease length and indexation. Often this can be well aligned with a businesses needs but it should not be the tail wagging the dog – operational needs should be the first assessment.
The final word
Remember that leases are contracts between two parties. They can be changed if both parties come together and agree to do so. Understand the impact of your request, e.g. the removal of a tenant break option often adds value to an investor or reducing a cap on a rent review clause could add value to a tenant. Speak to Capcore if you have queries about the value impact of a new lease you are looking at entering into or are already in.
