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• Monitoring the code of practice for commercial leases: executive summary

Cities and regions

Monitoring the 1995 code of practice for commercial leases: executive summary

The findings and recommendations in this report are those of the consultant authors and do not necessarily represent the views or proposed policies of Communities and Local Government .

Introduction

In 1998 DETR commissioned the University of Reading to evaluate the commercial property industry's original 1995 Code of Practice for commercial leases. The report published in 2000 (see below) found that while there had been a significant move to shorter leases and lease terms generally had become more flexible, upward only rent reviews were still prevalent in longer leases, while small business tenants were poorly informed about property matters. As a result, the Government invited the property industry to introduce a new, more effective Code of Practice as an alternative to legislation.

1   Aims and objectives

1.1   The overall aim of this research for the DETR is to provide Government with monitoring information on the operation of the Commercial Leases Code of Practice introduced by the property industry in December 1995, so that policy options can be evaluated.

1.2   The objectives set for the Code by the Government were framed with a view to improving the understanding which tenants have of the terms under which they pay for and occupy business premises. They were also designed to encourage landlords to approach lease negotiations with a greater degree of flexibility than had been the norm. There was also an intention that the property market should move towards greater transparency and that, in particular, the use of confidentiality agreements should be minimised.

1.3   The extent to which the Code has achieved the desired outcomes has been measured by examining the evidence in the context of three key questions:

• Has the Code become regularly used in the market place over the three years of the review period following its introduction at the end of 1995?
• Have the changes which the Government wished to see actually taken place in the market?
• Have any changes which have occurred been brought about, at least in part, by the use of the Code?

1.4   The research collected and analysed data on:

• the economic, institutional and legal framework within which the commercial landlord and tenant relationship operates;
• changes in the form of the lease between landlord and tenant in the retail, offices and industrial property sectors in the period both before and during the operation of the Code;
• the attitudes and perceptions of major participants in the leasing market; landlords, tenants and their professional advisors. Particular attention was paid to their use and knowledge of the Code of Practice.

2   Underlying market conditions

2.1   Prior to the introduction of the Code, the property market had experienced a period of boom in the late 1980s culminating in the recession in the early 1990s which produced the greatest fall in nominal property values since reliable records began in the 1960s. The property market began to recover in the period immediately preceding the introduction of the Code (1994 and 1995). The first three years of the operation of the Code have been in a recovering market which experienced both rental and capital value growth in each of the years 1996, 1997 and 1998. The strongest lettings market was in 1997.

3   Institutional pressures

3.1   Globalisation has had a limited impact on leasing practices in the UK market. However, multi-national landlords and tenants are increasingly aware of the wide variety of leasing terms available internationally, and there is some evidence of convergence of lease length in some international sub-markets, particularly for prestigious buildings in prime locations. The globalisation of accounting standards and prospective changes in how leases are treated on the balance sheet may add to tenant pressure for shorter leases in the future; however these proposals do not appear to have been an influence on lease structures during the first three years of the operation of the Code.

3.2   Changing attitudes to business practices and space and changes in locational requirements suggest an increasing need for more flexibile leases. The different requirements for core and periphery space require different leasing arrangements.

3.3   Institutional inertia has inhibited the adoption of new lease structures. Lenders and investors have been slow to embrace diversity, encouraged by comparative valuation methods which lack sophisticated techniques capable of pricing diverse lease terms. However, some leading investors, lenders and property professionals are now challenging this inertia and are becoming more aware of the benefits of increased lease flexibility.

4   Legal framework

4.1   A potentially significant change in the otherwise very stable legal framework before and during the review period was the abolition of privity of contract for new leases taken out from 1 January 1996. However, the almost universal adoption of authorised guarantee agreements (AGAs) has tempered the impact of this reform. In addition, the more stringent assignment conditions now permitted under the Act may make it more difficult for tenants to assign and may discourage them from taking longer leases.

4.2   The right of renewal conferred by the Landlord and Tenant Act 1954, reduces the disadvantage to tenants of short leases. The statutory renewal process itself tends to bring down lease lengths; it can also perpetuate existing lease provisions, with the result that statutorily renewed leases do not necessarily conform with current market leasing practices.

5   Changing lease structures

5.1   In 1990, the vast majority of better quality, larger commercial properties were let on a standard "institutional" lease of 20-25 years in length, with many responsibilities passed on to the tenant by the landlord. Since 1990, there has been a movement towards not only shorter but also more diverse lease lengths, with no particular standard length of term. This movement has been market driven, with most of the movement occurring in the weak market conditions of the early 1990s before the Code was introduced. However, there are no signs that the more recent market recovery has reversed this position. Leases have remained shorter across virtually all sectors, sub-sectors and regions. Retail warehouse are the exception and their leases seem to be virtually unaffected by the changes in other property types.

5.2   The longest leases are in the institutional market while the shortest leases are granted to locally based occupiers leasing smaller, less valuable properties. Retail properties command the longest leases, while the office market reacted first to the shortening of lease length. The strongest influence on lease length is therefore the size and value of the letting rather than spatial factors such as region or town type.

5.3   There is some evidence that short leases have led to a transfer of repairing obligations from tenant to landlord. Rent-free periods and other inducements to let however have declined with market recovery. Rent-free periods now relate to a fitting out period only. The position on break clauses is less clear with some data sources suggesting a decline in their use while others suggest not. However, where they are used, the majority of breaks are timed to coincide with the review date in the lease.

5.4   Market value based upward only rent reviews are still the predominant form of rent review, but there are some tentative signs of a decline in the use of upwards only, despite landlord pressure to retain them. However it is the growth of shorter leases and the incidence of tenants' break provisions which has had the most impact on rent reviews. The majority of leases by number taken out in the last few years are too short to include a review and most break provisions are linked to review dates. Where reviews are present, five years continues to be the most prevalent period. The use of alternatives (e.g. turnover rents, indexation) is still rare; even when used they often include base rents linked to market value on upwards only terms.

5.5   There is no evidence of an increasing trend to greater contracting out from the Landlord and Tenant Act 1954 Act, which remains fairly low.

5.6   The use of confidentiality clauses is very low, with a negligible effect on market transparency.

6   Tenants' understanding of their leases

6.1   A majority of tenants, particularly those who are unrepresented, appear to take their leases on the first terms offered and seek to negotiate no more than the initial rent.

6.2   Whilst nearly all tenants are aware of the rent review provisions contained in their leases, an equally high percentage do not understand the process by which any dispute over the reviewed rent will be settled, more so than any other aspect of their lease.

7  Use and impact of the code of practice

7.1   The Code is not in regular use in the marketplace. Where it is in use, it is not perceived as having any effect, mainly because those who use it are the more informed tenants who are already well aware of the leasing process. Tenants are not being informed about the Code by landlords and their advisors; the unrepresented tenant has virtually no other means of being made aware of its existence.

8   Policy options

8.1   Although the Code has had practically no impact, some of the changes the Government has sought have taken place. There is greater flexibility in lease terms, especially in the secondary and tertiary markets. Lease lengths have become shorter and more diverse, and there are some signs in shorter leased, lower value properties of a shift of repairing obligations to landlords. While the upwards only review to open market rent remains the dominant form of rent revision mechanism, a significant number of tenants are free from a ratchet review process due to the greater incidence of short leases and tenants' break provisions linked to review dates. The use of confidentiality clauses is low, and market transparency has improved. However, tenants still do not have a good understanding of dispute resolution procedures.

8.2   Original policy options included the outlawing of upwards only rent reviews and confidentiality agreements. The question to be addressed is whether there is now sufficient evidence in respect of both of these issues to conclude that the desired changes have or are taking place. If not, the possibility of intervention will need to be re-considered.

8.3   If satisfied that the required changes in leasing practices have taken place, it could be decided that, despite the lack of knowledge concerning their leases amongst smaller business tenants, tenants are now being offered flexible leases which support rather than restrict their businesses. In this case it could be decided that there is no need to interfere with the operation of the commercial leasing market and the Code of Practice could effectively be abandoned.

8.4   However, it could be concluded that the needs of the small business tenant, especially those who do not take professional advice when negotiating their leases, have still to be addressed. For these tenants in particular the Code is a useful document to which they are not yet obtaining satisfactory access. If the Code is to have an effect in the future, the process by which it is to be successfully circulated, and the role of Government, landlords and agents in that process, is a major question. It may be necessary to consider a move from a voluntary to a mandatory regime.

Monitoring the Code of Practice for Commercial Leases can be purchased as a two volume package.

ISBN 1 851123 83 0
£36.00