What’s the biggest sticking point at the moment when you’re negotiating with tenants?
Historically the discussions with new tenants focused on more the primary elements: rent, lease terms, fit out contribution, rent free periods, whereas items such as indexation were just taken for granted. But now there’s a huge focus on short-term cost savings, of which indexation is being targeted. It seems to be coming from the top down in every organization. CFOs are saying ‘we’ve got to minimize our bottom-line costs’ and so after just a single year of high indexation, they’re really pushing it on the expansion managers during the lease negotiations.
They’ve taken a hit this year and want to avoid it in their new stores.
Exactly. And I can see their point. They see it as a degree of protection for their bottom-line costs over the lifetime of the lease. However, this is a short-term reaction that would have a long-term impact for landlords. So, we have to find a common ground where it helps tenants this year but doesn’t compromise the longer-term lease strength.
Are they asking for caps, or how do they want to achieve that?
There are multiple ways tenants want to structure it. Capping is the simple one. You set some percentage as your maximum indexation – say 4-5% — and if the actual indexation rate exceeds that, they’re protected. That way they can forecast and budget their bottom-line costs. We’re even having some tenants who ask for it to be waived outright.
That’s a non-starter, isn’t it?
The whole thing is a non-starter, ultimately. Leases require indexation mechanisms. However, we still see attempts by tenants and leasing agents to indirectly waive indexation by having creative, stepped rent structures for the first 3 years of the term. For example, by setting the rent for the coming year at 2-3% above the rent for the previous year. Either way they’re all a form of protecting the tenants from 2024 indexation since they’ve already absorbed the cost of 2023.
But you can’t have a five-year lease with that degree of cost protection for the tenant to protect against what’s really a very unique, short term macroeconomic situation. We’re trying to explain to tenants that this double-digit indexation hit is just for one year. It won’t be the same going forward in 2024, 2025 until 2027.
As an investor, don’t you usually have to pay for a hedging arrangement on a loan?
Exactly.
Why should it be different for a tenant?
There’s a perception about investors and landlords that we’re sitting on some kind of pile of free cash, so we can live without indexation. That’s simply not true. We have operational costs which are increasing, large interest rate increases, and banks to pay! And fundamentally we buy real estate and investors invest into our funds as a hedge against inflation on other asset classes. This is the attraction of real estate. This wider asset class point is often lost in leasing discussions.
Meaning you have to defend indexation in order to defend the value of your investment.
Yes. Real estate investors are buying the certainty of a five-year income stream that’s going to be contractually indexed annually. That’s what they’re buying. The attraction of real estate generally is that it’s not degraded by inflation. We have to explain this to tenants. They come to us hands open, saying we’ve got to help them. Of course, every good landlord is going to engage in dialogue with tenants. But there are certain parameters and limitations to this. At face value, it might help them, but we know it degrades the value of the lease. Looking at the bigger picture of real estate, if landlords start doing this, we indirectly degrade real estate as an asset class.
You can explain it to tenants, but ultimately, they’ll see that as your problem. You can’t be surprised they try it, can you?
What’s more worrying for me is that we have to explain this to people on the agency side as well. To people on the leasing and property management side of real estate who are meant to be representing the landlord’s interests but actually indirectly do the opposite. We understand it would be a nice thing to do just to waive indexation for a year to help the tenants. However, as asset managers we find ourselves explaining the bigger picture more and more frequently — not only to tenants but also to people within the industry.
Surely agencies understand the bigger picture?
You’d be surprised. They’re looking to do deals and the best way to a deal is through compromise. We get that. But we can’t always work with what they’re trying to bring to the negotiations. We spend a lot of our time explaining that there are things we can do, but there are things we can’t do. We can talk about some kind of rent incentives at the beginning of the lease. We can look at an extra month rent free. We can possibly take the initial hit on a new deal at the front end of a lease. But by the point of exit, you need to be valuing the headline rent. Or at the point of valuation. We need to get that message to tenants, because once you explain it to them, they become more understanding of the overall situation. Often the agents are our bridge to tenants, so they need to understand our position also.
I’m definitely paying more in the stores these days. Retailers aren’t offering price caps for consumers.
For many retail tenants, their turnovers are up, through a combination of inflation (so yes, it is passed on to consumers) and a tangible increase in sales. Turnover revenues are rising more quickly than the inflation rate, so the indexation argument is nowhere near as strong anymore. Actually, what we see is that discussions with our existing tenants are simpler, since we have transparency on their performance. We structure deals with them in line with affordability ratios. It’s more time consuming with the new deals because expanding tenants are more aggressive, because agents need the deals and because CFOs across the world now seem focused on how to manage these spikes on their bottom-line. But the solution is in an overall deal package that works for both parties. Not by degrading the quality of the lease.
Iain Fanthorpe is country manager of Bluehouse Capital, which owns the Novo Plaza shopping center in Prague
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