Leasehold Liabilities: Burden or Opportunity

Surplus property liabilities are like icebergs to the corporate ship: what you see above the surface looks avoidable and, in the right light, even impressive. What is hidden underneath, however, can be a very significant financial threat to many companies.

The property liability iceberg is an important feature on the balance sheet, and it is increasingly a topic of board-level concern and debate.

On a positive note, the rising level of transparency on the true costs of surplus property, driven by increasingly rigorous accounting and reporting standards and greater scrutiny has resulted in the development of sophisticated finance-driven leasehold liability management solutions and a new and complex market in risk transfer is evolving.

SURPLUS PROPERTY

Tenants, landlords and investors have been stung into recognising the potential opportunities and advantages that arise from actively managing leasehold liabilities, and new markets and market makers are now beginning to emerge.

Consequently, surplus property is now the stuff of headlines. In the UK over the last six months, there have been reports that Barclays, Cable and Wireless, Abbey and RBS are all considering sophisticated transactions involving the transfer of surplus properties to counter parties prepared to take on the re-letting risk in return for a carefully calculated reverse premium.

At the same time, the country's leading landlords, operating under the aegis of the British Property Federation, have responded by offering to relax the often onerous covenants in commercial leases that hinder the re-letting of leased premises.

Surplus lease liabilities are very much on the agenda on both the demand and supply sides of the market.

THE PROPERTY PROBLEM

So what are the implications for holders of substantial portfolios of surplus space? Sadly, there is no changing the reality or the inevitability of lease costs. What has changed is the range and sophistication of options available to corporate occupiers to deal with the problem.

There is a growing realisation that there is much more to disposing of a surplus property than banging a board up above its door, painting the reception area and preparing a glossy marketing brochure.

Fortunately, occupiers can now avail themselves of a wide variety of structures and instruments that mitigate the leasehold liability overhang problem:

• Total risk transfer transactions involving the virtual assignment of surplus property with costs offset by the inclusion of valuable freeholds, sale and leasebacks or an element of service provision provided by the purchaser
• Tax- and treasury-efficient income streaming, whereby the agreed premium payment for the liability is converted into an income stream over the term of a contract
• Profit sharing whereby the reverse premium is calculated with reference to explicit and agreed assumptions – the parties to the transaction then share any out-performance against these agreed assumptions, which puts a limit on the transferring party's risk but allows it to participate in any potential upside
• Partnership agreements that create a joint venture to liquidate or otherwise reduce surplus property managed by the counter party with risk and reward sharing arrangements
• Indemnities whereby the liability is quantified and agreed between the parties and capped by the counter party, who provides an indemnity against that liability being exceeded in return for an annual premium payment
• Property derivatives that assist the company to hedge the risks associated with surplus leases

NEW APPROACH

Some of the most innovative solutions hark back to distinctly old-fashioned forms of trade. Holders of large portfolios of surplus property are beginning to explore opportunities to barter the goods or services that their enterprises produce in return for a transfer of their liabilities to a counter party.

The general trend is that a proactive approach to surplus lease liabilities is gradually replacing the reactive and rather fatalistic view taken in the past by all sides of the property industry.

Even agents have become aware of the need to share with their clients the risks and rewards of disposing of surplus property.

They are now more inclined to agree incentive-based fees which directly link their performance to the value that they create (or costs that they mitigate) by disposing of vacant property quickly and on the best possible terms.

TIME VALUE OF MONEY

The other change is that the time value of money is being recognised in a world that has historically ignored it. Growing use of FRS 12 calculations means that the benefit of disposing of property six months earlier than planned can now be measured as a net present value – although agents have been slow to recognise time value, they have been much quicker to spot its use to justify higher fees.

A foundation stone for all these approaches is an accurate and objective FRS 12/IAS 37 calculation that properly takes into account the full extent of the surplus property liability.

Old-fashioned rules of thumb such as three years' rent cover are no longer a sufficient (or safe) basis for such complex transactions. Calculations need to take into account business rates, service charges and other running costs, potential dilapidations and refurbishment costs, professional fees and management time.

ROBUST FINANCIAL MODEL

Computations of liability need to be underpinned by a robust financial model. This is frequently where valuers and the accountants collide head-on, leaving both parties bewildered.

The FD wants a firm number for the balance sheet and needs to understand the profit and loss statement, and the direct and indirect tax implications of any proposed transactions – irrecoverable VAT, for example, can often be a deal breaker if it is not addressed at an early stage of any transaction.

Surveyors are being challenged to gaze into their crystal balls and use their judgement to assess how long it will take to assign or find another tenant for a property, what rent might be achieved on any sub-letting and what incentives, if any, will need to be offered to achieve a disposal.

Marrying the surveyor's market assumptions with the demands of the FD is one reason why firms such as Deloitte are increasingly involved in leading the kind of multi-disciplinary team required to undertake complex surplus property assignments.

SUBSTANTIAL BENEFITS

The potential benefits of these transaction structures to holders of portfolios of surplus property are substantial.

In the first instance, they offer the business certainty and protection against any further deterioration in the property markets. Portfolio transactions can be managed quicker and more efficiently than the piecemeal letting of a large number of individual properties and can remove a major management distraction, refocusing the activities of the property function on core business.

Financially, different structures offer companies the opportunity to mitigate direct and indirect tax issues and ensure that the accounts accurately reflect the position they are in.

The message is that the lease liability iceberg can now be explored without fear or favour and course corrections made to ensure that the corporate ship is steered away from trouble.

Of course, a strategic approach to taking the helm is required: the captain needs a complete and accurate map of the extent of unseen liabilities so that the correct course can be taken.