Will the high street ever be the same?
Simon Thomas, Partner at Moorfields, explores where the issues really lie for retailers and restaurateurs in wake of recent closures and CVA’s.
Since our appointment over Toys R Us UK last year the news has been flooded with other retailers suffering similar issues including Maplin, New Look, Carpet Right, Claire’s Accessories, Mothercare and House of Fraser adding to the growing fear of a high street meltdown. Whilst restaurants including Byron, Prezzo, Jamies and Carluccios have been shutting large number of outlets in a bid to cut costs. It leaves us wondering how the high street will look over the next 5 years and the knock-on effect this will have on landlords and lenders.
So, what are some of the main issues?
The retail and leisure industry is going through a process of rapid change but there remains a lack of urgency from the Government to recognise this and take the remedial action needed. Business rates remain one of the largest overheads for retailers but despite the Chancellor announcing that he would bring the business rates review forward to 2021 and carry out re-valuations every 3 years instead of 5, this provides no immediate assistance to help todays struggling retailers and by 2021 the high street could be completely different.
In 2013, Moorfields reported that Blockbuster was incurring significant business rates of some £3.8m p.a and highlighted the need for a review of the rating legislation. With the demise of Toys R Us we can now again see the true extent of the problem with them paying £22m in business rates. In addition, restaurant chains Byron, Prezzo and Jamies Italian have all shut outlets, citing business rates and increased costs as reasons contributing to their failure, whilst Travel Lodge have reported that business rates will continue to hinder growth.
Rents in the south have generally increased whereas rents in the north, the midlands and in Wales have fallen. Because of the time lag in revaluations, business rates in the South have been based on valuations which are too low, whereas valuation appeals have shown that businesses elsewhere have been paying too much for some time. Repeated attempts have been made to iron out these differences with the effect that the system is now full of anomalies and this outdated system based on property rentals is clearly in need of a complete overhaul or should be replaced by a different, fairer, system to tax businesses.
Notwithstanding repeated calls from retailers for a change in the business rates system, the Chancellor dismissed calls to overhaul the system saying that he will consider other ways to relieve the tax burden on UK firms. Until this much needed review takes place, online retailers will continue to have an unfair cost advantage to the detriment of the high street and ever-increasing business rates will almost certainly be a major factor in further store closures.
Landlord and Tenant Act 1954
The United Kingdom is now the only country in the world that permits upward only rent reviews (“UORR”). Much criticised as being unfair to tenants, the stability of the rentals has been a positive feature in attracting investment into the UK property market with guaranteed levels of minimum rents and has given confidence to institutional lenders.
In a period of growth, rent increases are accepted as a normal feature of business activity. However, when a market overheats, as in Ireland during the early 2000’s, this leads to rapidly rising rents. The Cedar Dean Group reported in 2018 that this is now happening on the London high street, particularly in the restaurant market. Competition for prime locations is intense and is forecast to result in 20-30% increases in rents in up-coming reviews. This is leading to some businesses forecasting that the levels of rent will become unsustainable, which, with the resultant increase in business rates, will ultimately force them either out of central London or out of business.
The Irish economic bubble burst in 2008 resulting in a widespread recession. Retail and the high street was particularly hard hit and as rental values fell, the high rents meant it was harder to assign leases or to sublet. For the moment, London’s and the south’s economy remains buoyant, but the pressure on the costs of high street retailers remains ever upwards.
Whilst the economy as a whole may be said to be on the up, there are substantial regional differences. As noted above, rents in the north, the midlands and Wales have been declining and with UORRs, existing tenants are at a significant disadvantage compared to businesses taking on new leases.
Increasingly, the right to a renewable lease on the same terms as the original is being excluded from lease terms. This does give flexibility to both landlord and tenant but, in turn, it removes the element of security of tenure for the tenant and gives the landlord an advantage in agreeing the terms of a new lease.
Given all the above, landlords will say that tenants entering into a lease do so with open eyes but at a time when a business is starting or expanding there is always uncertainty as to whether it will be successful. Larger enterprises will have the benefit of extensive professional advice in negotiating lease terms but, conscious of costs, the smaller businesses are less informed and vulnerable to onerous lease terms.
There have been several calls over the years for a reform of the 1954 Landlord and Tenant Act. In 2007, the Code for Leasing Business Premises in England and Wales was introduced to promote the use of upwards or downwards rent reviews, index linked reviews, certain rent level increases or turnover based rents but this code is only voluntary and has gained little acceptance. In 2016 The Landlord and Tenant Act 1954 Working Group submitted a number of proposals to amend some of the statutory processes within the Act to reduce the costs of lease renewal proceedings, but these have yet to be implemented.
It is clear that the Landlords and Tenant Act 1954 needs reform. However, there is not a single solution to the problems. The banning of UORR in Ireland created a two-tier system with exaggerated differences between pre and post ban leases and decreased capital values as uncertain rentals of new leases has suppressed investment.
Moving forward, the system needs to be realigned for both landlords and tenants to include suitable break clauses and protection and the increased use of alternative bases for rent reviews. Retailers need to understand that landlords need to make money in order to reinvest into the retail landscape but in turn landlords need to understand the business environment of their tenants. Landlords do not want to be left with empty units and then struggle to attract new tenants.
Company Voluntary Arrangements
There has been a lot written about these in the past few months and recent CVA’s have only sparked further debate. House of Fraser, Carluccios, Mothercare and New Look are just some of the high street names which have proposed CVA’S to reduce store numbers and gain rent reductions.
Historically CVA’s have been approved by creditors in the hope that the company would gain some breathing space. But that was during the recession that followed 2008 and then CVA’s generally promised eventual payment in full.
The retailing model of 2018 and beyond is now quite different to that of ten years ago and the online share of retail spending will only increase further. Retailers are now looking, not just to reduce costs, but to restructure their businesses to cater for the changing marketplace, consumer preferences and increasing price competition.
According to The Centre for Retail Research, online retailing is forecast to reach 17.8% of the market in 2018 with online food retailing forecast being 6.3% of the market but, significantly, online non-food is set to represent over one quarter, 26.5%, of retail spend.
Understandably, landlords are feeling pain, particularly where retailers are utilising the CVA process to exit from a location that is no longer profitable. Potentially the smaller investor is hardest hit with only one or two properties where a closure would have a dramatic effect on income, whereas an investor with a larger, more diverse portfolio, is more able to absorb some reduction in income and might be able to take a longer-term view.
The history of CVA’s may be littered with subsequent failures resulting in an administration or liquidation process but, where locations are set to continue trading under a CVA, landlords should expect to at least receive rates cover in the short term. The dilemma facing them is whether to accept (or renegotiate) the terms of the CVA or, if it’s not approved by the requisite 75% of creditors, be faced with the administration or liquidation of their tenant resulting in empty stores, no income and a business rates liability (surely another area for taxation reform?).
The CVA process can’t be looked at in isolation. Business rates and the Landlord & Tenant Act lead to retailers focusing too heavily on property assets when they are struggling. A CVA is a genuine means of saving a business and can potentially lead to the turnaround of a successful business. It should ensure that the time is taken to re-consider business plans looking at all areas including marketing, operations etc, not simply looking at property assets and providing customers with a more 21st century digital offering as well as the traditional bricks and mortar model.
How are these issues affecting the future landscape?
Lending market and Investors
Future investments in retail look far from certain and whilst some investors still believe that headwinds are short-term, overall, retail rents are reducing, and landlords are having to incentivise tenants making it more and more difficult to deliver investment returns.
According to Local Data Company, 26% of retail vacancies have been empty for four years or more. These closures are forecast to increase further in the next few years, with many of being the larger stores, and this will lead to a commensurate and significant loss of jobs in the High Street retail sector.
But the picture is not all doom and gloom, it depends where you are. Store vacancies at a regional level inversely reflect regional incomes and spending. As indicated in business rates revaluations, business rents in the south and south east are increasing and the large investors in these regions also report low vacancy rates. Elsewhere in the country, it is a different picture. It’s likely that retailing will become more concentrated in regional rather than local centres, but the biggest impact will come from lenders who are unwilling to lend to regional or secondary shopping centres.
I am certain that the nature of High Street retailing will change given the relentless march of online retailing, particularly in the non-food sector. Government has yet to make changes to the way businesses are taxed, upward only business rent reviews in the midlands, north and Wales will result in increased or at least non-competitive costs and inflated rents in the south and a reluctance of landlords to invest in regional developments will result in many high streets being suffering unless these matters are addressed.
And then there is Brexit . . .!
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