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KEY PERFORMANCE INDICATORS III – LET’S TALK ABOUT LEASE LENGTH!

 * March 1, 2016

An important metric used by real estate investors to measure the overall tenancy
risks of multi-tenant properties like shopping centers is the Weighted Averaged
Unexpired Lease Term.

BY STEFFEN HOFMANN

In view of a quasi-zero-interest rate environment in most industrialized nations
today, institutional investors are shifting a more substantial share of their
global asset allocations towards real estate as an asset class. Traditional
fixed-income investments simply do not provide investors with the desired yield
levels that they did previously. Even though current transaction yields in some
European markets are hitting historic lows, on a relative basis, real estate
allows for more attractive income yields than the wide range of fixed income
products and other benchmarks. As long as investors acquire the right underlying
real estate asset, capital growth can be driven through active asset management.

In this setting, income-producing shopping centers, with their diversified
income stream generated through a multitude of retailers, are a sought-after
real estate segment. Due to a notorious scarcity of suitable investment stock,
contributors of capital had to move somewhat higher up the risk-curve during the
previous investment year 2015. Nevertheless, the majority of institutional
investors keep looking for core/core plus allocations with premium prices being
paid for fully let retail properties with grade A tenants on long leases. When
it comes to lease length, many conservative investors are evidently of the
opinion that the longer the lease duration at acquisition date, the better. The
rationale behind this is simple: index-based long leases are perceived to
deliver predictable investment returns and provide their investors with secured,
long-term, inflation-proof rental income, while retaining long-term capital
growth potential for the distant future. All right!

Image: Friars Walk; Credit: Queensberry

The longer the WAULT, the better the investment?

An important metric used by real estate investors to measure the overall tenancy
risks of a multi-tenant property such as shopping centers is the so called
WAULT. WAULTs will be accounted for and highlighted on every key figure page of
the transaction documentation. They assess the likelihood of a property going
vacant. The abbreviation WAULT stands for the Weighted Averaged Unexpired Lease
Term. WAULTs are measured in years. This widespread KPI is mathematically
calculated across all tenants as the sum of the remaining contractual fixed rent
of an asset divided by the contractual annual rental income of this asset at a
specific point in time. In this context, it’s worth noting that potential lease
renewal options could theoretically extend the term of a lease agreement beyond
the first expiry date, however such renewal options are not considered when
calculating WAULTs as their exertion is uncertain and uncertainty, after all, is
what investors aim to minimize when calculating risks.

Unsurprisingly, investment properties with long WAULTs not only attract large
institutional players like pension funds and insurance companies, they also
achieve stunning debt-finance-rates as commercial real estate lenders are even
more rigorous risk-minimizers and seek certainty in cash flows in order for
their loans to be repaid. Risk managers for both, investors and banks, obviously
assume that properties with long leases face the least risk of income loss and
value decline.

Image: NaveDeVero; Credit: Corio

What’s the optimal lease length?

Let’s face it: Right from the outset, an optimal lease length does not exist! As
a matter of fact, some regional markets in Europe are used to quite different
standards in terms of the ordinary length of a lease. In the UK and Germany, for
example, retail players are familiar with 10-year standard leases. Department
stores anchoring shopping malls in the UK often even sign up for 15 to 25 years.
The previous lease regime in France led to nine-year leases (with theoretical
tenant rights to vacate the premises every three years), the new regulation
encourages 10-12 year leases. In the Italian market, five- to seven-year leases
are the prevailing standard, whereas we often find six-year leases in the
Portuguese shopping center market and five-year leases dominating Spain. And
guess what? We find good and bad shopping center investments in each of these
markets! This means WAULTs must not be the most important determinants when it
comes to retail investment success!

Everybody will agree that investors always need to accept some level of risk in
their acquisitions—otherwise risk premiums can’t be earned as compensation for
tolerating that extra risk. So why not go for shorter leases? Well, that’s
exactly what sector specialists are currently doing. Unlike uneducated investors
or sector novices, sophisticated retail investors do indeed give less importance
to WAULTs. They have learned that long leases are not necessarily the best
leases—and definitely not across the entirety of tenants in the wide mix of a
shopping center. Clearly, particularly in the early phase of a development
project, both, investors and their debt financing partners, want to see anchor
tenants signing up for a 10- or even 15-year long-term commitment to a new store
location. Otherwise, the project simply won’t fly. Securing anchor tenants
long-term is crucial when commercializing the remaining retail space to further
retailers. Experienced investors, however, should not be afraid to accept a
range of shorter leases for small units (SUs = shops <500 sq m) and, in
exceptional cases, also for mid-sized units (MSUs range from 500 sq m to 2,500
sq m) in a shopping mall—in particular if they see themselves as active asset
managers.

As long as central KPIs (e.g. footfall, sales, space productivity, and
occupational cost ratios) display a healthy picture of the investment property,
shorter WAULTs of 3.0 to 4.5 years should not be a threat to investors in our
opinion as, with sufficient preparation time, perceived income risks can be
competently mitigated through active asset management. That’s the beauty of
retail asset management! Lending partners, which are usually less close to the
properties than asset managers, can be taken on board by way of providing
performance data and explaining the asset management business plan to their risk
managers. Furthermore, even if banks apply an additional risk margin over
standing asset loans with shorter leases (e.g. due to German Pfandbrief
regulations), in the current environment, the attainable debt-finance terms will
still promote investment returns. Let’s remind ourselves that the European
central bank’s interest rate is still as low as it can get and we are currently
observing a negative Euribor in the European money market!

Image: Thier Galerie; Credit: ECE

Four important reasons why shorter leases can even be better leases:

 1. Our experience shows that retail investors should always aim for a good
    level of tenant rotation during the hold-period of an asset just to keep the
    tenant-mix fresh. Proactively seeking to rotate 5-10% of the Gross Lettable
    Area in a shopping mall every year will pay off in the long-term. In this
    way, landlords keep providing their local customers with an attractive
    retail offer and are able to defend market share in a competitive
    environment against new market entrants. When it comes to tenant selection,
    shorter term leases simply give more flexibility and landlords stay in
    control of their premises.

 2. If the strategy of the investor is to acquire and reposition an established
    shopping mall to unlock anticipated ERV potential, occupiers with long
    leases might easily block important access to strategic shop units. Securing
    vacant possession of all required units to implement strategic business plan
    milestones can be a costly exercise whenever landlords find themselves
    forced to buy out their own tenants from existing leases. In such cases,
    single-sided lease renewal options for retailers can hammer investment
    returns. A best-endeavor clause, whereby tenants can be offered an
    alternative space of similar quality somewhere else in the mall whenever the
    owner wants to refurbish the property is, from a legal point of view,
    nothing but an empty phrase.

 3. If the investment is made at an early point in the market cycle, at which
    rising rents are expected to come through, investors are well advised to
    keep some leases shorter and gradually access rental growth by way of
    repeated lease renewals, carrying out more frequent re-leasing
    activities—even if they face additional costs in terms of leasing agent and
    legal fees. Investors who understand their property performance data will be
    able to gain the security of continuous occupation, along with the
    opportunity to increase their rental income and alter lease terms and
    conditions with subsequent leases in line with evolving market requirements.

 4. Landlords will miss out on attracting new market entrants if they are not
    willing to accept shorter leases here and there. While the cost of fitting
    out a store and filling it with inventory is substantial and thus not easily
    amortized over a lease term that is too short, signing leases of between
    five and seven years can actually make economic sense for retailers to test
    out a new market or shop format. Bearing in mind that, in Southern European
    legislations in particular, shorter lease durations prevail, landlords of
    Northern European retail assets likely need to compromise on lease length if
    they wish to integrate trendy fashion brands coming from these regions into
    their international brand-mixes.

Getting the mix right means accepting shorter WAULTs for Smaller Units!

Image: Jakobsbergs; Credit: Citycon

As outlined above, long-term leases offer stability of income and guaranteed
tenancy—at least on paper. The obvious disadvantage with that pictured long-term
income stability is that retail is a quite dynamic industry that undergoes
severe changes. Just about nine years ago, for example, none of us had an
iPhone, because smartphones simply did not exist. Investors who bought a brand
new shopping center with a WAULT of 10.0 in 2006, for example, will desperately
yearn to get some long-occupied rental space back in the course of this year in
order to optimize an outdated tenant-mix. Thanks to rapid technological
progress, the retail landscape has changed and the business of retailing will
keep changing. From an asset management perspective, there is nothing wrong with
change, as long as we can develop the shopping center positioning in the right
direction. When it comes to retail asset management, income stability, on the
face of it expressed and measured in long WAULTs, is perhaps not exactly the
ideal solution. That’s why we encourage investors to accept shorter leases for
small units—which usually by far outnumber the sum of large units and mid-sized
units in a shopping center.






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