The high cost of short-term gain

It's not often I find myself writing broadly about the same area of the pub business for three weeks running.

But the collapse of London & Edinburgh Swallow Group (LESG) warrants a few more thoughts about the flourishing pub auction market.

My best guess is that more than 1,000 pubs have been sold to private investors through the auction route in the past five years.

LESG and its subsidiaries sold more than 350 pubs and hotels and was most active from 2002 to 2004.

In the past 18 months, Provence has taken over LESG's mantle as the most active vendor of pub investments at auction, selling, by my estimate, around 300 pubs in total.

This month Provence is selling pubs worth several million pounds at auctions.

Call me cynical, but it looks to me like a 'get rich quick' scheme. The more rent LESG companies offered to pay, the higher the pub was likely to be sold for at auction​The PMA Team, MA Deputy Editor.

I attended a Barnett Ross auction at the end of last year and found 30-40% of the would-be investors were members of the Asian community. These and other investors were mostly, in comparison to the big commercial property players of this world, small-time. They were people looking for a secure property-backed investment to add to their pension portfolio.

The average investor buying an LESG pub tended to see a 7 or 8% yield on their investment, considerably higher than the return to be obtained by leaving his or her money in the bank.

Provence investors have tended to earn a slightly higher yield of around 9% or more, which, on the face of it, reflects a greater level of perceived risk of default. In the case of LESG, investors have had a very rude awakening.

They will discover they simply overpaid for pub and hotel freeholds because LESG was offering rents that were unrealistic. Why did LESG choose to sell its pubs at auction? The unescapable conclusion is that the company found this was a terrific way to sell pubs for more than had been paid for them. There are, after all, much more straightforward ways to raise money against a freehold pub estate. Call me cynical, but this looks to me like a "get rich quick" scheme. The more rent that LESG companies offered to pay as a tenant, the higher the pub was likely to be sold for at auction. LESG management was on a profit share in respect of auction proceeds so the temptation must be to offer high or unaffordable rents.

As I have stated before, it's an odd business model that delivers huge profits at the front-end. A property expert told me this week that he thought private auction investors "understood that there was a certain element of risk or a certain element of over-rentedness" with LESG properties. I doubt it.

Increased risk

Investors appear to have been pretty naive on the whole when buying LESG sites. A freehold pub tenanted by Mitchells & Butlers or Spirit will sell at a public auction with a rent yield of around 5%. The increased risk involved in buying an LESG pub investment does not seem adequately covered by an extra 2% return on money. Very few LESG buyers seem to have visited the pubs they were acquiring and discussed trading levels with the sitting tenant. LESG was certainly not offering detailed accounts to indicate underlying profit levels so investors could assess the affordability of the rents on offer. I doubt more than a few investors took the time to tour L&E sites to assess the company's skill (or otherwise) as operators. That LESG was trying to run such a vast range of businesses should surely have given rise to suspicion from investors as well. There's a very different skill set involved in running a sizeable golfing hotel compared to a two-barrel-a-week tenancy in Liverpool. Managed pubs need intensive management and proper investment planning over the years.

Licensees left to carry can

One LESG managed hotel, the Golden Lion in Hunstanton, Norfolk, sold to a private investor by Alan Bowes, was closed last week by the administrator Ernst & Young because it was losing so much money. When I visited at the weekend there was obvious neglect in the form of rotten window frames. I think this is one of the finest trading opportunities on the golden coast of North Norfolk but there is no sign of the investment needed to lift it to the trading heights it's capable of.

Some observers have suggested that the Swallow Group part of the company's name must have acted to create an impression of covenant solidity in the mind of investors. But many of the companies offered as tenants in LESG-linked auction sales are not exactly household names - companies such as Newlord, Firstafter and Winlease.

Last week I was inundated with phone calls from LESG tenants when I offered to tell them how much their pub had sold for at auction - and the rent the company had offered. Many were surprised in the extreme by the daft sums investors had paid for their humble boozers. LESG's financial engineering may have produced huge windfalls at auction but had nothing to do with long-term sustainability. Ultimately, of course, it's L&E tenants who deserve the greatest sympathy here.

Less than a year away from a smoking ban, LESG's licensees should be receiving support and investment from a well-resourced pub company to prepare for it.

Licensees have been left to carry the can by a company more intent on playing a lucrative property game than developing its pubs for the future. I have spoken to a number of lessees and tenants this week who have already been approached by their freehold owner. It seems there will be direct negotiation between owner and lessee now on rent, repairing obligations and other issues.

Tenants' rents substantially smaller

The problem for freehold owners is that rent being paid by tenants is substantially smaller than the rent offered by LESG at auction. LESG would have made up the difference with off-invoice discounts from the brewers.

Ultimately, this is a problem for freehold owners not licensees. As I understand it, the terms of tenants sub-lease survive LESG's default and become the terms applicable with the freehold owner. Tenants are in a good position in their direct negotiations with the freehold owners. Commercial property owners need tenants. And many landlords will not look forward to taking on the full repairing obligation - a sizeable discount on rent may be available for licensees who will to take on this obligation. A few years ago, you'll remember, the Trade & Industry Select Committee examined the relationship between the well-known pubcos and their tenants.

The Select Committee was, of course, looking in the wrong part of the industry. Peaking under LESG's stone would have produced a few nasty surprises.