Robert Sayles: RPI - the ticking time bomb?

Up until quite recently, pubcos had the luxury of enjoying guaranteed returns from rental premiums.

The upward only rent review clause in lease agreements ensured that this particular income stream was protected against market fluctuations.

Consequently, it was left to the tenant to shoulder any hardship that resulted from a downturn in the market.

Following government pressure, the BBPA finally provided assurances that such clauses would no longer be enforced (a stance to be confirmed by pubcos through their codes of practice).

In addition, RICS has become increasingly proactive of late in attempting to put its house in order. The recently-issued guidance note sought to close some of the loop holes in valuation procedures, a move prompted by concerns that exploitation had resulted in unsustainable rental premiums being set.

These initiatives, whilst welcome for tenants, have posed something of a headache for pubcos. After all, both offer the prospect of a somewhat unwelcome scenario; diminishing returns from rental premiums.

However for the concept of fair maintainable trade (FMT) to be meaningful it must surely legislate for the fact that trade levels fluctuate? And let's be brutally honest about this, the term 'fluctuate' doesn't begin to tell the current story, does it?

Volumes have been quite literally been hammered, particularly during the course of the last three years. The concern for many is that such declines do not appear to be reflected in current rental demands.

As turnover and property valuations continue to fall, one could be forgiven for thinking that rental premiums would be realigned to the 'new market'. The sad fact is that in many cases they continue to reflect the trading levels of a bygone era.

In fact, a cursory glance at sites currently on offer shows that FMT on these 'opportunities' is still being set 25%-30% above current trading levels.

Rather than reduce rents, pubcos are asking tenants to play catch up from day one; an almost impossible task given the current market. What tenants need more than anything else of course is a solid and realistic base upon which to build their businesses.

It was partly such concerns that prompted the RICS to issue their guidance note. Of course such notions do not sit well with some pubcos, particularly those seeking to service burgeoning debt with already diminishing returns.

Given their liabilities, certain pubcos are unlikely to sit idly by whilst one of their primary income streams is trimmed back. It has led some critics to conclude that it is these financial obligations not the market place that will shape the future of pubco agreements.

In a recent meeting with two prominent members of the Business, Innovation & Skills Committee (BISC) David Rusholme and John Anderson of the Royal Institution of Chartered Surveyors (RICS) suggested that pubcos were looking to circumvent their recently issued guidance note.

Such concerns arose from increasing evidence that pubcos are seeking to phase out agreements which offer rent reviews in favour of new five year leases linked to the retail price index (RPI).

Why would the pubcos want rental agreements linked to RPI? Their primary motive I would suggest is to ensure that revenues derived from dry rent are protected in a falling market.

The link to RPI allows pubcos to do two things:

Firstly, effectively bypass RISC guidance by offering agreements with no rent reviews. These agreements are after all, exclusively reliant upon annual inflationary increases. In short, pubcos will ensure rental premiums are not linked to any mechanism which might require them to fall.

Secondly, rather than merely ensuring that rental premiums are consolidated, such agreements will allow rents to increase at substantial levels; this at a time when turnover continues to plummet (see table, right)

Furthermore, the absence of a rent review facility has led some to conclude that this is nothing more than a cynical ploy to keep the gravy train on the rails under the veil of 'flexible' lease agreements.

I recently popped along to visit a pubco and raised this very point, only to be informed that RPI can go down as well as up.

With this in mind I looked at the figures for the last decade. All the indications are that the two gentlemen from the RICS have every reason to voice concerns.

Needless to say, if you've been on an RPI-linked agreement during this period there has only been one winner; suffice to say it isn't you!

The enclosed table (right) shows that RPI has risen every year bar one since the year 2000. Only 2009 saw a decrease and that by a pitiful 0.5%.

Given this, one could be forgiven for concluding that the link to RPI is little more than an upward only rent mechanism, albeit it in another guise.

I have also included figures from the BBPA's beer barometer which show that during this same period volumes fell every year without exception. It is an undeniable fact that tenants have had to cope with two major hurdles; substantial falls in turnover coupled with rising rental premiums.

I think it would be fair to say that somewhere along the line the link between rent and fair maintainable trade has been well and truly severed.

The figures in the table show that:

• Rent linked to RPI would have increased by 35% over an 11 year period.

• Beer volumes during the same period have fallen by more than 40%

Significantly, three of the biggest rises in RPI have occurred in the last four years, when declines in beer volumes have been at their highest.

Let's just think about that for minute, shall we? A 35% increase in rent coupled with a 40% fall in market volumes. And we wonder why 50 pubs a week are closing?

All the indications are that RPI will continue to inflate rental premiums. Just as worryingly, there is nothing to suggest that the steep declines in volumes witnessed in recent times won't continue for the foreseeable future.

As the disparity between turnover and rental premium grows more and more pubs will join the churn cycle.

So, if any of you out there are looking to take on an agreement with a pubco at the moment, might I suggest that during the course of discussions you do the following.

Ask whether or not the proposed agreement is linked to RPI. If it is, then I suspect the pubco representative will smile broadly before informing you that it can go up as well as down.

At this point it might be wise to mention that it almost always goes up. Whilst he/she is digesting this piece of information ask them how the concept of rising rent equates with falling volumes.

I would very be interested in hearing what sort of response you get.