FOR PROFESSIONAL AND INSTITUTIONAL INVESTOR USE ONLY NOT FOR PUBLIC DISTRIBUTION. James Guppy TITLE REAL ESTATE UK REAL ESTATE WINTER 2013

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1 FOR PROFESSIONAL CLIENTS ONLY FOR PROFESSIONAL AND INSTITUTIONAL INVESTOR USE ONLY NOT FOR PUBLIC DISTRIBUTION (PLEASE READ IMPORTANT DISCLOSURES) James Guppy TITLE UK REAL ESTATE UK REAL ESTATE QUARTERLY SUBTITLE INSIGHT QUARTERLY INSIGHT WINTER 2013

2 Renewals, breaks and voids the growing importance of managing lease events The UK commercial property market has undergone dramatic structural changes over the last 20 years. The shortening of average lease lengths and its impact on investment performance and decision making is perhaps one of the most overlooked yet important of these changes. BACKGROUND This process began in the early 1990 s when the traditional 25-year full repairing and insuring (FRI) leases, incorporating upward only rent reviews, began to give way to shorter, 15- and then 10-year terms. Traditional leases enabled property investors to have greater long-term certainty of their cash flows and to gain access to the upside of market and inflationary cycles with limited downside risk. The shortening of lease terms represented a fundamental change in the risk profile of the asset class. One of the reasons why this change has not attracted the attention of property investors is because it has occurred over a long period of time. These changes only applied to new leases, whereas the majority of portfolio income would be tied up in existing longer term leases. The table below illustrates how lease terms have changed over the last 23 years. WEIGHTED AVERAGE NEW LEASE TERM Source: IPD All property An increasing prevalence of lease break clauses, dates on which the tenant (or the landlord) can terminate the lease prior to its contractual expiry date, has accompanied the shortening of lease lengths. The use of incentives such as rent free periods and capital contributions to secure tenants is also increasingly widespread. [2] UK REAL ESTATE QUARTERLY INSIGHT

3 PRICING THE IMPACT PRICING THE IMPACT Shorter leases mean that landlords Shorter leases may be mean faced that with landlords may be fa The impact of shorter leases The is impact to increase of shorter the leases is to increase the prospect the of re-letting a the building prospect on a of more re-letting frequent a building on a more uncertainty in investment cash uncertainty flows and in investment the costs cash flows basis. and the A traditional costs lease on basis. a single A traditional let building lease would on a single let buildin associated with managing assets. associated Their with impact managing is assets. Their be on impact FRI terms. is Devolving be control FRI of terms. maintenance Devolving to the control of mainten not easy to predict as there not are easy cyclical, to predict sectorial as there are cyclical, tenant sectorial is unlikely to be the tenant best strategy is unlikely for to the be landlord the best to strategy for th and locational factors which and influence locational the factors level of which influence ensure the level the of building is ready ensure to let at the all building times. Rather is ready the to let at all times. uncertainty and costs. During uncertainty periods of and strong costs. During periods investors of strong may prefer to acquire investors multi-let may prefer buildings to acquire and so multi-let build occupational demand, competition occupational by occupiers demand, results competition by retain occupiers control results of the maintenance retain control via a service of the maintenance charge. This via a service in a reduction in both leasing a incentives reduction and in both the ability leasing incentives may and result the in ability extra costs in may the result short-term in extra although costs in these short-term alt of tenants to demand shorter of tenants leases or to break demand options. shorter leases should or break be options. recouped through should reduced be recouped void costs through and higher reduced void cos Conversely, when demand weakens Conversely, the when probability demand of weakens the rental probability income in of the long-term. rental income in the long-term. tenants leaving increases, as tenants does the leaving length increases, of any as does the length of any Another strategy which has Another been employed strategy which is to offer has been employed is potential vacancy. This trend potential is more vacancy. pronounced This in trend is more pronounced in incentives and break options incentives which are and conditional. break options Rather which are condit less well-located and/or poorly less well-located configured properties and/or poorly configured properties than the tenant having a free than option the tenant to move having properties a free at option to move p which can be easy to let in boom which times, can be but easy struggle to let in to boom times, but struggle to a lease break, landlords can a lease impose break, penalties landlords if the can break impose penalties find tenants during a slump. find Correctly tenants identifying during a slump. and Correctly identifying and is exercised or offer incentives, is exercised such as or a offer further incentives, rent free such as a furt pricing this cyclicality in performance pricing this and cyclicality the timing in performance of and the timing of period, if it is not. This requires period, the if landlord it is not. to This think requires longterm about the value of the term entire about cash the flow value rather of the than entire cash flow ra the landlord to acquisitions can result in significant acquisitions outperformance, can result in significant outperformance, just as getting this wrong can just dampen as getting potential this wrong returns. can dampen potential returns. just obtain the highest possible just obtain rent, which the highest may have possible a rent, which m To put this in context, in 2012 To put only this 32% in of context, tenants in 2012 only 32% greater of tenants short-term impact greater on capital short-term value. However, impact on with capital value. H renewed their leases (68% renewed vacated their leases buildings) (68% 1. vacated their 40% of buildings) all tenants 1. exercising 40% their of all break tenants clause exercising in 2012, their break claus The office sector, which saw The an office unusually sector, large which number saw an unusually including large 75% number of retail tenants including 1, the 75% benefits of retail of reducing tenants 1, the benefits o of 25-year Central London of leases 25-year expire Central in 2012, London saw leases expire this rate in 2012, are substantial. saw this rate are substantial. only 21% of tenants renewing only their 21% leases of tenants in 2012 renewing as their leases in 2012 as EXPLOITING OPPORTUNITIES EXPLOITING OPPORTUNITIES compared to 46% for the retail compared sectorto 1. The 46% higher for the level retail sector 1. The higher level The key challenge for investors The key remains challenge how for to accurately investors remains how of renewal of retail leases reflects of renewal not of the retail underlying leases reflects not the underlying price lease cash flow events. price Shorter lease cash leases, flow rising events. Shorter leases, strength of this sector but strength the substantially of this sector lower but level the substantially lower level incentives and the increasing incentives use of break and the clauses increasing use of break cl of physical obsolescence of retail physical properties obsolescence compared of retail properties compared have made this more complex, have but made this this also more creates complex, but this also c to offices. to offices. opportunities for investors opportunities who can understand for investors and who can understa POTENTIAL STRATEGIES POTENTIAL STRATEGIES exploit these changes. This exploit can be these achieved changes. in the This can be achieved i There are, however, a number There of strategies are, however, that a an number of strategies short-term that an by taking advantage short-term of cyclical by taking pricing advantage of cyclical pr investor can employ to mitigate investor the can impact employ of shorter to mitigate the impact opportunities. of shorter Over the long-term, opportunities. the more Over potent the long-term, the more p leases. One is to offer tenants leases. the flexibility One is to offer very tenants short the flexibility strategy of will very be short to deliver higher strategy levels will be of income to deliver higher levels of inco leases which can generate leases premium which levels can of generate rents. premium returns levels of and rents. rental growth returns year after and year rental through growth good year after year thro This model tends to work for This well-located model tends properties to work for well-located relationships properties with their tenants. relationships with their tenants. where there is a large potential where pool there of occupiers; is a large potential it is pool of occupiers; it is 1 Source: IPD/Strutt & Parker Lease 1 Source: Event Survey IPD/Strutt & Parker Lease Event Survey very dynamic as rents will tend very to dynamic be more as volatile rents will in tend to be more volatile in response to the ebb and flow response of occupational to the ebb demand. flow of occupational demand. Another is to try to establish Another longer is term to try relationships, to establish longer term relationships, working to understand tenants working businesses, to understand responding tenants businesses, responding to their changing requirements to their and changing fixing any requirements problems and fixing any problems that they may have, thus encouraging that they may them have, to want thus to encouraging them to want to keep their landlord. keep their landlord. WINTER 2013 [3] WINTE

4 Market review The pace of the UK economic recovery accelerated in the fourth quarter of 2013, driven by a recovery in consumer and business confidence and a buoyant housing market. This improvement was replicated in the commercial property market which recorded returns of 4.4% 2 in the three months to December, 1.6 percentage points higher than the previous quarter. For the calendar year as a whole, total returns on UK commercial property stood at 10.5% 2, compared to the 18.5% 2 recorded by UK equities and -5.2% 2 recorded by UK government bonds. The improvement in performance was broad-based as all the main sectors and regions recorded positive capital growth. Returns on Central London office and retail investments remained strongest, underpinned by rising rents and investment demand. However, the greatest improvement was in the markets surrounding Central London, particularly in the Thames Valley. This improvement was largely driven by strengthening investment demand for office and industrial properties, accompanied by an improving occupational market. Outside of the South East of England, occupational demand remains relatively subdued and the improvement in performance is largely the result of a recovery in investment demand for properties in the larger commercial centres. Over the twelve months to December 2013, the office and industrial sectors returned 13.6% and 13.1% 3 respectively as both were favoured by domestic and international investors alike. The retail sector however continued to lag, recording a return of 8.1% 3 as online sales grew and the sector struggled with elevated levels of town centre vacancy. 2 Source: IPD UK Quarterly Index Q Source: IPD Quarterly Property Index December [4] UK REAL ESTATE QUARTERLY INSIGHT

5 OFFICES PRICING THE IMPACT Shorter leases mean that landlords may be fa The impact of shorter leases is to increase RETAIL the PERFORMANCE the prospect COMPOSITION of re-letting a building on a more The West End of London regained its position as the uncertainty in investment cash flows and 12 the months costs to Q basis. A traditional lease on a single let buildin best-performing sub-sector in the fourth quarter of 2013, 16% associated with managing assets. Their impact is be on FRI terms. Devolving control of mainten delivering strong capital growth from a combination of not easy to predict as there are cyclical, 12% sectorial tenant is unlikely to be the best strategy for th rising rents and yield compression. Outside of Central and locational factors which influence the 8% level of ensure the building is ready to let at all times. London, rental growth is emerging in a handful of uncertainty and costs. During periods of strong 4% investors may prefer to acquire multi-let build Thames Valley centres which, together with renewed occupational demand, competition by occupiers results retain control of the maintenance via a service investor appetite, has driven the sharp improvement 0% in a reduction in both leasing incentives and the ability may result in extra costs in the short-term alt in the performance of the South East office market. -4% of tenants to demand shorter leases or break options. SE UKshould be Shopping recouped through Retail reduced void cos Occupational demand across the Central London and Shops Shops Centres Warehouses Conversely, when demand weakens the probability of rental income in the long-term. Thames Valley office markets has improved steadily over Income ERV Yield Residual Total tenants leaving increases, as does the length return of any growth impact return the course of the year to exceed its long-term average, Another strategy which has been employed is potential vacancy. This trend is more pronounced Source: IPD Quarterly in Index as at 31 December although outside of the South East, occupational demand incentives and break options which are condit less well-located and/or poorly configured properties remains subdued. than the tenant having a free option to move p which can be easy to let in boom times, but struggle to INDUSTRIAL a lease break, landlords can impose penalties find tenants during a slump. Correctly identifying and OFFICES PERFORMANCE COMPOSITION is exercised or offer incentives, such as a furt pricing this cyclicality in performance Investment and the timing activity of in the industrial sector was at its 12 months to Q period, if it highest level seven years in is not. This requires the landlord to acquisitions can result in significant outperformance,. Competition for 20% term about the value of the entire cash flow ra just as getting this wrong can dampen investments, potential returns. particularly those in London 15% just obtain the highest possible rent, which m and the South East, has driven prices up, although To put this in context, in 2012 only 32% of tenants greater short-term impact on capital value. H 10% rising rents have also played a role. renewed their leases (68% vacated their buildings) 1. 40% of all tenants exercising their break claus 5% 0% The office sector, which saw an unusually Vacancy large rates number in the logistics including sector 75% declined of retail tenants 1, the benefits o of 25-year Central London leases expire significantly in 2012, saw over the course this of rate are The substantial. absence -5% only 21% of tenants renewing their leases of speculative in 2012 as building over the last five years has City West End Rest of SE Rest of UK EXPLOITING OPPORTUNITIES compared to 46% for the retail sector resulted. The higher in a dearth level of available prime accommodation, Income ERV Yield Residual Total The key challenge for investors remains how return growth of renewal impact of retail leases return reflects not particularly the underlying the Midlands and South East. price lease cash flow events. Shorter leases, strength of this sector but the substantially lower level Source: IPD Quarterly Index as at 31 December Industrials in London and incentives the South and East the continue increasing use of break cl of physical obsolescence of retail properties compared to enjoy stronger occupational have made and investor this more demand complex, but this also c to offices. than the rest of the country. opportunities However, higher for investors levels of who can understa RETAIL POTENTIAL STRATEGIES income return (despite higher exploit rates these of vacancy) changes. and This can be achieved i The performance of the retail There sector are, however, improved a number of strategies the emergence that an of modest short-term rental growth by taking supports advantage the of cyclical pr significantly over the second investor half of can 2013, employ although to mitigate the impact performance of shorter of industrial opportunities. properties outside Over the of London long-term, the more p the market remains sharply leases. polarized. One is Central to offer London tenants the flexibility and the of South very short East. retail continues to enjoy very leases strong which occupational can generate and premium levels of rents. strategy will be to deliver higher levels of inco returns and rental growth year after year thro investment demand whereas This the model rest tends of the to country work for well-located INDUSTRIAL properties PERFORMANCE relationships COMPOSITION with their tenants. suffers from a high level of where vacancy, there and is a weaker large potential tenant pool of occupiers; 12 months to it Q4 is 2013 and investor demand. With very the dynamic exception as of rents Central will tend to be more 16% volatile in 1 Source: IPD/Strutt & Parker Lease Event Survey London, market incentives response remain substantial, to the ebb and although flow of occupational 12% demand. the fourth quarter s numbers Another suggest is to that try to rents establish are longer term 8% relationships, beginning to stabilize and working that rental to understand growth is beginning tenants businesses, responding 4% to spill over into Outer London to their markets. changing Outside requirements of the and fixing any problems 0% South East, retail rents continue that they to may drift have, lower. thus encouraging them to want to keep their landlord. The retail warehouse sector strengthened considerably -4% London Industrials SE Industrials Rest of UK Industrials in the last quarter of The absorption of space released by retailer administrations in 2012 is all but Income return ERV growth Yield impact Residual Total return complete which, together with the lack of further Source: IPD Quarterly Index as at 31 December significant tenant failures, has put the performance of this sector onto a firmer footing and attracted renewed investor interest. 4 Source: CBRE as at 31 December WINTER 2013 [5] WINTE

6 Market outlook The rapidly strengthening economy provides significant scope for optimism for occupational demand in 2014 and However, the current recovery has been too dependent on the consumer and we have yet to see a sustained recovery in business investment. There is an expectation that flows into UK Real Estate will continue unabated as both overseas investors and UK institutions look to re-allocate capital to the sector. This is likely to put further downward pressure on investment yields in 2014 and potentially 2015, which together with rental growth is likely to drive up values. Falls in unemployment have not, as yet, been matched by wage or price inflation and so interest rates are unlikely to rise over the next 12 months. However, the resurgent housing market and improved employment outlook is likely to put upward pressure on rates in 2015 or Higher bond yields could tempt investors to withdraw capital from the property market, especially if growth begins to falter as consumers adjust to higher mortgage rates. London and the South East are expected to see the greater share of economic growth over the coming years by virtue of their higher exposure to faster growing service sectors and, over the medium-term, to stronger global growth. Outside of the South East, a greater dependence on the public sector, which is being forced to reduce expenditure over the next five years, is likely to act as a brake on the recovery. These trends are expected to be most beneficial to the office and industrial sectors in London and the South East. Rental growth is already widespread in Central London office markets and this is expected to spread out into the Thames Valley over the course of Whilst performance is likely to improve across the region, the polarisation in occupational demand towards the better office locations around Central London and in the Thames Valley is expected to continue. As a result, there is likely to be a wide range in performance between different centres. That said, in a number of weaker centres, the polarisation of the market is already apparent as net effective rents are at historically low levels versus the prime rents in the best centres. The absence of speculative development activity outside of Central London over the last five years has reduced the availability of good quality accommodation to rent. This is expected to result in strong competition for limited grade A space over the next months, driving prime rents higher in a number of markets. However, it is anticipated that development activity will pick up over the course of 2014 and 2015, and the delivery of this new space to the market in 2016 and 2017, accompanied by higher interest rates, may represent a medium-term threat to the performance of these markets. The next two years are likely to see an improvement in the outlook for retail property, although this may be short lived as this sector more than any other is exposed to the impact of interest rate rises on consumer spending. The regional impact of higher interest rates is uncertain; higher interest rates might be offset in the South East by higher wage growth, although should house prices in the South East rise rapidly over the next few years the impact could be greater here. [6] UK REAL ESTATE QUARTERLY INSIGHT

7 PRICING THE IMPACT The impact of shorter leases is to increase the uncertainty in investment cash flows and the costs associated with managing assets. Their impact is not easy to predict as there are cyclical, sectorial and locational factors which influence the level of uncertainty and costs. During periods of strong With around 80% of retail leases expiring over the next five occupational demand, competition by occupiers results years5, BlackRock Real Estate expects the decline of many in a reduction in both leasing incentives and the ability small and medium-sized town centres to accelerate over of tenants to demand shorter leases or break options. the next few years as retailers consolidate their physical Conversely, when demand weakens the probability of presence into 80 of the largest retail centres. tenants leaving increases, as does the length of any potential vacancy. This trend is more pronounced in The success of click and collect as part of a multi-channel and/or poorly configured properties retail offer has led to Argos, less Nextwell-located and John Lewis reporting which can be easy to let intoboom times, but struggle to strong Christmas sales figures. This trend is expected find tenants a slump. Correctly identifying and benefit Retail Parks (and potentially tradeduring counters) due to pricing this cyclicality in performance and the timing of ease of access and availability of free parking. acquisitions can result in significant outperformance, Occupational and investor demand for industrial just as getting this wrong can dampen potential returns. accommodation is expected to remain robust over the next put this in context, in 2012 only two to three years. StrongerTo rental and capital appreciation is 32% of tenants their leases (68% vacated their buildings)1. expected in London and therenewed South East where availability is more limited and the size of The the market is shrinking assaw a result office sector, which an unusually large number of conversion to higher valueofland uses.central London leases expire in 2012, saw 25-year only 21% of tenants renewing their leases in 2012 as The logistics market, which is closely tied to the retail sector, compared to 46% for the retail sector1. The higher level continues to evolve and is likely to face headwinds after of renewal of retail leases reflects not the underlying The growth of internet retailing and click and collect strength of this sector but the substantially lower level is expected to result in the complete reorganization of of physical obsolescence of retail properties compared many retailers logistics operations over the coming years. to offices. This could render many existing buildings and locations uneconomic but also present significant opportunities for POTENTIAL STRATEGIES new ones. There are, however, a number of strategies that an 5 Source: theguardian.com and markit.com investor as can employ to mitigate the impact of shorter at 30 September leases. One is to offer tenants the flexibility of very short leases which can generate premium levels of rents. This model tends to work for well-located properties where there is a large potential pool of occupiers; it is very dynamic as rents will tend to be more volatile in response to the ebb and flow of occupational demand. Another is to try to establish longer term relationships, working to understand tenants businesses, responding to their changing requirements and fixing any problems that they may have, thus encouraging them to want to keep their landlord. Shorter leases mean that landlords may be fa the prospect of re-letting a building on a more basis. A traditional lease on a single let buildin be on FRI terms. Devolving control of mainten tenant is unlikely to be the best strategy for th ensure the building is ready to let at all times. investors may prefer to acquire multi-let build retain control of the maintenance via a service may result in extra costs in the short-term alt should be recouped through reduced void cos rental income in the long-term. Another strategy which has been employed is incentives and break options which are condit than the tenant having a free option to move p a lease break, landlords can impose penalties is exercised or offer incentives, such as a furt period, if it is not. This requires the landlord to term about the value of the entire cash flow ra just obtain the highest possible rent, which m greater short-term impact on capital value. H 40% of all tenants exercising their break claus including 75% of retail tenants1, the benefits o this rate are substantial. EXPLOITING OPPORTUNITIES The key challenge for investors remains how price lease cash flow events. Shorter leases, incentives and the increasing use of break cl have made this more complex, but this also c opportunities for investors who can understa exploit these changes. This can be achieved i short-term by taking advantage of cyclical pr opportunities. Over the long-term, the more p strategy will be to deliver higher levels of inco returns and rental growth year after year thro relationships with their tenants. 1 Source: IPD/Strutt & Parker Lease Event Survey James Guppy W I N T E R [7] WINTE

8 e ebb and flow of occupational demand. ry to establish longer term relationships, erstand tenants businesses, responding ng requirements and fixing any problems have, thus encouraging them to want to lord. WHY BLACKROCK As the world s largest investment manager, we believe it s our responsibility to help investors of all sizes succeed in the New World of Investing. We were built to provide the global market insight, breadth of capabilities and deep risk management expertise these times require. The resources you need for a new world of investing Investing with BlackRock gives you access to every asset class, geography and investment style, as well as extensive market intelligence and risk analysis, to help build the dynamic, diverse portfolios these times require. 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