_Spotlight on Retail: Headleases

The changing retail market is going to bring many issues forward, one that has been largely ignored is the shopping centre headlease and how these are still being wrongly viewed as secure income. 

The owners, usually annuity funds or Councils, because of the low perceived risk, shall take note. 

Creating a secured income strip or headlease is always popular in markets with rental growth. The problems are only exposed in sharp downturns, such as the one currently occurring in UK retail. 

The valuation of these headleases is something that has always lurked in the background, apparently not requiring the detailed understanding that a valuation of the Centre would. I remember being left to do this as a graduate valuer, not at KF I hasten to add, as it apparently just required an upward DCF into perpetuity and not a full understanding of the underpinning asset.    

The theory is simple. Let us say a 10% upwards only headlease on a shopping centre where the leasehold is held by a fund. The Landlord has the benefit of the fund’s covenant and recourse to the asset. Hence it is valued at 4% say, while the leasehold may be 8%+. But with today’s increased risk profile is such a premium still valid?

What about if the headlease is upwards and downwards? Why is it not then similar to the yield of the scheme? The recourse to the asset is arguably cancelled out by the lack of control. Yet we are still seeing premiums applied.

How about if the gearing is 20%+ upwards only? 20% of income in 2007 could easily be 50%+ and in extreme circumstances 80%+ of today’s income. These are still too often valued as secure fixed income at c.5%. This can lead to the seeming paradox of a headleases value being greater than the value of the headlease & leasehold combined i.e. a negative marriage value.

This obviously has implications for the Leaseholder, where a commitment to pay a fixed income above the income generated by the Centre can result in the Centre L/H becoming a liability.   

Often Centres are acquired in vehicles, with no further recourse and no covenant strength behind the single owner. The problem then becomes a very real one for the Freeholder. One day they find their secure income stream is not a fixed income, but recourse to a lower income from the Centre when the leaseholder defaults. This will lead to an immediate collapse in their value. Furthermore, if the leaseholder’s only motivation has been to collect income with no consideration to sustainable investment, the chances are they will inherit a Centre in terminal decline. 

It is never easy to acknowledge such a downside might play out. However, there has to be a recognition of the risks and that premium valuations may no longer be appropriate. 

This is particularly pertinent where the Freeholder is the Council. At a time when Councils are under real financial constraint, as well as value and income, the bigger picture and implications for the future vibrancy of the borough need to be considered. Leaving a centre to ‘fail’ in the hands of an unmotivated leaseholder is rarely the answer.     

For more information contact the Knight Frank Retail Team.