Heat's on for over-rented pubs

There have been claims that the pub-owning company Provence is charging tenants unaffordable rents at some country inns. Its pubs are sold to investors on the basis of the rent levels promised by the company. Below, Barry Gillham, chairman of Fleurets, looks at the value of a pub as an over-rented investment

The auction market is red-hot at the moment (some would even claim it is overheating) while investors really don't know where to put their money.

Meanwhile, the Stock Exchange has given most people negative returns over the past five years.

The bond market is vulnerable to increased interest rates or company failures and deposit accounts continue to pay very low returns.

Investors have turned their attention to property, while smaller investors are particularly interested in lot sizes of under £1m. The auction market is a keen supplier of such investments.

Until comparatively recently, pubs and hotels were not considered suitable as investment properties. Investors in particular did not like profits method valuations, because they did not understand them. However, the market today is seeing an increasing number of pub investments.

Chef & Brewer started the trend when it did a sale-and-leaseback deal with Land Securities in 1995. Land Securities has sold many of these investments in the past three or four years and there is now a wide spread of freehold owners.

The leases in the main remain with Spirit Group, which bought the Chef & Brewer chain from Scottish & Newcastle Retail.

Yates did a joint venture with Quintain in 1997, which was essentially a sale-and-leaseback transaction. Again, Quintain has now sold all of these investments to a variety of purchasers.

Yates has assigned some of the leases, but Laurel remains lessee in the majority of cases.

Both of these transactions were of big, profitable managed houses (managed houses are the top 20% of pubs in terms of turnover and profitability).

Most are in town centres and have relatively strong underlying property values in the unlikely event of tenant failure and the investor having to find another tenant or sell the freehold with vacant possession.

Some of the Chef & Brewer pubs are not in high streets, but generally on large sites in suburban locations and continue to represent strong property-backed investments irrespective of the covenant of the lessee. Indeed it can be generally expected that, upon assignment or tenant failure, a tenant of equal stature (or nearly so) could be found in many cases.

Rents were full but not too pricey

When sale-and-leasebacks were created, the lessees fully expected to be running businesses from the units for the foreseeable future. The rents may have been full (to maximise the amount of cash raised) but they were not unaffordable, nor unreasonable. The first of the Chef & Brewer properties came into auction rooms, I believe, in July 2002 and fetched returns such as 7% in Orpington, Kent and 7.1% in Farnborough, Hampshire, on sale prices of £1.020m and £1.115m.

Among the first Quintain/Yates investments to be auctioned were the Coventry and Birkenhead outlets, which sold in February 2003 for £1.9m at a yield of 7.7%, and £1.02m at 7.8% respectively. Earlier, two Yates outlets, not part of the Quintain estate, sold in July 2001 at yields of 7.4%.

These may be regarded as 'blue chip' pub investments. As the auction market has heated up yields have fallen and the most recent examples are Chef & Brewer investments in Chiswick at 5.1% in February 2005 (though this was low because of an outstanding rent review) and in Reading at 5.4% in October 2004. Similarly, the last eight Yates investments sold at auction in October last year for between 5% and 7.5%, with typical examples being in Oxford at 5.34% and Sheffield at 6.8%.

Average yields fell from about 7.4% to 5.9%. This blue chip covenant A3 high-street investment sector, where values are significantly above the £1m benchmark, is a relatively well-structured and informed market where rents may be full, but the majority of investments sold are not sale-and-leasebacks created by the occupier, but units originally let at arm's length, at market rents pursuant at the time.

As has been well-documented there are current issues of saturation in the high street and arguments that the rental tone has fallen in many locations. Nevertheless a perception of strong location with potential alternative use options continues to transpose into strong realisable prices and yields.

Also, rents in this sector are reviewed on a pound-per-square-foot basis, in line with a number of other core property sectors, which makes it easier for the investment purchaser to analyse and consider prospects for future rental growth and indeed the serviceability of the passing rent.

Small pubs prove to be big draw

The interest in sales of pubs by auction has trickled down to smaller inns, usually run under tenancy or lease. London & Edinburgh and its various associated companies have raised the most capital by way of the immediate sale of the freehold investment in pubs it has recently bought.

They grant a lease to the trading company, often offering guaranteed uplifts at the fifth and 10th-year rent reviews. London & Edinburgh in turn grants subleases of its pubs to tied lessees, who buy beer on a tied basis. Sometimes the rent collected from the tied lessee will cover the rent paid to the freeholder but more often London & Edinburgh makes up the shortfall (and its profit) from the wholesale profit it makes as the tied supplier of beer.

Two of the first pubs sold at auction by London & Edinburgh Inns, in December 2000, were in Bury St Edmunds, which sold for £166,000, showing 7.7%, and Hastings, which sold for £125,000, a yield of 9.5%. More recent auction sales in March 2005 have seen a property in Midhurst sell for £775,000, a yield of 6.7%, while one in Atherton, Lancashire, realised £452,500, giving a yield of 7.5%. Average yields have fallen from 9% to 7%.

Market must be wary of yields

The yield gap between the big managed houses and the tenanted pubs has narrowed from 7.4% to 9% in 2002/3 to 5.9% to 7.2% in 2004/2005. On the face of it, this narrowing of the yield gap, from around 1.6% to 1.3% or thereabouts, is a relatively minor one, but this needs to be considered in the light of the different characteristics of the two sectors and, in particular, the context of the commentary on rents, rental values and capital values which follows.

The market needs to be wary of too much yield compression between prime and secondary properties, which is a classic feature of a potentially overheated market. In such conditions the secondary property market becomes relatively more risky, particularly, if it becomes exposed to weak occupational factors and unsustainable rents.

Bidders should get wise to value

So far, so good. However, other companies have seen it is possible to buy pubs with vacant possession at one price and sell them at a much higher price as an investment at auction. Some are creating investments at rents that are unlikely to be affordable in the medium or even short term.

There is nothing illegal about creating an investment at a rent which is up to double the market rate. It is up to the bidder at auction to be aware of the market value of the property he is bidding for.

He should make his decision based on the prospects for rental growth or even the likelihood of the existing tenant paying the current rent in the foreseeable future. He should consider what would happen if the current tenant should suffer business failure or seek an assignee.

Is there a likelihood that a tenant of equal or better financial standing would wish to run the business, paying at least as much rent as is currently covenanted?

Buyers blissfully ignorant of risk

I have had recent experience of providing valuations to the lending institutions approached by buyers at auction after they are lega