Comment - Is this the end of the road?

What a difference a couple of years make. Until comparatively recently pubs and hotels were deemed unsuitable as investment vehicles.

Chef & Brewer's sale and leaseback deal with Land Securities in 1995 changed this view. The rents on these deals may have been 'full', but they were neither unaffordable nor unreasonable. The first of the Chef & Brewer properties came into auction rooms around July 2002, fetching returns such as seven per cent in Orpington, Kent and 7.1 per cent in Farnborough, Hampshire, on sale prices of £1,200,000 and £1,120,000 respectively.

Also, a whole new investment market in licensed properties has developed in the past 10 years, with the likes of All Bar One, Slug and Lettuce and Hogshead taking retail units in town centres.

This 'blue chip' high street investment sector, where values are significantly above the £1m benchmark, is relatively well structured and informed. True, there are issues of over-supply in the high street and arguments about rental quality, but good locations with alternative use options continue to drive prices and yields. Plus rents are reviewed on a '£ per square foot' basis, making it easier for investors to consider rental growth and the serviceability of the rent.

Some companies have, meanwhile, bought pubs with vacant possession at one price to sell at a higher price as an investment at auction. This is probably a direct result of market sentiment, given a general business trend of separating the running of a business from the ownership of property.

Operator v investor

The difference in value of a property to an investor and to an operator is best explained by the risk and effort involved in each case. An investor takes the 'top slice' of profit, collected as rent, and is unconcerned with the vagaries of running a business.

And here's the crunch. The operator needs to be actively involved in ensuring that profits are earned and therefore he requires a higher return on his invested cash.

However, as a natural consequence of a sale and leaseback transaction, profits retained by the business operator are at greater risk. They are the 'bottom slice profits'. A leasehold business is more highly geared than a freehold one.

While some entities are coming up with investments at rents that could prove problematic 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's up to the bidder at auction to be aware of the market value of the property he is bidding for. He should assess its rental growth prospects, or even the prospect of the existing tenant paying the current rent in the foreseeable future.

The state of the sector

Two stark issues not on investors' radar are the sheer degree of the over-rented position in many instances involving the secondary tenanted pub investment market, and the significant gap between the respective investment value and vacant possession values in this sub-sector.

This contrasts with the high street and traditional managed house investment markets, where there is stronger demand from occupiers should a business fail (be that from alternate operator or alternative uses) and where in general there is a closer relationship between rents being paid and current open market rental values.

For the operator, the sale and leaseback provides extra capital to purchase more properties, which in turn increases buying power. This creates additional company wholesale profit and helps improve the perception of tenant covenant strength, although not without problems, though, as recent events would attest.

Investors are clearly attracted by the yield profile which remains relatively healthy set against current borrowing costs.

Also, it has to be said that to date there have been relatively few company business failures in this sector. For the lending institutions there is money available to lend and the ability to take cover from additional properties as security help balance the potential risks.

Demand still high

At the end of the day, people are still hungry for licensed property as an investment. There are also operators prepared to create investments at levels of rent which by general standards are likely to prove unsustainable.

If the creators of these investments suffer business failure in the future there will be many investors left with property worth much less than they paid. If the creators of these investments find assignees to take over unviable businesses there will be even more stories of heartbreak and bankruptcy.

Can the auction houses simply wash their hands of the problem? Is it the fault of greedy investors who do not bother to take advice until it is too late? Or are the banks once again simply too keen to lend?