by Duncan Lyster, Director, Investment Department
For a large part of the last decade, the world looked at the Republic of Ireland and puzzled over the low levels of commercial property yields. The reason often trotted out was the exceptional rental growth story, now clearly unsustainable with the benefit of hindsight.
With the occupational markets in varying states of disarray, investors cling to the security of income they worked hard to secure in better times. The programme for government includes a commitment to end upward only rent reviews for existing Irish leases.
Legal experts can debate the legality of such a step. What is clear is that the property investment market is frozen as a result. In 2009 and 2010, when the economy was in free fall and debt was virtually impossible to secure, investments continued to be traded. While the economic picture is no better, the uncertainty we have at present has shut down activity. This is costing the state significant stamp duty and adding to the credibility problem we have beyond these shores.
If the government is true to its commitment, it will move the Republic of Ireland from a market most comparable with the UK to a more European lease structure.
This is not necessarily a bad thing, it’s just different. It will mean less predictable rental streams. Although it may seem like a distant prospect, the letting markets will become less tenant friendly as net take-up eats away at the overhang of space. When occupational markets are tight, landlords will exert their power over tenants in different ways, perhaps not granting long leases so tenants do not hold all the cards come rent review. It will in effect commit tenants to 5 years of rent at a level.
It will also mean that it will be harder to justify development of new property. In order to get a developer funded to develop, rents may need to be much higher than under the upward only model. What people forget is that, in a flat market, the upwards only model allowed rent to stayed the same for the entire 5 years, thus ignoring inflation in the intervening period.
The new legislation will probably lead to greater volatility in rents, which can work for and against both tenants and landlords.
It will make the Republic of Ireland a less attractive place for overseas property investors. Given the lack of local capital available, or likely to be available in the medium term, this is not good news for tenants who rely on investors to develop, refurbish and improve the stock of buildings for tenants to trade from.
Irish long-term average yields are very much in line with UK regional cities as one might expect due to the fact that our lease structures have been largely similar. Changing the lease structures will move the Republic of Ireland closer to those markets of a similar size economy with 5-year rental commitments. Yields should reflect the risks and potential rewards available to investors. Larger more robust economies like the UK and Germany should offer less risk and intuitively be priced at a keener level. The differential between Ireland and these larger economies over the last 20 years does not show this. This was down to the perceived rewards from ‘Tiger growth’ available in Ireland.
Changing our lease law moves us further away from the UK and probably closer to similar sized economies in peripheral European countries like Denmark or Portugal where 5-year lease lengths are commonplace.
The changes to leases proposed may well see our yields settle at or about 100 basis points higher than historic yields in Ireland. That translates to a reduction in capital values of between 15% and 20% on average. The 20-year average retail yield is 5% with office at 6.25%. Seeing them settle closer to 6% and 7.25% respectively, has major implications for our Banks, NAMA and pension funds in which a large proportion of the population have an investment. We know who will have to fund the shortfall….
What is clear is that occupational markets were correcting prior to this market intervention. The government interference has had, and will continue to have, further significant knock-on effects that appear not to have been fully considered by those driving these changes.