Small Business, Enterprise and Employment Bill

Written evidence submitted by the Royal Institute of Chartered Surveyors (RICS) (SB 45)

RICS are pleased to submit our comments on the Small Business, Enterprise and Employment Bill and Draft Statutory Code relating to the proposed Pubs Code.

RICS, as the leading professional body representing valuation and author of professional guidance on Capital and Rental Valuation of Public Houses, Bars, Restaurants and Nightclubs in England and Wales, provides comment, from a valuation point of view, on aspects of the Small Business, Enterprise & Employment Bill (Part 4, The Pub’s Code Adjudicator & the Pub’s Code) and also the draft Statutory Code at Annex F. Our advice is provided in the public interest and in relation to the valuation implications of the proposals.

BACKGROUND INFORMATION

RICS is the leading global organisation for professionals working in real estate, land, and construction and on related environmental issues as well as those working in the personal property and business assets sectors.

Over 120,000 RICS members, who are Chartered Surveyors, exist globally and operate out of 146 countries, supported by an extensive network of regional offices located in every continent. RICS Headquarters is based in London and our international work is supported by a network of regional offices and national associations.

RICS members play a vital role throughout the entire asset life cycle – from initial inspection and measurement of real estate, through development and investment to occupation and use of physical structures and other assets, including valuation of financial and business interests. RICS also provides impartial advice to Governments, policymakers and non-Government organisations.

RICS is an independent professional body, which was established in 1868 and has a UK Royal Charter. It is committed to setting and upholding the highest standards of excellence and integrity, providing impartial and authoritative advice on key land and asset issues affecting businesses and society.

RICS is a regulator of both its individual members and firms enabling it to maintain the highest standards and providing the basis for unparalleled client confidence in the sector.

The general ethical principles for all RICS regulated members and firms are set out in our professional and ethical standards from which the following is an extract:

Act with integrity – Be honest and straightforward in all that you do

Always provide a high standard of service - Always ensure your client, or others to whom you have a professional responsibility, receive the best possible advice, support or performance of the terms of engagement you have agreed.

Act in a way that promotes trust in the profession - Act in a manner, both in your

professional life and private life, to promote you, your firm or the organisation you

work for in a professional and positive way.

Treat others with respect - Treat everyone with courtesy, politeness and respect and

consider cultural sensitivities and business practices.

Take responsibility - Be accountable for all your actions - don't blame others if things

go wrong, and if you suspect something isn't right, be prepared to take action.

Members of RICS are Chartered Surveyors who are qualified professionals and generally have five or six years of both study and professional training as a minimum. Thereafter, after qualifying, they gain sector experience in their chosen field. They are required to continue lifetime learning (continued professional development) throughout their career. Many Chartered Surveyors have trained to a higher level in particular specialisms.

As well as learning about legal aspects of property ownership, occupation and management, a Chartered Surveyor is trained to analyse market transactions and, if valuation is the chosen career path, to apply such analysis for valuation purposes. Valuation is not a formulaic process which is one of the common misconceptions held by the layman.

RICS and Valuation Standards

The first RICS Valuation Standards were produced in 1976 and have undergone considerable expansion and refinement through successive editions since then. The current standards and associated guidance are contained in the publication of the "RICS Valuation – Professional Standards", incorporating the International Valuation Standards, which took effect on 1st January 2014. The standards are commonly known as "the Red Book" and contain mandatory rules and best practice guidance for valuations of real estate and other assets. Whilst an obligatory reference work for RICS members and RICS-regulated firms worldwide undertaking valuation work, it is also widely referred to by non-RICS valuers.

The global section of the Red Book provides a broad ethical framework which can be applied to valuations of any asset type in any jurisdiction, in harmony with national legislation and covers the following:

• Compliance, competence, independence and ethical requirements;

• Terms of engagement;

• Valuation bases (global);

• Valuation applications;

• Investigations, inspections and verification of information; and

• Valuation reports.

The requirements relating to application, competence, independence and objectivity are set out in Practice Statement 2.

The global standards and guidance are accompanied by detailed national standards and guidance, of which there is an extensive suite for the UK.

Public houses fall within a category of property known within the valuation profession as Trade Related Property. This is property which has been specially built or substantially adapted for a specific use. In fact most forms of leisure property are trade related properties. They are bought, sold or leased on the basis that it is the trading potential that drives value, both capital and rental.

The valuation of trade related property is normally undertaken using the profits method of valuation, as acknowledged by Valuation Practice Guidance – applications (VPGA) 4 of The Red Book, which has been in existence for many years. Although a profits method valuation is not a formulaic calculation, it reflects a number of inputs derived directly from property markets analysed and where appropriate adjusted by application of the skills, knowledge and judgement of the valuer. Inter alia it has to take into account the terms of the lease, the physical attributes of the property and the trading potential that the property offers an operator, not necessarily that which is being achieved.

Valuation is by its very nature, subjective. It is an art, not a science. In the UK, the majority of disputes that get referred to a third party – which is very few in both actual number and percentage of reviews undertaken annually – usually have Chartered Surveyors acting on both sides. This clearly demonstrates how even highly qualified, experienced valuers can have differences of opinion. It is not a matter of failure in the landlord and tenant relationship. It is a difference of opinion on one or more of the individual aspects of the rental valuation. For more information please visit http://www.ricsvaluation.org/

RICS Guidance Note GN 67/2010 "The capital and rental valuation of public houses, bars, restaurants and nightclubs in England and Wales"

This RICS Guidance Note has been mentioned numerous times throughout the consultation paper. It is an update of the previous RICS Valuation Information Paper No 2 and was produced in 2010. It sets out the well-established practice of public house valuation derived from the 1970’s, when public houses started to be let on commercial leases in addition to the traditional tied tenancy. In the remainder of this response, references to the "Guidance Note" mean references to GN 67/2010.

The procedures in this Guidance Note are recommended for specific professional tasks and are intended to embody "best practice". It recognises six different categories of pub type and four different ways of operating the business. The experienced licensed property valuer will understand the complexities of the individual sectors and how they interact with each other, depending on the circumstances of each property and their ability to be converted. In addition to the above factors, each type of pub and each way of operating it relate to both the tied and free of tie markets. It is important to note that members are not required to follow the advice and recommendations in the guidance note i.e. it is not considered mandatory from an RICS perspective, but they are asked to consider the following:

1. Where an allegation of professional negligence is made, the court is likely to take into account any guidance issued by RICS as to whether the surveyor had acted with reasonable competence.

2. Members conforming to the guidance should at least have a partial defence to an allegation of negligence if they have followed the guidance.

3. Members have the responsibility of deciding whether the guidance is relevant in each instance. If it is followed in an inappropriate instance then the member will not be exonerated merely because they followed the guidance.

4. Where members do depart from the good practice recommended in the guidance note, they should do so for good reason and they may be required to explain why they did so.

The consultation includes the proposal that all valuers should make reference to the guidance RICS has produced. Whilst we do support this position, we refer you to point 3 above which states that there may be specific instances where the valuer feels that it is inappropriate to follow the guidance. RICS makes an allowance for this depending on the circumstances of the case but it appears that the Statutory Code will force him/her to follow it regardless. The government may wish to consider whether there might be exceptions to this proposal, but on the proviso that the Guidance will be followed unless there is a very good reason why it has not been, such reason to be made clear.

GENERAL OBSERVATIONS

The Principles of Valuation of Public Houses

RICS is specifically mentioned in the draft Statutory Code, particularly in connection with its Guidance Note. The Code is to make it compulsory that a qualified Chartered Surveyor approves the landlord’s assessment of rent.

Public houses (pubs), are recognised as trade related properties, and are seen as a specialist market. The reason the pub market is specialist is because each public house is a unique business entity. It is a property asset and business, and often a home, valued as a single entity. It is rare for two public houses to be the same.

An individual public house can be operated in a number of ways. For example, a wet led operation, perhaps with considerable gaming machine income; a wet led operation with bar snacks; a wet led operation selling premium products; a traditional community local with a mix of wet sales and food sales; a business that concentrates on food sales; and an out and out food operation more akin to a restaurant.

Pubs are valued by reference to their trading potential. In the Guidance Note this is referred to as the Fair Maintainable Turnover (FMT) and Fair Maintainable Operating Profit (FMOP). In valuation terms, the valuer considers the operation of the business in the hands of a reasonably efficient operator, assuming that the property is properly maintained and decorated. The actual choice of the style of operation is a matter for the property owner, whether that be an owner/occupier or a landlord granting a lease to an incoming tenant.

The different styles of operation will produce differing trading results, both in terms of turnover and profit.

Valuation Variables

When dealing with leased or tenanted premises, the deal that is struck between the landlord and the tenant with regard to the terms of the lease and in particular, the rent to be paid, will be dependent upon a number of variables emanating from the above. Often the terms of the transaction will be confidential. The transaction may involve matters other than rent, for example, an undertaking by an incoming tenant to invest in the property or perhaps extend the property. Very rarely are the full terms of a letting transaction made available to parties other than the landlord and tenant who sign the formal contract, the lease.

Valuation is an art not a science. The Courts have historically allowed latitude in a valuer's opinion of value when considering professional negligence, 10% either way being acceptable, a greater tolerance where there are complex matters involved.

The tied pub sector has a plethora of tied leases in place. These have varying:-

· lengths

· repair obligations

· rent adjustments – periodic or annual

· ties – beer, lager, cider, alcopops, wines, spirits, minerals, etc

· discounts

· tied release fees (a recent innovation)

· levels of tenant investment – repair, refurbishment, improvements

Thus, analysis of market transactions is both complex and difficult.

The principle of a profits valuation is the assessment of three key fundamentals – Fair Maintainable Turnover; Fair Maintainable Operating Profit; and the split of the divisible balance (known as the tenant’s bid).

A small change at each stage of the valuation calculation can have an exponential effect on the end result. The valuer needs to have market knowledge and experience of freely negotiated transactions to make appropriate adjustments to ensure that the end result sits within the tone of values for the type of business in the local area.

Valuers analyse market transactions and apply that analysis to reach an opinion of value. Market transactions are freely negotiated contracts between a landlord and a tenant. The agreed rent is a negotiated sum; it is not a formulaic calculation.

Occasionally, one or other party has particular reason, perhaps timing, dispute resolution, etc, to agree terms which might not sit within the general tone of values in the local area, thus the transaction can produce distorted analysis. In general terms, a value will fall within a reasonable range. The final terms of the transaction will depend on the willingness of the parties to transact.

Valuation Based on Transactions

RICS has reservations of the unintended consequences of requiring transactions involving lettings, to be based on a valuation, as opposed to market supply and demand interaction.

By requiring all rental agreements to be based on valuation as opposed to market forces, it may significantly reduce the number of open market, freely negotiated transactions. Eventually, the number of open market transactions may fall to zero in the tied lease market, thus the market will become artificial. There will be no true market evidence. This may deter market participants (landlords) from investing in the sector. It will put pressure on existing landlords, including pubcos and brewers, to exit the market or find different methods of operation.

Register of Rents

RICS does not support the introduction of any form of register of rents in the tied lease sector due to the wide variation of lease terms and tie provisions.

Benchmarking

RICS does support the principle of benchmarking – providing the inputs are genuine and correctly analysed to produce consistency. Access to benchmarking statistics needs to be carefully considered.

THE BILL

Arbitration by Adjudicator

With regard to Clause 39 under the Section headed ‘Arbitration by Adjudicator’, RICS is concerned that confusion may arise over the term ‘arbitration’.

In its simplest form, arbitration means settlement of a dispute by an arbitrator. However, in the property world, arbitration is a familiar term, primarily in connection with rent review disputes.

Most commercial leases include a dispute resolution clause that, in the event that the parties are unable to agree a rent at review, the matter can be referred to either an Arbitrator or an Independent Expert. There is usually reference that if the parties cannot agree an appropriate third party, an application can be made to the President of the RICS for the appointment of a suitable individual from the President’s Panel of trained experts.

Where an Arbitrator is appointed, it is usual for the lease to provide for him to act in accordance with the Arbitration Act 1996 which sets out in detail the obligations and duties of the parties, their representatives and the Arbitrator. We note that there is reference in the Bill to the Arbitration Act 1996.

Arbitration, as acknowledged in the Groceries Code Adjudicator Arbitration Policy Guidance Note, can be expensive. It is rarely an economic option for tied lease rental disputes, where rents are likely to be in the range of £20,000 to £50,000 per annum. This was the reason the industry introduced the Pubs Independent Rent Review Service (PIRRS), being a swifter and cheaper dispute resolution process adopting the Independent Expert approach as opposed to the Arbitration approach. The PIRRS service has had the backing of RICS and many practising specialist Chartered Surveyors.

It should be noted that under the Arbitration Act 1996, the parties are jointly and severally liable for the costs of the Arbitration. It is for the parties to agree how the costs should be apportioned, or for the Arbitrator to decide if they cannot agree. RICS requests that assurances a given in respect to the inter-relation between the new legislation and the internationally accepted Arbitration Act 1996.

Tenancy At Will

At paragraph 61, reference is made to the form of ‘tenancy’. RICS notes that the drafting includes a Tenancy at Will.

Within the public house sector, Tenancies at Will are often used to sustain the value of the trading entity by keeping the pub open pending a sale or letting.

Unlike shops or offices, which can be simply closed or boarded if vacant, pub owners need to ensure that the business continues, when a substantive tenant vacates. Otherwise, there would be a significant fall in the value of the freehold asset. Such Tenancies at Will are granted on varying but usually soft terms, to operators for a temporary holding period; sometimes to companies that specialise in such holding arrangements; sometimes to a nearby publican.

RICS believes that requiring the landlord and tenant, when agreeing the terms of a Tenancy at Will, to comply with the Statutory Code may have the unintended consequence of effectively closing a valuable and important sub-market.

Parallel Rent Assessment

Under the definition of ‘parallel rent assessment’, RICS believes greater clarity is required.

The definition as stated would produce a parallel rent assessment which is a hybrid and not backed up by any market evidence. Any assessment would also have to take account of the variety of benefits available to different tenants, which are difficult to quantify and would have different values dependent on the type and experience of the tenant. It would thus be wholly theoretical.

We believe the definition should be drafted so as to ensure that in the free of tie scenario, the tenant does not enjoy the benefit of any landlord support – what the industry refers to as Special Commercial and Financial Advantages (SCORFA).

DRAFT STATUTORY CODE

Our general comments above apply. RICS makes the following specific comments:-

The differences between a Lease and a Tenancy are not addressed in the consultation. In the pub sector these two terms have very different meanings, with different risks and obligations attached. These distinctions should be addressed to avoid future confusion.

The draft code is intended to apply to pub companies with more than 500 public houses. Whilst the RICS understands the reasoning behind this distinction, we perceive that an unintended outcome of this would be the creation of a two tier market, with distinctions between pubs that fall either inside or outside the code. The valuation of pubs is already complex and two tiers could result in difficulties in sourcing appropriate comparable evidence of recent transactions in the appropriate market tier. There would be additional difficulties in the event that a pub is sold, subject to a tied tenancy, from one tier to another. This would render the previously agreed passing rent inappropriate, as the assumptions on which the rent was originally based will have changed.

Part 5 - Business Plan

Section 10 of part 5 refers to the possibility of providing the right to request an open market rent review in the event of a significant change occurring to lease terms or trading conditions. In essence this equates to an interim rent review. Periodic rent reviews are already an industry standard (usually three or five yearly), aimed at reflecting changes in trading conditions. The introduction of an additional right to an interim review will introduce an extra element of uncertainty to those who invest in the pub sector. This is likely to result in further caution or a withdrawal of investment, which may have significant adverse effects on the industry as a whole.

RICS notes that under paragraph 12 (a) i. the POB must ensure that the tenant has taken independent professional advice, including business, legal, property and rental valuation advice. (RICS members advise that where tenants are private individuals, they are often reluctant to incur the costs of taking such advice).

Under 12 (b) the Statutory Code requires the POB to advise the tenant to consult RICS Guidance and any relevant industry benchmarking reports. Firstly, RICS Guidance sets out best practice for Chartered Surveyors operating within the sector. The Guidance Note includes many technical issues which are directed towards a qualified and trained valuer, rather than a prospective publican. The fact that under paragraph 12 (a) i. the POB must ensure that the tenant has taken rental valuation advice, we suggest makes the reference to the Guidance Note under 12 (b) superfluous.

Part 7 - Rent Negotiations

RICS would like to raise the following points:

· Should the valuer, whether acting for the landlord or the tenant, be provided with the agreed business plan?

· RICS notes that the POB must provide sufficient information to the tenant to allow them to negotiate the rent. Should the tenant not be required to declare actual trading results for the business in the case of rent reviews and lease renewals? Perhaps for the previous three years?

· RICS believes the wording under paragraph 20, relating to a manager, needs further consideration. In practice, a manager is appointed for larger trading entities. Different types of business will have different turnover/profit thresholds. Where the business is a typical managed house operation, the cost of the manager should, of course, be reflected. However, where a tenant wishes to retire or semi-retire and appoints a manager to run the business, as a lifestyle decision, it would lead to artificially high costs and thus a lower rent which would be unfair on the POB.

Part 8 – Parallel Free of Tie Rent Assessments

Tied and free of tied rental markets in the leased sector are very different in many ways. It is therefore difficult to compare rental assessments from across the two markets. Additionally, in order to compare a tied lease with a free of tie lease the valuer would need to have sight of the full accounts and stock sheets from the free of tie tenant of comparable properties; this information is not available. As a result a realistic rental assessment on this alternative basis is not achievable. RICS therefore questions what the Parallel Free of Tie Rent Assessment will achieve. How is it proposed that it will help to resolve the rental dispute?

RICS also believes the drafting needs greater clarity with regard to the ‘point at which negotiations have failed’.

In the general property market, the point of failure would usually be when either the landlord or the tenant makes an application to the President of the RICS for the appointment of an Arbitrator or Independent Expert. This involves the applicant in a cost. However, in practice, negotiations invariably continue. The number of applications that follow through to a final Arbitration Award is a very small percentage. RICS believes that the parties should be encouraged to continue discussion and negotiation.

Annex A – Content for Profit & Loss Account (Fair Maintainable Trade)

RICS avoids providing standard valuation pro forma templates wherever possible; leaving it up to the expertise and discretion of the surveyor to decide how to value an asset and what level of detail it is appropriate to apply. Valuers are, in any event, required to apply the Red Book standards of transparency in all valuations.

The imposition of a template encourages a formulaic approach to valuation, using artificial calculations for items that are subject to variation based on open market evidence. This takes no account of real world scenarios and results in an artificial calculation.

If a pro forma approach is adopted, RICS believes the terms of the proposed or actual agreement should be stated towards the top of the pro-forma, i.e. agreement type, term, repairing obligations, rent review pattern, tie provisions, discount terms, etc. This is important so that the context of the rental value assessed is not misrepresented.

RICS suggests that showing the breakdown of all tied purchases is overly complicated. Few valuers practising in the market have access to such detail on all of the comparables, particularly when one is dealing in the free of tie market. In practice, licensed property valuers refer to wet sales, food sales and machine income. Such information can be sourced from a variety of transactions such as sales, assignments, valuations etc. Very rarely are volume statistics available in these circumstances. Accountants state sales either in total or split between wet, food and machines and show the gross profit on wet sales and food sales, often as a single figure. RICS believes the pro-forma as drafted is overly complicated and likely to give rise to unnecessary disputes.

With regard to the list of expenses, RICS believes the Statutory Code offers an opportunity for the industry to introduce a standard for public house accounting and the matter should be given very careful consideration. At present, different bodies produce statistics with differing cost headings.

October 2014