Small Business, Enterprise and Employment Bill

Written evidence submitted by David Morgan (SB 70)

I have had the opportunity of viewing the Small Business Enterprise and Employment Draft Bill and have the following thoughts from the perspective of a Chartered Surveyor having specialised in licensed and leisure property for over thirty-five years.

1.0

1.1 My name is David Morgan. I am a Fellow of the RICS, a Fellow of the British Institute of Innkeeping, a Member of the Academy of Experts, and a Member of the Expert Witness Institute and am registered by the RICS as an Accredited Expert.

1.2 My initial involvement in licensed property began in 1975 as a Divisional Estates Manager for Courage (Western) Limited. I entered Private Practice in 1978 and am currently a Director of Morgan & Clarke Chartered Surveyors, specialising in the Licensed/Leisure Industry with a strong focus on public houses. The majority of the Clients of Morgan & Clarke are lessees although we do act for private companies who own public houses. We do not act for Brewery Companies or Pubco’s. My day to day professional involvement in the Industry concerns rent and lease renewal, focusing specifically on issues of viability. I have confined my observations on matters where I have specific expertise and market experience.

2.0 Market Rent Only Option

2.1 I have reviewed the proposed Bill, Clauses 26-33 and note the detailed structure of the ability of a tenant or a prospective tenant of a pub owning business to serve a Formal Notice of the intention to implement a Market Rent Only Option. The definition of Market Rent, (Clause 28) mirrors the generality of modern public house rent review provisions and are reasonably standard throughout the Industry. It is however important to provide background commentary on the RICS Guidance Notes 67/2010 that form the template for Chartered Surveyors in the consideration of rent review matters within licensed property. GN67/2010 is not a mandatory requirement but recommended as ‘Best Practice’ for Chartered Surveyors. The Guidance Notes do not apply to non-Chartered Surveyors.

2.2 I had the opportunity of serving on the Special Working Party convened by the RICS in 2010 which included representatives of Punch and Enterprise, Regional Brewers and other Specialist Chartered Surveyors. The Lessee’s point of view was more specifically represented by myself, my co-Director, Simon Clarke, and Gary Mallon. All three of us have the unique perspective of either currently or previously having hands’ on experience of trading and operating public houses. That experience was, to my knowledge, not shared by any other members of the Working Party.

2.3 The Working Party re-wrote previous RICS Guidance Notes which in part, with the final document, represented a compromise solution but the ultimate wording was agreed unanimously by the Members of the Working Party. The new guidance was published in December 2010. The content of GN67/2010, in terms of methodology, has direct bearing on evaluating the proposal contained within Section 36 (4) of the Draft Bill that proposes "that tied pub tenants should not be worse off as a result of any product or service tie".

2.4 The transfer from a supply-tied rental to a free-of-tie rental is, to some, initially complicated by the purported advantages of SCORFA (Special Commercial OR Financial Advantages) which include the following items.

2.4 (a) Upwards/Downwards Rent Reviews – if this is written into the current lease, there is no reason why this advantage should not be continued. Pub rents are undertaken on a profits’ test basis which is intended to reflect viability. There are a substantial number of short and long term leases that are the subject of rent increases tracking the annual upwards movement of the Retail Price Index. This method of rent calculation has no bearing upon viability and would remain active whether or not the lease is supply-tied or free-of-tie or capable of downwards revision at periodic open market review.

The Industry Framework Code does not apply to supply-free leases and thus the market recommended advantage of upwards or downwards rent review is not currently available for existing free-of-tie leaseholds. There has been noted resistance, specifically by Wellington Pub Company, to the notion of upwards and downwards’ rent reviews at lease renewal to which they have exercised strenuous objection on the basis that such upwards and downwards’ rent reviews are not generic in a supply free market.

2.4 (b) Lower Rent – rent review clauses often state that the rent shall be the best rent obtainable in the Open Market and the only difference between supply-free and supply-tied rent is the assessment of gross profitability which would be greater in a free-of-tie lease.

2.4 (c) Not Fully Repairing - Brewery tenancies and certain short-term leaseholds are the general basis of occupation, not being on a full repairing obligation.

The majority of medium/long term leases contain the repairing covenant that the lessee has to put and keep the entire property, both decoratively and structurally, in good and substantial repair. This obligation would not change in a supply free lease agreement. However, it is considered to be a substantial disincentive, for Brewers who hold short term tenancies, to consider the grant of free of tie if there is not a full repairing obligation. However, it is recognised that the intention of exempting pub owning companies with less than five hundred properties would, in the main, remove the majority of brewery companies from the intended legislation.

2.4 (d) Technical Services Assistance – it is sometimes the case that lessees now have to pay for technical services help such as the repair of cellar temperature control equipment. One recent example had an attendant cost of £550 for servicing CTC equipment.

2.4 (e) Cheaper Insurance - the insurance market is highly competitive with individuals being able to secure advantageous insurance premiums. Block insurance cover is now no longer seen as an automatic cheaper option.

2.4 (f) Easy Exit Terms – no tenancy agreement or short term or long term lease contains a structured basis of surrender other than by a break clause. If a break clause has been inserted, that would carry over to the free-of-tie situation. Lease surrender is a negotiable position with the strength of negotiating powers lying with the freeholder. Often Pubco’s "fine" lessees wishing to surrender and, in certain instances, this can be represented by six months’ rent plus an automatic Terminal Schedule of Dilapidations.

2.4 (g) One order/one delivery – no specific financial advantage. Certain Pubco’s now levy an extra charge if an order is not placed online but made over the telephone. No such charges exist in the free trade market which would be to the advantage of the supply-free lessee.

2.4 (h) Guaranteed Long Term Discounts – Pubco’s do not make or manufacture transport or deliver draught and bottled beer. The discounts that they achieve from brewers are only in small part passed on to the supply tied lessee. The resultant wholesale cost of supply tied products results in a lower gross profit margin than a supply free situation. No financial advantage.

2.4 (i) Cellar and Heating Maintenance – the lessee is responsible for the maintenance and upkeep of heating appliances and, with the exception of some brewery tenancies and short-term leases, is also responsible for maintenance of cellar cooling equipment.

2.4 (j) Statutory and Civic Legislation Compliance – almost always the financial responsibility of the tenant or lessee who, in lease terms, is deemed to observe all statutory and civic regulations.

2.4 (k) It is considered that the financial advantages of ‘Special Commercial OR Financial Advantages’ (if indeed they can be accurately quantified in financial terms) are not of great magnitude and are of no particular sacrifice to the lessee if a free-of-tie situation is to exist and if the only income that was derived from the property to the freeholder was that of rent. There are an appreciable number of supply-free leases currently within the Pubco Estates that operate viably without the so-called advantages of ’Special Commercial OR Financial Advantages’.

3.0 Function of the Valuer

3.1 Many years ago, all brewery companies had an Estates Department, generally staffed by Chartered Surveyors (Pubco’s only came into being after the Beer Orders in 1989). That regime has now long since been replaced by non-RICS-qualified Retail Field Staff (RFS) who act as "Valuers". The vast majority of rent negotiations are undertaken between the non-qualified RFS and the lessee on a face-to-face basis after the RFS has obtained, as far as practicable, the accountancy information of the trading operations of the property. Many modern leases require that accounts are made available. The RFS have continuously up-dated access to current and previous supply data, either through flow-monitoring equipment or through the delivery records which cross-reference with their company’s accounts department.

3.2 In a practical sense, the Retail Field Staff "Valuer" does indeed make the market at rent review rather than lease renewal. This is based upon the freeholders’ general perception that rents, if at all possible, should increase rather than decrease on the basis of a Rent Pro Forma that has been pre-prepared in-house and which requires "deliverance" in accordance with corporate objectives. Retail Field Staff are not professionally bound by the established RICS Guidance Notes although, in accordance with the Industry Framework Code, are duty bound to observe their stipulations.

3.3 It is only if there is a no agreement as to rent, principal to principal, that the direct services of a Chartered Surveyor are utilised, either internally within the company concerned (National Rent Controller or Portfolio Manager for example) or externally with the engagement of a qualified Chartered Surveyor specialising public house valuations.

3.4 In situations of Third Party Referral (TPR), certainly concerning Enterprise Inns, the external Valuer reports to the National Rent Controller and is engaged, specifically, to present the case at TPR and is precluded from entering into any form of negotiation, professional to professional. There is thus no continuing dialogue.

3.5 The above scenario is commonplace whether or not the public houses are supply- tied or free-of-tie with the exception that free-of-tie properties would not necessarily have any trade supply records upon which the rent calculation is based. Accounts may or may not be made available.

4.0 Rent Calculation

4.1 Much has been made of future trading potential of a business which, in reality, is little more than guesswork. Pubco’s and Brewers, as mentioned earlier, always seek the guidance of current on-site trading performance and accounts. This can then form the backbone of a rent calculation to be utilised in a Parallel Rent Assessment.

4.2 Basically there are three elements to the profits’ test valuation. First, the actual trade or reasoned and estimated ‘Fair Maintainable Trade’ on a VAT exclusive basis, second, the Assessment of Gross Profit Margins and third, a detailed understanding of the reality of the business expenses incurred in the achievement of the fair maintainable trade. The last item would not be the subject of variance to any great extent whether the property was supply-tied or supply-free.

4.3 The Parallel Rent Assessment could envisage an up-lift in wet trade as a result of free-of-tie status. The dry or food trade would not necessarily be the subject of variance. However, the core principle of understanding the current levels of trade is of paramount importance linked with the previously mentioned guidance of GN67/2010 which, at times, can be utilised to selectively promote a particular point of view concerning the trade levels that should be adopted in the rental valuation exercise.

5.0 THE ART OR SCIENCE OF PUBLIC HOUSE VALUATION

5.1 Much has been made that valuation is an art not a science. Market evidence however would indicate that there is a strong bias towards the science of valuation based upon a large number of input factors or direct evidence. The days have long gone when an Expert could stand up in Court and, under cross-examination, airily declare "I am an Expert. The evidence that I have given is my Expert Opinion and there the matter rests." Arbitrations, Courts and Tribunals, in the current era, require a high level of proof to support Expert Opinions expressed with the request often being made that an Expert Opinion should be backed up by incontrovertible evidence either by on-site circumstance or direct comparability.

5.2 The Industry Framework Code and, indeed, the vast majority of Codes of Practice, require that a detailed Rent Assessment Form should accompany an expressed opinion of Open Market Rental. By way of illustration to those unfamiliar with Trading and Profit & Loss Accounts and Pub Rent Assessment Forms, I have included in Appendices A and B, actual market examples. For the sake of confidentiality, names, addresses and Pubco referencing coding have been deleted. The information in the Trading and Profit & Loss Accounts is derived from retail sales set against purchase invoices, producing a gross profit margin. The accounts ‘Expenses’ are the detail of actual on-site costs, with the exception of depreciation which is a taxation allowance.

5.3 Appendix A

This is an example of a Punch Taverns’ Rent Review Form which, for wet trade purposes, is loosely based on delivery records. Documents A2 and A3 represent the Trading and Profit & Loss Accounts for the year ending 31 October 2012 and 2013. It will be observed that the on-site records for total sales in 2012 were £311,150 and £284,727 in 2013. The Punch rent assessment has an estimate of total turnover of £398,108. All numbers exclude VAT.

5.4 Appendix B

An example of an Enterprise Inns’ Rent Assessment Form in B1 with supporting barrelage data from flow monitoring sources in B2. In this instance, the trade accounts for the financial years ending 31 March 2011 and 2012 were split separately between bar sales and kitchen sales. It will be observed that Enterprise Inns’ estimate of Fair Maintainable Trade expressed as total turnover is £402,700 with the on-site accounts for 2012 recording bar and food sales at £193,009. Again all numbers exclude VAT.

5.5 It is not relevant to analyse the content of each example save to illustrate the detail that has now become generic in all pub rent review pro forma which is reflected industry-wide to a greater or lesser extent. This market evidence would appear to underscore the proposition that valuation is now very much more a fact based science than an opinion-related art form.

5.6 It is considered that the transfer between supply-tied and supply-free is primarily sales volume related, linked to an adjustment of gross profit margins. Each item is naturally site specific and is capable of detailed analysis if required.

5.7 The accounts’ evidence and pub rent pro forma, as outlined above, has at its core the assumption of ‘Reasonably Efficient Operator’ status which transposes into Fair Maintainable Trade. It is important to have clarity in respect of ‘REO’ status which is the start point for the formulation of Fair Maintainable Trade.

6.0 REASONABLY EFFICIENT OPERATOR (REO)

6.1 RICS GN67/2010, paragraph 2.10 defines the status of REO as follows:-

"a concept where the Valuer assumes that the market participants are competent operators acting in an efficient manner of a business conducted on the premises…..it involves estimating the trading potential rather than adopting the actual level of trade under the existing ownership and it excludes personal goodwill".

This paragraph is quoted extensively in the support of the estimation of trading potential which, almost always, underscores an increase in the guesswork of future trade.

6.2 However, what is almost never quoted is the subsequent paragraph 2.13 "trading potential" which states as follows:-

"the future profit in the context of a valuation of the property that an REO would expect to be able to realise from occupation of the property. This could be above or below the recent trading history of the property. It reflects a range of factors such as the location, design and character, level of adaption and trading history of the property within the market conditions prevailing that are inherent to the property asset" (Emphasis Added)

6.3 The definition of trading potential requires, as its initial benchmark, the trading history of the property and allows for the future potential to be above or below the recent trading history of the property. This fact transcends the often quoted concept of "stand back and look" which is considered the promotion of (educated) guesswork as to future levels of increased trade.

6.4 If, as is often the case (and, indeed, illustrated in Appendix A1 and B1) the proposed Fair Maintainable Trade and the assumed trading potential is substantially higher than the current trading performance. The automatic assumption is that the hypothetical tenant would trade at a superior level to the current tenant which would indicate that the current tenant is not of Reasonably Efficient Operator status. This factor is rarely, if ever, addressed in any form of incontrovertible evidence that would validate the lack of REO status by the current incumbent.

6.5 REO status is also linked with the concept of personal goodwill (of the current operator) which is defined in GN67/2010, paragraph 2.9 as follows:-

"the value of profit generated over and above market expectations that would be extinguished upon sale of the trade related property together with the financial factors relating specifically to the current operator of the business such as taxation, depreciation, policy, borrowing costs and the capital invested in the business"

6.6 Goodwill as a valuation concept is very difficult to quantify with certainty and, from experience, is nearly always disregarded by Freeholders with the ultimate result that a highly successful lessee or trade operator is valued on their trading success on the basis that goodwill does not exist.

7.0 The "No Worse Off" Principle

7.1 It seems to me that the underlying concept of the proposed Bill is to create a system of Parallel Rent Assessment that allows for the mathematical consideration of the adjustment of rental between being supply-tied and supply-free. There is ample evidence in the open market of both sales levels and profit margins being achieved by supply-tied and free-of-supply-tie public houses.

7.2 From experience, it would appear that the average stay or hold in a supply-tied leasehold property is approximately three years. Exit from the lease is usually by open-market disposal or, to a lesser degree, the surrender of the current lease with the Brewery Company or Pubco openly offering the new lease or tenancy for market competition. Far less often is the exit route at lease end when the new lease is not taken up.

7.3 The open market has a very large number of examples of leasehold public houses being offered for sale through such national agencies as Christies, Fleurets, Sidney Phillips, Guy Simmonds, Davis Coffer Lyons, RTA, Davy & Co, etc. In any given seven-day period, there are hundreds of examples being offered for open sale with a large number quoting in the particulars of lease rent and accountancy details. It is difficult to conceive that the availability of market evidence would show a marked reduction in future years, let alone cease to exist.

7.4 It is clear that there is market evidence of profit margins being achieved by supply-tied lessees who have varying levels of product discount. In the situation of a known level of product discount and associated gross profit margin, it is relatively simple to illustrate such evidence of the difference between the two (i.e. free-of-tie versus supply-tied) levels of gross profit.

7.5 There would be an increase in the free-of-tie divisible balance which would result in an increase in the rent concerned and also a commensurate increase in the profit retained by the lessee.

7.6 To explain this concept on a simple mathematical basis (the science rather than the art) – if the supply-tied divisible balance (estimate of current/future trade and the calculation of gross profit margins less operational expenditure) resulted in a divisible balance of £60,000 with the tenant’s so called "bid" being 50%, the resultant rental would be £30,000 and the remuneration to the lessee would also be £30,000.

7.8 However, if the gross profit margins were significantly increased from, say, 54% up to 65% (or even higher) and, for example, the divisible balance was £90,000, the 50% "bid" would yield a rental of £45,000 and a tenant’s remuneration of £45,000.

7.9 This simple concept would ensure a fair and higher level of remuneration for the tenant and an increased site rental to the freeholder.

7.10 The negative result is that, in a free-of-supply-tie situation, the Freeholder would not have the hidden income of wholesale contribution from the substantial discounts that, for example, the Pubcos achieve from the brewers who supply their estates. This sacrifice of income by way of wholesale contribution would not occur with smaller brewers if, as is proposed, the Bill does not apply to freehold estates of less than 500 units. ɸ

8.0 Conclusion

8.1 The concept of Parallel Rent Assessment is a relatively straightforward mathematical exercise which can either be undertaken, principal to principal, or as is proposed in the Bill, by an Independent Assessor. RICS GN67/2010 is a solid template for considering all the relevant issues, not least the concept of Reasonably Efficient Operator and the detailed study of actual on-site circumstance rather than the guesswork associated with increased trade as a result of "future potential".

8.2 The issue of "future potential" is often linked with the provision of a business plan to accompany either the grant of a new lease or the affirmation of the suitability of an assignee. Practical considerations, however, transcend the concept of realistic future potential illustrated by a disturbing recent example whose identity must remain confidential due to on-going issues.

8.3 The potential assignee had approached the retail field staff and expressed interest in taking the assignment of the supply-tied leasehold but was concerned over the current level of rental. The assignee was clearly informed that, if the Business Plan did not justify the current rental, then the application for assignment would not be approved. The Business Plan was suitably adjusted with a substantial over-estimation in Fair Maintainable Trade on the basis that there was a rent review within eighteen months and the opportunity of downwards’ revision. The assignment was granted.

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ɸ FOOTNOTE.

This numerical benchmark of 500 units was first proposed by myself at a Fair Pint Steering Group meeting in April 2008 and was subsequently adopted into Fair Pint proposals. I have for some time been no longer involved in the Fair Pint Steering Group.

8.4 Current Industry Code of Practice and the Industry Framework Code make the stipulation that the prospective lessee or prospective assignee is encouraged to take

independent professional advice including business, legal, property and rental valuation assistance. We have a confidential number of examples that illustrate that the concept of full professional advice is very rarely taken up, almost always due to the perceived associated expenditure, with disturbing examples of Retail Field Staff backing up that level of potential expenditure. There are current examples of new leases being entered into, and assignments’ being taken, where there has been no professional advice taken whatsoever. This position can only be addressed if the details of the identities of all of the professional advisers are confirmed between both parties

8.5 The hypothetical tenant, being properly and closely professionally advised, would not sensibly consider paying an inflated rental based upon his own achievement of future potential and would almost certainly be advised to utilise the template of current trading success/records in the formulation of a rent bid.

8.6 It is considered that there is a genuine opportunity for the readjustment of supply-tied lease rentals to reflect viability in the concept of being free-of-tie or being "no worse off". If however this financial adjustment, linked with product discounting and levels of rental, is artificially influenced by annual increases in rental linked with the upwards movement of the Retail Price Index (RPI), the question of viability, looking forward, comes under considerable strain. It is inevitable that the expenses of running a business will increase year on year as a result of in-built inflation and statutory pressures such as the annual rise in minimum wage rates.

8.7 Free-of-tie operators, by their very nature, have far more flexibility in the style of trading operation and wet product selection than supplied-tied operators. The free-of-tie option can be adduced by the parallel rent assessment which, in concept, is seen as relatively straightforward in terms of calculation.

8.8 If agreement is not reached as to Parallel Rent Assessment, principal to principal, the Bill allows for a Rent Assessor who is charged with the duty of assessing the Parallel Rent Assessment and of giving reasons.

8.9 In a practical sense, the requirement for a market rent only option would seem to me to only be relevant if there was dissatisfaction with the current supply-tied tenancy or leasehold deal. If properly applied with genuinely viable rental levels and appropriate product discounting, together with identified ‘Special Commercial OR Financial Advantages’, the situation could easily exist that the supply-tied tenant or leaseholder is in fact no worse off than the supply-free tenant or leaseholder. It is noted that with only one or two exceptions, there are very few cases of rent disputes with regional brewery companies. This would appear to indicate a genuine caring, hands-on approach that is sympathetic to both their tenant’s or leaseholder’s requirements and ensuring continuing future viability. The vast majority of the case load that reaches Morgan & Clarke Chartered Surveyors is concerning Pubco lessees whose Retail Field Staff are the only point of liaison with the lessee.

8.10 It is also noted that the majority of regional and family Brewery Companies would be exempt from the proposed Bill having estates of less than 500 units.

October 2014

Prepared 6th November 2014