The Value of Rental Deposits

1. The Value of Rental Deposits Norman Hutchison, Alastair Adair and Kyungsun Park ERES, Milan June 2010

2. Background • Income key driver of property return • Risk of default depends upon covenant strength of tenant and stage of cycle - see Hutchison et al. (2009) • Default could result in a substantial period with nil cashflow: period to regain possession, possible lengthy void period, followed by rent free period • In UK deposits are not uncommon, but if they do exist they normally amount to 3 to 6 months of rent.

3. Research Aims • To consider the negotiating strength of landlords and tenants in lease negotiations • To consider the well established deposit system in South Korea for lessons that could be learned • To calculate the level of deposit which is necessary to mitigate income risk

4. Literature Review • Professional literature (little academic?) on incidence of rental deposits in the UK • Previous work has focused on the differences in negotiation strength at rent reviews, lease renewals and open market letting • McAllister and Tarbert (1999), • Crosby and Murdoch (2000). • But large literature on well established deposit system in South Korea

5. Negotiating strength in a cyclical environment Level of deposit, if any, depends upon the negotiating strength of the parties at the commencement of the lease. • Other factors maybe more dominant: level of rent, length of lease, rent review frequency and terms, repairing obligations break options etc. e.g. During downside of a cycle: a)Landlords • anxious to get property let • willing to offer rent free periods + other incentives b) Tenants • Unwilling to pay deposits - business uncertain • Access to bank finance to fund a deposit problematic ?

6. South Korean Lease Contracts-Jeonse Contracts • 3 types of lease contract: • Jeonse, Walse, Jeonwalse • Jeonse contract : tenant pays upfront deposit with no periodic rent payments • Jeonese deposit 40% to 80% of property value • Landlord can earn return on deposit , and must only return deposit at end of lease • Eliminates 100% impact of tenant default • Outside Seoul, 84% of office contracts use Jeonse • In Seoul, Jeonse ratio is only 22.8%

7. South Korean Lease Contracts-Walse Contracts • Walse Contract • Tenant pays a security deposit and monthly rent • Security deposit normally equivalent to 10 months rent • Amount of monthly rent linked to Jeonse deposit • Unpaid expenses can be deducted from deposit • Min lease: two years, max lease: 5 years • In Seoul,77% of all office leases contracted on this basis.

8. South Korean Lease Contracts-Jeonwalse contracts • Jeonwalse contract (hybrid) • Security deposit plus monthly rental • Security deposit: 30% to 70% of Jeonse deposit • Monthly rent: lower than Walse rent • Choice of contract depends on long term funding market – underdeveloped in South Korea • Landlords have used Jeonse and Jeonwalse contracts to help fund real estate investments or projects • From a Tenant’s perspective choice of contract depends on how easy it is to raise finance for deposit

9. Use of deposits: worldwide comparison(Source: Jones Lang LaSalle Research 2009)

10. Choice of contract depend upon negotiating strengthsLow vacancy rates in SeoulSource: Jones Lang LaSalle Research (2009)

11. Deposit Agreements in the UK-Key Heads of Terms

12. Alternatives to a Deposit • If weak tenant covenant, landlord may require tenant to provide guarantee from a third party. • Landlord may ask guarantor to give ‘blanket guarantee’ covering all tenant's obligations under the lease – depends upon negotiating strength. • Deposit agreements gives landlord ‘instant access’ to funds. • Guarantee may give more comfort -but would have to invoke formal enforcement .

13. Calculating the Amount of Deposit • Amount of deposit: function of loss of income and expenses that ensue, depends upon - • timing of default • length of void period • amount of incentives offered to new tenant • costs of marketing • legal costs in setting up new lease and costs incurred in pursuing defaulting tenant and repossession of property

14. Scenario Testing • Purpose of the scenario is to estimate the level of deposit which would compensate for tenant default occurring at different periods of the lease. • Certain assumptions: • loss of income • void and rent free periods • different states of the market

15. Assumptions

16. States of the Market • Recessionary Market 12 month void 12 month rent free Total: 24 months loss of income • RecoveryMarket No void period 12 month rent free Total: 12 months loss of income

17. Calculation Steps 1) Benchmark NPV - valuation assuming no default, given 10 yr holding period 2) 18 different scenarios assumed: • tenant defaulting: from end year 1 to end year 9 (with 10 yr holding period held constant) • On default , two different states of the market were assumed: a recessionary market and recovery market 3) NPV of each of the 18 different scenarios calculated and the amount deducted from benchmark NPV to show amount of deposit required to compensate for the default

18. Results

19. Interpretation of results-default in early years most damaging

20. Monte Carlo SimulationParameters for the random variables

21. Simulation Results50,000 trials

22. Wider implementation of a deposit system in the UK? • Negotiating positions in UK very different to South Korea • 2009 vacancy levels: London offices 8%/10%, Seoul 4% • Uk Tenant’s have negotiation strength - increase in break options • Deposit agreement is part of heads of terms of deal • Tenant’s viewpoint - deposit is unwelcome, but maybe a key to a certain location • Landlord may seek to trade security of income with level of income – reduced rent if pay deposit. • Need and level of deposit function of credit score?

23. Conclusion • Deposits only relevant if there is a likelihood of default. • Landlords need to be aware that occupiers in certain sectors are more prone to default. • Easiest time for landlords to introduce a deposit is when market is strong. Think through the cycle! • Level of deposit should be sufficient to cover losses.