Hitting the headlines

It might seem as though on the one side there are the established owners of existing properties, who wish to hold on to them for the long term and generate revenue from profitable levels of rent. While on the other there are the discounters, who are more interested in trading properties and are willing to do anything to fill them with tenants in an attempt to make them appear more attractive to prospective investors. So to do this, the allegation goes, they have to provide hefty incentives, such as long rent-free periods, but they also have to maintain the illusion that the asset is a profitable one – and therefore the real, effective rents and the asset’s actual profitability are somehow hidden from investors by insisting on using the official and much higher headline rate. But is this a fair and accurate picture of what is actually going on at the moment? “The disparity between headline and effective rents varies between developers and between existing stock and new build or build-to-suit stock,” says Mark Freeman, the head of valuation and advisory at Cushman & Wakefield in Poland. “The properties in which very low effectives have recently been agreed – and which probably initiated this discussion – have yet to trade, so it’s perhaps too early to call whether the value or price paid is unrealistic. Investors are not naïve, particularly the big institutions buying large portfolios, and how they’ll react to the current low effective rents has yet to be seen.”

Contortions and distortions

However, Ben Bannatyne, the managing director and regional head of Prologis in the CEE region, is of the opinion that the issue is real and serious. “The practice in Poland of masking the true rent that a tenant is paying must be stopped. Currently there is a lack of the market transparency that is a fundamental element of a well-functioning market.” The normal situation, as he explains, is that “during a real estate downturn, or when there has been more supply than demand, real estate developers have generally adapted to the market by offering prospective customers additional incentives to lease their space.” According to him these could take the form of a rent-free period or a contribution to fit-out costs, thus protecting the market (headline) rent – and as the market improves, the level of incentives reduces. “Over a long lease of say 15–20 years, the impact of the incentives is only felt in the first couple of years, so the impact on valuations is minimal,” he adds. “However, in Poland most investors are acquiring logistics projects based on the headline rent – and not the effective rent – and, therefore, the higher the headline rent, the higher the capital value per sqm. This has led to developers artificially inflating rents or keeping headline rents high and offering significant incentives to customers in order to keep the underlying effective rent low. On a long term lease this is not such an issue, but in the logistics sector, where leases are typically 3–5 years, this creates a huge distortion in the market,” claims Ben Bannatyne. In his view this has resulted in a two-tier rent – the effective rent that the customer is actually paying and the rent or cash-flow that the investor believes they have acquired, namely, the headline rent. “In some cases the two forms of rent can vary by as much as 50 pct,” says Mr Bannatyne. Hubert Michalak, the senior vice-president and head of warehousing investor Hillwood Poland, concurs that there is currently a wide divergence between the two ways of measuring rent, but he only agrees with Ben Bannatyne’s analysis up to a point. “The gap between effective and headline rents has been known about for years – and this has been a feature of the market for the last decade. Some investors will be very familiar with it, but some may be less aware of the effective rents. Those who are already active on the market, however, know this very well – and for me personally the divergence of effective and headline rents is just a fact and doesn’t surprise me in the slightest. If you invest here, then you have two options: you either obey the rules of the game – or you just get out,” insists Mr Michalak.

Competing and profiting

If inflated headline rents and hidden effective rents is a real issue, then it would not only depend upon the naivety of investors, but it also raises the question of how developers could possibly operate if they are basically leasing their properties at a loss in the hope of selling them on for a profit in the future. Could this really be happening? Radosław T. Krochta, the CEO and vice-president of the board at MLP Group, insists that even a company such as his, which offers attractive rents, is nevertheless profitable: “You can have a look at our quarterly results. From the beginning of 2014 until the end of Q3 we made a net profit of PLN 40 mln. Next year we will probably reach PLN 100 mln. Our results are audited by KPMG and KNF. Is that not enough profit?” He goes on to add that: “We are one of those developers that could be said to be ‘spoiling the market’. There are such developers like us, Goodman or Panattoni, who offer low rents, and Prologis or Segro, who have high rents. We have aggressive rents, but we make a profit,” says Mr Krochta. How does Segro evaluate the situation? “We sense a kind of clash on the warehouse market: in terms of investment the Polish market is in an excellent condition and last year’s transactions value of almost EUR 750 mln is an absolute record. However, on the other hand we are asking ourselves: what will be happening on the demand side? It needs to be remembered that in the long-term the stability of the investment market is correlated with the situation on the leasing market,” believes Bożena Krawczyk, the investment director for Central Europe of Segro. The strategy of Segro, which is both a developer and an investor – with a total area of app. 1 mln sqm in Poland, 25 pct of which are purchased facilities – for long-term cooperation with tenants plays an important role in extending its cooperation with them both in terms of the lease period and new locations. “The tenant market is a challenge. Our vacancy rate is lower than the market average, but the effective rents that can be seen on the market are a source of concern for us,” emphasises Bożena Krawczyk,. For one of those higher-rent developers just mentioned, Prologis, and as a company that owns properties for the long term, a low effective rent environment is hardly an ideal one to operate in. “We have seen examples of leases of 3–5 years where the headline rent has been EUR 3.50 per sqm and the effective rent is below EUR 1.80. Clearly, such a distortion cannot lead to a healthy real estate market,” claims Ben Bannatyne. But how has such a state affairs even come about? According to him, the enabling factor behind it is the lack of transparency on the market and the fact that, in some cases, “a large part of the incentive that is being offered to the customer is paid ‘outwith’ – or outside – the lease agreement. This means that it is not taken into account during the valuation and so the future investor is, effectively, unaware of it. By capitalising the headline rent, there is a significant profit created, part of which can be used as an incentive for the customer,” he says. Therefore, in his view, it is possible to make a profit through leasing at low or even loss-making rent levels, as long as the high headline rent sleight-of-hand comes into play. “This distortion has created a situation in the market where the effective rental levels being offered to customers in pre-leases on new buildings are much lower than the headline rent for existing properties of the same specification in the same location and, in most cases, the effective rents are well below the level of rent required to develop a new building. Only through financial manipulation has it been possible to develop new space. This is how it has been possible for Poland to see a continued supply of new development while, at the same time, experiencing the lowest effective rental rates of anywhere in Europe – if not, globally,” complains Ben Bannatyne.

The big gamble

Another explanation, however, is given by Mark Freeman of Cushman & Wakefield. While admitting that effective rents are low, for him this is not so much a consequence of distortions and false valuations in an opaque market, but of a rush by major players to take a significantly large enough slice of a highly promising market.
“Vacancy is low – so it isn’t a question of weak demand. In 2009/10 there was a massive oversupply of stock and warehouse owners fought tooth and nail over tenants. Now there is low vacancy, but effective rents remain low – so it can only be a fight for market share. Not all developers are the same, some build and hold, others build and sell. If the latter aren’t building they’re not earning,” argues Mr Freeman. According to this kind of analysis, developers are not expecting rents to stay at such low levels indefinitely – and the gamble they are making is that rents will rise, allowing both the developer to offer discounted rents now and buyers to accept a higher price for the asset. Future rents staying at around EUR 2 is a more pessimistic outlook on the current market and the expectation for discounting developers is that rents will go up to around EUR 3. But the risk in such approach, however, is that investors could eventually say no such a valuation, in which case the developers will have to rethink their strategy. Radosław T. Krochta of MLP Group feels that any lack of transparency is limited to a few cases of dubious business ethics: “When it comes to business ethics and also clients’ ethics, there are of course some tenants who happily accept hidden incentives, but there are some who refuse to take such offers. They also want to sign transparent deals. That is why these practices often don’t work,” insists Mr Krochta. Hubert Michalak of Hillwood Poland concedes that the “lack of transparency might lead to some problems, and obviously I would prefer to operate on a market that is more transparent, with no hidden incentives.” But he does not agree with Ben Bannatyne’s view that anything underhand is going on: “Everyone seems to be actually obeying the Polish commercial law. But it is the market rather than the law that is allowing this to happen, it is tenants and landlords who enable these structures to exist. We calculate and analyse all our investments very carefully – and we are optimistic with regards to the Polish industrial market and looking forward to operating on this market into the future,” says Mr Michalak.

Turning high demand into higher rents

For Ben Bannatyne of Prologis, however, the situation has led to an overheated and over-supplied development market – and this cannot be reconciled with the low rents on offer and needs to be reined in by introducing or insisting upon greater transparency. “Ultimately, it is the new investor or long term owner of such a property who will have to pay. If you were to stop this practice in Poland and base valuations off the rent that the customer is paying – the effective rent – then, in most cases, the development of new space would simply grind to a halt. Whilst in the short term this would have a negative impact on valuations, in the medium term it would result in strong rental growth, as vacancy levels would drop rapidly and the pent-up demand for space would lead to significant rental growth,” claims Mr Bannatyne. He presses the point by comparing Poland to the US and UK, in his view the two most transparent real estate markets in the world, emphasising that this is why they attract significant amounts of capital and why they are much less volatile in the long term. “While managing our portfolio or considering a purchase, as an industry rather than a passive investor, which means holding projects for five to seven years, we take into consideration not only the yields, which as everyone can see have clearly been undergoing compression. Our role involves ongoing portfolio analysis and an assessment of total returns generated from a given property, which expresses not only a growth in the capital value but also the stability of the revenue, which is easier to obtain when market conditions are transparent,” says Bożena Krawczyk of Segro. As Ben Bannatyne concludes: “Having a situation where the landlord and tenant are on a completely different page when it comes to the headline rent is not good for anyone in the long term. If Poland is to mature into a truly global real estate market, then transparency is absolutely key.” ν