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) CountryDeposit Korea10 months rent Japan10 months rent Germany3 months rent or bank guarantee equal to 3 months rent Czech3 or 6 month cash deposit or bank guarantee Hungary3 months gross rent or bank guarantee Singapore3 months gross rent China3 months net rent + management fees USA2 months UK3 or 6 months rent

10. Choice of contract depend upon negotiating strengths Low vacancy rates in Seoul Source: Jones Lang LaSalle Research (2009)

11. Deposit Agreements in the UK -Key Heads of Terms 1. Amount of depositNegotiable! 2. Duration of depositEntire lease or defined period? 3. Holding of the depositPaid to landlord on commencement of lease. Held in separate interest bearing account. Held in trust to safeguard tenant against risk of landlord's insolvency. 4. InterestAgreement will normally state that the tenant is entitled to any interest earned on the deposit sum. 5. Withdrawals by landlordLandlord right to withdraw funds from deposit to meet overdue rent+ any breach of non-monetary obligations. Tenant may be required to top up the deposit following any withdrawals. 6. Return of depositLandlord to return deposit plus interest to tenant at end of the lease.

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 Initial rent free period12 months Passing rent£100,000 p.a. Lease length10 years Rent review periodEvery 5 years, upward only Initial yield8% Target rate of return10% Implied annual growth rate2.33% Holding period10 years Marketing and legal costs5% of revised rent Length of void periodUp to 12 months Tenant incentives12 months rent free Exit yield8%

16. States of the Market Recessionary Market 12 month void 12 month rent free Total:24 months loss of income Recovery Market 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 Recessionary Market (24 month loss of income) Recovery Market (12 month loss of income) NPV (1) Deposit required (2) Multiplier of Market Rent as a Deposit (3) NPV (4) Deposit required (5) Multiplier of Market Rent as a Deposit (6) Control Valuation: No default £1,159,091 Default Event: End of year 1 £999,168 £159,923 1.60£1,074,051£85,0400.85 2 £1,012,151 £146,940 1.47£1,081,813£77,2780.77 3 £1,022,478 £136,613 1.37£1,087,283£71,8080.72 4 £1,030,492 £128,599 1.29£1,090,779£68,3120.68 5 £1,036,501 £122,590 1.23£1,092,584£66,5070.67 6 £1,047,667 £111,424 1.11£1,099,840£59,2510.59 7 £1,056,712 £102,378 1.02£1,105,248£53,8430.54 8 £1,063,907 £95,184 0.95£1,106,741£52,3490.52 9 £1,071,698 £87,393 0.87£1,111,495£47,5960.48 Average Deposit 1.210.59

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

20. Monte Carlo Simulation Parameters for the random variables MinimumLikeliestMaximum Growth rate0%3%4% Initial yield7%8%9% Target rate of return9%10%11%

21. Simulation Results 50,000 trials Recessionary Market (24 month loss of income) Recovery Market (12 month loss of income) Average deposit – multiplier of market rent Average deposit- multiplier of market rent Mean1.200.64 Standard dev.0.09 Maximum1.480.91 Minimum0.870.32 Range width0.610.59

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.