Keeping true to the principles of valuation

Valuation formulae invariably tell you to disregard the effect on rent of a tenant’s improvements. Section 34 of the Landlord and Tenant Act 1954 says this. So too does almost every modern rent review clause. The rationale for it is pretty obvious, and it sounds simple enough to apply in practice. But there is a fundamental difficulty with it which is not often discussed. Humber Oil Terminals The difficulty can most obviously be seen in the facts of the lease renewal of the Immingham Oil Terminal, around 10 years ago. The IOT is a jetty on the Humber estuary, built in the 1960s to serve two nearby oil refineries. It is used to import crude oil. The British Transport Docks Board built it and let it to the refineries on a 40-year lease. When the term of the lease ended in 2010, the landlord successfully opposed a statutory lease renewal. It also applied for an interim rent to be determined. That led to the interim rent decision of Sales J in Humber Oil Terminals Trustee Ltd v Associated British Ports [2012] EWHC 1336 (Ch); [2012] PLSCS 112. Sales J’s judgment, it is fair to say, is not an easy one to digest. But there is one important thread in it for present purposes. In fixing an interim rent, the court has to identify the rent it is reasonable for the tenant to have to pay. In doing so, the court must have regard to the rent that would have been payable under section 34 for a new yearly tenancy of the property. The section 34 rent is the amount someone would pay for the property if it was being let in the open market, disregarding the effect on rent of the tenant’s improvements and assuming all tenant’s fixtures have been removed. So what were the improvements and tenant’s fixtures to disregard at the IOT? They consisted of the entire system of pipework, pumps, valves and loading rigs used to move crude oil between vessels in the estuary and the refineries. All that the Docks Board had built in the 1960s was the concrete platform stretching out into the estuary. The liquid-handling equipment had all been installed by the tenant. In 2010, it would have cost around £142m to replace the concrete jetty structure. However, it would then have cost another £70m to replace the liquid-handling equipment and make it functional as an oil terminal. The problem is that, when you value something, you have to envisage a transaction involving the property, and work out how much money would change hands for it. To do this, you have to know what the physical property is that is being let or sold. Is it the property that exists in reality? Or is it in some other assumed physical state? If you are told to disregard the effect on rent of the tenant’s improvements, then the obvious way to do that is to assume the transaction involves the property in the physical state it would have been in if the improvements had never been carried out. But what if those improvements are essential in order for the property to be of any use? That is fine if the incoming tenant can afford to carry out the improvements that are being disregarded, but what if that is unaffordable? At the IOT, the refineries were going to be spending the equivalent of £70m equipping the jetty. They could afford to do that under a 40-year lease but what if it had been much shorter? The point is an obvious one but if your improvements are going to cost £10m and you are taking a 10-year lease, then the cost is £1m a year. However, under a five-year lease the cost would be £2m a year. The shorter your lease, the more expensive the improvements are, and if your lease is very short then the improvements may be entirely unaffordable. It is often tempting for tenants as well as landlords to avoid confronting this point, because it can lead to the seemingly unpalatable valuation conclusion that the rental value is nil. In Humber Oil, both sides had therefore suggested theories as to why an incoming tenant would equip the jetty even with only a yearly tenancy. The judge rejected both sides’ evidence on that. He said – rightly – that if the unimproved jetty was being offered on a yearly periodic tenancy then the rent would be nominal. But, he said, a nominal interim rent would be unfair because, in fact, the tenant had been using the IOT to import 20m tonnes of crude oil a year. In Humber Oil, the judge fixed a much more than nominal interim rent of £14.8m pa. However, there were two factors peculiar to Humber Oil that enabled this. The first was the wording of the interim rent provisions, which gave the judge a discretion. The second was the particular valuation method the parties had adopted, which was the depreciated replacement cost basis. That valuation method uses the cost of replacing the property as its starting point, and it is seemingly easy therefore to strip out the value of the improvements simply by leaving out the cost of replacing them from the calculation. These were both factors peculiar to Humber Oil, and neither of them will normally be present. So what is the solution in other cases? The solution normally proposed is to say that you must not assume the improvements do not exist. You are not to disregard the improvements, only their effect on rent. So you start by valuing the property in its improved state, and then make a valuation adjustment downwards to eliminate the effect on the rent of the tenant’s improvements. There are, however, a number of serious problems with that solution. The root of the problem The first problem is that there is a fundamental contradiction at the heart of the argument. Suppose, for example, you are valuing a five-year lease of a property worth £1m in its improved and operational state but only £10,000 a year if unimproved.  The landlord’s argument is you start with the figure of £1m a year and then adjust it downwards to remove the effect of the tenant’s improvements. The point of this is to try to capture the value of the property as a working facility. However, if, in the process of disregarding the effect on rent of the improvements, you bring yourself all the way down to the figure of £10,000, then the exercise will have been a waste of time. You may as well have valued the unimproved property in the first place. So the aim is to get to a figure below the rental value of the improved property but above the rental value of the unimproved property. If you succeed, though, you will necessarily have allowed the existence of the improvements to affect the rental value, because otherwise you would have ended up with a figure of £10,000. Therefore, if you do the exercise correctly, you will not achieve what you had hoped to achieve. You have to aim to fail, in other words, in order to hope to succeed. Put another way, this approach involves following three sides of a rectangle (namely, valuing the property with the improvements; asking by how much the improvements have increased the value; and then deducting that increase, to arrive at the value disregarding the effect on rent of the improvements) as opposed to simply following a single side of the rectangle and valuing the unimproved property directly. If you follow the three sides accurately, you will end up in the same place as if you had simply followed a single side. The second problem is the supposed basis for the approach in the authorities. The support is usually said to come from two sources. One is Humber Oil. The other is Coors Holdings Ltd v Dow Properties Ltd [2006] EWHC 1862; [2006] PLSCS 107. So far as Humber Oil is concerned, it provides no support at all. It is true that the IOT was valued as a functioning facility, but that was because the statute gave the judge a discretion to decide what rent it was reasonable for the tenant to have to pay. So far as Coors is concerned, it superficially seems to help, until you appreciate that the court wasn’t actually talking about a disregard of improvements at all, but instead about a peculiar and bespoke valuation formula. The third problem with the argument is that it is contrary to the decisions in two cases in the 1970s: GREA v Williams [1979] 1 EGLR 121 and Estates Projects v Greenwich [1979] 2 EGLR 85. In those cases, the judge made the point explicitly that if you can disregard the effect on rent of some improvements by valuing the unimproved property directly then that is the correct approach, and it would be “ludicrous” to do otherwise. The fourth problem, though, is the most serious. It is that the cases where this problem arises are all ones where the cost of carrying out the improvements is so high, and the lease length is so short, that the incoming tenant will not carry out the works that are being disregarded, but where the property without the improvements has little or no value in the market. All valuation methods are ultimately ways to model how a tenant would actually behave. Here, the first stage is to value the improved property. So far so good. The second stage is then to deduct something for the rental value of the improvements. But how is the valuer to work out what sum to deduct, to model how the tenant would actually think about it? You cannot use the cost of the improvements, depreciated for age or otherwise, because we know the tenant is not going to carry them out. The cost would therefore be irrelevant to them. But if the value of the unimproved property is irrelevant, and if the cost of the works is irrelevant too, then what is the valuer supposed to do? There is no answer to that question. In truth, the landlord’s approach is really about saying that the correct deduction is whatever sum, once deducted, gets you to the rent that you think it is reasonable for the tenant to have to pay. It is, in other words, an exercise in pure reverse-engineering. This approach is therefore not a real solution to the problem. Indeed, the problem here is not really about how the valuation hypothesis is being applied. It is about the valuation hypothesis itself, which breaks down when it comes into contact with this particular combination of facts. Mark Sefton KC is a barrister at Falcon Chambers Click here to read the other part of the lecture, presented by Maggie Stobo Image © Martin Moxter/imageBROKER/Shutterstock