36.  Lessees have many complaints about the way in which rent is calculated. This is a complex subject, because as well as receiving an income from the basic rent, pubcos can receive income through requiring lessees to buy a range of products and services through them. The basic rent takes some account of these 'ties', but whether it does so to a sufficient extent is one of the main bones of contention. Complaints about the method on which any rent is calculated are frequently and inevitably bound up with complaints about the tie system.

'Dry' rent

37.  Punch's introductory guidance to new lessees says "We adopt recognised valuation methods used in the open market".[51] For most pubs basic rent, often referred to as 'dry rent', is not determined by price per square footage like many other commercial properties but on a division of 'fair maintainable trade' (FMT), that is, the amount of profit that a 'reasonably efficient operator' might be expected to generate. The theory of how this should be done is set out by RICS in its valuation guidance.[52] According to this FMT should be calculated by estimating the amount a pub could make, looking at factors such as its location and size. In addition the cost of actually running the pub should be estimated by considering costs such as staff, utility bills and the price of beer and other products from the supplier. These estimated costs are then subtracted from the potential turnover to give a balance — the "divisible balance". This is divided between the lessee and the pubco, normally on a 50/50 basis. However we have received evidence to suggest that the 'theory' is not necessarily followed. Nigel Wakefield, a member of the BII, told us following a recent BII rent review road show:

I assumed wrongly that a complex mathematical approach would be implemented to assess rent increases or valuations for individual pubs. I sat there, with total incredulity, whilst one of the so-called top rental valuers told that, his method would be to go two, three or four local pubs within a ten mile radius and ask the landlord what his rent was and by using comparables arrive at a figure, discounting the best and worst pubs.[53]

38.  While setting rent and reviewing rent may be a matter of negotiation, the RICS guidance does becomes important if there is a disagreement between the lessee and their pubco. If the matter goes to arbitration then the theory of FMT is applied to the rental valuation. It accordingly sets the framework for the sector and the negotiations. The FMT model is the focus of much criticism as it is not seen to be evidence-based.[54] Even those who support it agree that calculating FMT is not an exact science. In a paper entitled 'Making Pub Rents More Transparent', Rob May, the former Chairman of RICS, Trade-Related Valuation Group said, that valuing for sustainable rents "that do not impose excessive costs on the operator nor undervalue the owner's investment seem to be a 'judgement of Solomon' and sometimes they are not judged accurately".[55]

39.  The Punch website makes clear: "there will always be an element of negotiation around the figures used in the initial calculation."[56] These negotiations are frequently between lessee and a pubco representative[57] although it may involve a chartered surveyor on either or both sides. RICS said

With regard to the large pubcos employing Chartered Surveyors, this is a commercial matter, and the engagement of qualified and experienced specialists must be correct. We understand the valuer will be looking to present the best case in negotiation for his 'client' the landlord. Similarly, a valuer acting on behalf of a tenant will do everything he can to present his case for the lowest possible rent; this is no different to any rent review negotiation.[58]

RICS also made clear:

Chartered Surveyors do not create a market. They analyse what the market is transacting. All sale and lease transactions are freely negotiated. Different parties will play to a different agenda. It is the valuer's task to investigate and analyse such transactions and apply the evidence to a specific situation. In negotiation, the valuer will attempt to agree the best result for his client. Each party is free to walk away from a proposed transaction.[59]

40.  Chartered surveyors may be involved in valuation in two roles — either as the advocate for a client or as an independent arbiter when rents are disputed. Many surveyors will have worked for pubcos. This double function has led to concerns that chartered surveyors involved in arbitration do not necessarily declare their interests, and this was raised in evidence. However Mr Willis, Chair of the Trade-Related Valuation Group of RICS said

Any valuer who is a chartered surveyor who is a specialist in licensed property or any form of the profits valuation is covered by the RICS rules of conduct and the guidelines and the valuation information. Part of that is that he must be experienced. It is integrity and experience in client service which are the fundamental key to the chartered surveyor role.[60]

41.  Lessees must appreciate that if a chartered surveyor is involved in their rent negotiation he or she is acting on behalf of a client and that is a legitimate role. However membership of a chartered institution is no longer considered an automatic guarantee of integrity and certainly not of impartiality; RICS members called on to act in arbitration should be aware of the sensitivity of their situation and must be scrupulous in declaring their interests.

TRANSPARENCY

42.  By whatever means a pubco values a pub, fair negotiations need transparency — a lessee needs to know on what assumptions their rent is based so they can query them in negotiations. This was an issue raised by our predecessors who recommended in 2004 that

Pubcos should provide their tenants with a comprehensive breakdown of how their rent was calculated. This should reveal the whole detail of the profit assessment and how the specific requirements of the lease conditions had been interpreted by valuers.[61]

Pubcos have told us that they do do this. Admiral said that it "will share its profit and loss assessment".[62] Marston's said "using their profit-and-loss account, the retailer is taken through the business model."[63] Enterprise told us: "the assumptions used in the construction of rent calculations are disclosed to licensees, together with an estimated and summarised profit and loss account which supports the rent assessment."[64]

43.  But this was disputed by other witnesses. David Morgan said that he had never found the detail recommended in 2004 included in pubco rental calculations unless a rent review was referred to a third party for resolution.[65] He concluded "There is no transparency; it does not exist."[66] ALMR also told us that the 'headline operating cost figure' was rarely broken down into its component parts with no justification provided as to how it was arrived at:

It is therefore just an assumption of how much the landlord thinks it will cost to run the pub which is neither transparent nor evidence based. [67]

Our survey bears this out. It shows that 44% of the lessees questioned had not seen any form of breakdown of their rent calculations.[68] A lessee said that he had written to his pubco 13 times asking for supporting evidence for his rent and it was never supplied.[69]

44.  In addition, as highlighted in Chapter 2, the Trade and Industry Committee's recommendation that the detailed profit assessment (as described above) should form an addendum to leases to increase transparency[70] has not been implemented. In justification Greene King said that there was "a distinct danger of potential mis-representation if a 'guaranteed income' was indicated."[71] Enterprise said that it disagreed with the recommendation because "it is those assumptions which support the assessment of rent at the date of review which are pertinent, not those used at the time of an earlier assessment."[72]

45.  Given the inherent subjectivity of the rental valuation method, it is very important that there is transparency about the assumptions on which it has been calculated. We note that there is disagreement between lessee representatives and pubcos over whether the Trade and Industry Committee's recommendation that "Pubcos should provide their tenants with a comprehensive breakdown of how their rent was calculated" has been implemented. The evidence that this recommendation has not been fully implemented is confirmed by our survey results which show that 44% of lessees had not been shown a breakdown of how their rent was calculated. This is unacceptable.

A FAIR VALUATION?

46.  Without transparency, the valuation process is open to abuse and negotiating a fair rent becomes more difficult. A valuation could be carried out in an aggressive manner by manipulating the inputs into the calculations — in particular by under-estimating the running costs of a pub. If the cost percentage is too low, the divisible balance is falsely high: the landlord gets a higher rent and the lessee less profit. ALMR have recently carried out a benchmarking study on operating costs and found that pubcos tend to calculate running costs[73] as approximately 30-35% of turnover but in reality they are on average over 52%.[74]

47.  We note that, without transparency, rental calculations are open to manipulation by the pubcos, in particular by systematically underestimating the costs for a lessee of running their pub. We recommend that there should be industry guidelines on the average costs of running a pub such as those in the ALMR benchmarking survey. These can be used by lessees as comparators against the rental assessments put forward by their pubco.

TRADING HISTORY

48.  The recommendations on transparency made in the Trade and Industry Committee's 2004 Report were prompted by evidence from a Morgan Stanley study which found that a third of lessees rated their pubco as less than satisfactory for disclosing all relevant information.[75] In 2009 our survey found a similar number of lessees (34%) did not feel sufficiently prepared by information and advice from their pubco before signing their lease.[76]

49.  One area of particular concern was information regarding the past trading history of the pub. While the profits that a 'reasonably efficient operator' might be expected to make are by definition a matter of judgement, past trading history is factual and could be used to assess whether the rental valuation was fair. Indeed, the BBPA Framework Code of Practice states that companies should provide "information relating to the trading history of the pub".[77] Pubcos therefore supply information on barrelage and goods supplied to the pub.[78]

50.  It has been suggested that an incumbent lessee should also have access to the previous lessee's books.[79] The situation is complicated because sometimes this commercial relationship is between the lessee who is selling on the lease, and the buyer, rather than between the new lessee and the pubco. Nonetheless, the pubco will have some knowledge of the pub's history, and is in a position to share the information with the new leaseholder. It is not clear that the relationship is always as open as it should be. For example, Paul Daly told us that he was not provided with any figures when he took on an Enterprise pub through assignment.[80]

51.  We have heard from concerned lessees who have taken on pubco pubs and are failing only to find out that the past few lessees have also failed and that they were not informed of this by the pubco when taking on the lease.[81] We questioned the pubcos on this:

Q270 Mr Clapham: On to the rent situation, when a prospective tenant is moving into one of your public houses, do you divulge to them the previous sort of performance of that public house? Do you tell them about the bankruptcies, if there have been any bankruptcies? Do you tell them about the performance of the last person in that public house?

Mr Townsend: I am almost sure that we would not divulge the personal information relating to the prior occupier of a house and the personal financial situation, but the trading history of the pub, absolutely. We will share with them the information that we have available, and that is typically the sales of products that we make into the pub and the share of gaming income that we may have enjoyed from the pub. We do not have access to the pub's books in the circumstances of either a new let or indeed an assignment. As has wrongly been suggested to this inquiry on an earlier occasion, we do not have access to the tenant's books.

52.  However our survey showed that 36% of lessees did have to provide their accounts to their pubco.[82] Of the 230 Enterprise leaseholders questioned, 70 (or 30%) said they had to produce their accounts. We wrote to Enterprise to question their evidence and were told again:

I can confirm that ETI [Enterprise Inns] only obtains access to a lessee's profit and loss account if the lessee chooses to share such information with ETI. This can occur at any time if the lessee so desires, and is particularly helpful in providing supportive evidence during a rent review negotiation.[83]

But in the same letter Enterprise went on to tell us:

There are certain circumstances under which such disclosure is obtained by ETI as a mandatory pre-condition. These are —

i) the provision of temporary financial assistance;

ii) an out-of-cycle rent review requested under ETI's Code of Practice.

In both cases, we require full disclosure of recent trading accounts (last two years if available), stock results and VAT returns as well as evidence of current overhead costs being incurred.

In the new ETI Retail Partnership Tenancy agreement launched in the latter part of 2008, it is a mandatory condition that licensees employ the services of a qualified trade accountant and provide full disclosure of profit and loss accounts to ETI on at least a quarterly basis.[84]

The oral evidence given to the Committee by Mr Townsend was, at best, partial.

53.  The BBPA Framework Code of Practice considers "Precise turnover will not usually be available to the pub company but details of volume purchased from the company directly can be provided".[85] We have no reason to doubt that pubcos are abiding by this limited duty. However, we believe that even if they do not have access to the books of the previous lessees, they should reveal the circumstances in which the pub was left. It could be argued that by providing information about past trading difficulties, pubcos are putting those selling leases at a disadvantage. We do not accept this. While it is perfectly legitimate to accentuate the good things about a business for sale, it is not appropriate to hide material facts. Moreover, the majority of leases in our survey were not assigned, but obtained direct from the pubco; in these cases there is no question of interference in a separate commercial negotiation.

54.  We accept that in many cases pubcos do not have access to their lessees' books. However, they have access to a substantial amount of information about the business of a particular pub, and are likely to have extensive information if a business is in difficulties. Pubcos entering a commercial relationship with a new lessee should be required to share all their information on a pub's trading history with them.

AVAILABILITY OF COMPARABLES

55.  One way to improve transparency in rental valuations would be if a lessee could compare whether their rent was in line with other similar pubs. Our predecessor Committee recognised this and recommended that there should be a national register of rent reviews to help lessees compare their rents against those of similar pubs.[86] This recommendation was not taken up. Mr Willis, the Chairman of RICS's Trade-Related Valuation Group told us that there was no rental register for any form of commercial property. He said that the reason for this was that no two properties were the same and no two leases were the same so 'a little knowledge is a very dangerous thing'.[87] In response David Morgan argued:

if you have three […] you can get a distortion. If you have 30 pubs they tend to even out a little bit. If you have 300 pubs you then get a general tone. If you have a whole stack of comparables they generally tend to form a pattern and you can interpret the pattern as you will.[88]

56.  David Morgan argued that because comparables were not readily available to lessees a pubco had a "manifestly unfair advantage" as it had:

access to all of the comparables of its own estate, either locally or regionally. There is absolutely no opportunity for a tenant to have access to any of this database and from my personal experience it is never offered for the assistance of the tenant, other than to cherry-pick the very highest examples.[89]

He gave the example of a case he had recently handled where he asked a pubco representative for the details of a pub owned by the same pubco within close proximity and was refused.[90] A lessee told us that he asked his pubco Punch for trading figures of similar pubs to his and was told that there were none available.[91]

57.  Rob Hayward, Chief Executive of the BBPA highlighted that the Valuation Office's rateable valuations were available as comparables.[92] However these do not take account of a tie nor do they take account of living accommodation.[93] Mr Willis conceded that "the number of comparables that are provided at the early stages perhaps could be improved".[94]

58.  A system must be put in place to allow lessees to assess whether their rent is fair and in line with similar businesses. Our predecessor's recommendation to create a register of rent reviews would have increased transparency. We note it has been disregarded, and neither the pubcos nor RICS have taken any serious action to make sure the rental system is not unfairly biased against the lessee.

A new valuation method?

59.  Some witnesses suggested that the fair maintainable profit valuation method should be abandoned. The valuation method used to establish rents for public houses needlessly lacks the transparency and simplicity of the methods used for other commercial properties. As Nick Bish from ALMR said:

It is built on the basis of the tied estate of the old breweries transported into the new model of the leased estate and it does not fit comfortably. We would rather see, […]full commercial leases in the public market where it is based on square footage and comparables and so on. I accept entirely that a pub is a pub and you can turn a chemist into a shoe shop, so the high street is a way of doing things, but the pub is not sufficiently distinct, certainly for a long leased business, not to go down that route.[95]

60.  The rental valuation method for pubs appears to be the product of history and tradition. If it is to be fair, there must be far greater transparency about how rents are calculated to ensure equality between the parties to the negotiations. If this is not improved as a matter of urgency, there are compelling arguments for abandoning the method entirely.

Rent reviews

61.  Rent reviews are a subject of particular contention between pubcos and their lessees. The main concern expressed in submissions to the Committee was that, in a time when takings were decreasing, pubcos were still asking for higher rents, despite the notionally shared risks between pubco and lessee.

62.  Rent reviews happen on average at five yearly intervals. BBPA explained that the purpose of these were to re-assess rent:

on the basis of the trading pattern of the pub and what could reasonably be expected of the business as it exists at that time. Things to be considered will be changes in demographics, capital investment by the pub owning company or the lessee, general trading conditions and any other relevant factors that have an influence on the revenue of the pub.[96]

63.  Pubcos denied that they were asking for unreasonably high rental increases. Enterprise said that since 2004, it had conducted 4,690 rent reviews and the average annual growth in rent, arising from rent reviews throughout this period, was below inflation at approximately 2.5%. In addition 162 reviews had resulted in permanent rent reductions.[97] Punch told us that more than a third of their rent reviews in the last year had either seen the rents staying the same or going down.[98]

64.  Nick Bish told us that the rent review model was not working because:

in a declining market rents and agreements are based on a five-year period and this seems not flexible enough to cope with, as we are all observing, a steep, some would say potentially catastrophic, decline in the economy.[99]

However Martin Willis from RICS argued that the rent review system was not peculiar to the pub industry and that difficulties were being faced by most small businesses due to the economic climate:

Essentially the problems that are in the industry at the moment are largely down to the recession which is affecting every other form of commercial property and particularly small businesses. Any business, even a small shop, may well have a five yearly rent review […] It is affecting all small businesses and I believe anybody faced with rent review increases at the moment is having to look at them very closely.[100]

65.  As discussed earlier in this chapter, pubco BDMs normally carry out rent reviews rather than chartered surveyors. It is therefore questionable whether the FMT method is actually carried out correctly or at all at rent review. If there is no transparency and lessees are not given a breakdown of their rental calculations it is hard for them to know. It has been argued that there is no "due diligence" in the process as recommended by our predecessors.[101] David Morgan said:

The interface, because it is adversarial, is the BDM or BRM. They are obviously in the business to get the highest rent they are able to get. They are looking after shareholders' interests and their own job; they are not there to cut the rent down. If they are able to get as high as they are able to, they do.[102]

He believed that the pubco representative approached rent reviews with three aspirations:

• a sky-high rent demand that only an idiot might accept, but you never know;
• a middle ground rent review that has been authorized by his superiors as a settlement level that can be justified internally; and
• an ultimately lowest level settlement that is either accepted after significant negotiation processes have been exhausted, or by third party referral.[103]

66.  There are certainly indications that in preparing rent reviews, pubcos work out the figures backwards from the rent which they are seeking. A lessee told us:

Enterprise Inns continually manipulated the costs and other variables to support a desired rental figure. Rather than input appropriate variables to determine a rental level, they worked backwards from a sought after rent until the calculation fits their requirements.[104]

He supplied us with the calculations his pubco had made when his rent was reviewed. In the first calculation there was an income of £5,000 for 'Machines' and £500 for 'Food and Catering' (being crisps and snacks) however when he pointed out he had no machines the figures were adjusted to take account of this. This second calculation did not show a machine income but the food and catering income had gone up 1,200% to £6,000. The total rent expected remained the same.[105]

67.  A lessee has limited negotiating power in a rent review. Walking away from the business is not easy, particularly since in some cases not just a business but a home is lost. At present, challenging a review formally requires significant resources. That means that transparency in valuation during a rent review is even more important than when a lease is first arranged. It also means that low-cost dispute resolution methods are desirable. There has been some progress on this, which we examine in a later chapter.

Goodwill and improvements

68.  Lessees have also complained that rent increases took into account increases in trade following improvements they themselves had made to the business. One lessee told us that having turned around his pub, after a year, his rent was increased by 50% and his pubco told him that "the rent had been set too low for the previous tenant" although there had been no mention of this when he had taken on the pub.[106] In another case a lessee was presented with a 100% rental increase at her first five-year review even though there had been no change in the local environment or economy — the only difference being the money she had invested in upgrading, as she put it, an 'old and shabby building'.[107] In principle, trade increase brought about by improvements made by the lessee, above and beyond maintenance of the building, should be disregarded in rent reviews. So too should any increase in trade attributable to the lessee's goodwill. In practice these factors are hard to disaggregate and seem often not to be disregarded.[108]

69.  David Morgan told us he had never encountered a rent review negotiation that accepted or considered the tenantable goodwill, and that pubcos 'exploited' structural alterations.[109]

70.  It is difficult to measure the extent to which trade has increased because of improvements to the premises funded by the lessee. Nonetheless, we consider it is manifestly unfair for pubcos to profit from increases in trade brought about by such changes; here, too, transparency on how rent is calculated and access to figures for comparable premises would properly strengthen the lessee's negotiating position.

Upward only rent review and RPI clauses

71.  The Trade and Industry Committee recommended that upward only rent review (UORR) clauses should be abolished. This appears to be the case for new leases, and the pubcos have assured us that where such clauses remain in existing leases, they will not be enforced. However the Fair Pint Campaign told us that UORR clauses have simply been replaced by annual Retail Price Index (RPI) rental increases.[110] This was denied by the pubcos. Enterprise told us:

completely contrary to the evidence that was given by an earlier witness suggesting that we try and negotiate wider conditions in return for removing [UORR clauses], it is absolutely not the case.[111]

However in our survey 27% of lessees told us that RPI clauses did in fact replace their UORR clause[112] — and 17 of these were Enterprise lessees. In addition ALMR have told us that:

where downward rent reviews are agreed on non-RPI leases following negotiation, the pubco has asked for the terms of the lease to be changed to provide for an annual increase in line with RPI, even though the Code of Practice is silent on that point. In some cases, this has nullified the benefit of a rent reduction.[113]

Once again, the evidence given to the Committee from the pubcos does not quite tally with the information we received from other sources.

72.  We have also been told that in some leases it states that if the index decreases rent will remain the same — and not decrease. David Morgan said:

In the Enterprise Inns Retail Partnership Agreement which is now common throughout the entire estate and is the basis of lease agreements in the generality, Schedule 3 contained within that agreement, deals with rent reviews. Schedule 3, Section 1 "Annual Reviews" states in paragraph 1.1 that the rent will be increased by the same percentage as the increase in the Retail Price Index over the 12 month period since the previous annual review date. In paragraph 1.3, it clearly states: "if the index has decreased during the relevant 12 month period, the rent will remain the same". Quite simply, the rent is not capable of a downwards review until the fifth year.[114]

However Enterprise said in evidence

All new ETI agreements state that rents will be "adjusted" in line with RPI, whether upwards or downwards, and in the current period of rapidly falling inflation this will serve to limit, or even remove, annual increases for licensees with indexed agreements.[115]

Punch has undertaken to reduce rents if RPI decreases.[116]

73.  Enterprise defended the indexation of rent saying that indexation substantially lessened the likelihood of a significant change to the rent at the time of review, as rent was adjusted to take account of inflation during the period between cyclical reviews. In addition Enterprise said that many people actually preferred the "smoothing" effect of indexation between rent reviews.[117] Greene King agreed saying:

The RPI adjustment is seen by tenants as preferential as it enables better financial planning over the term as opposed to a potential 'hit' at review.[118]

74.  In contrast, opponents of RPI adjustments argued that they meant, on a compounded basis, rent increased by approximately 25% over the five-year period between rent reviews.[119] ALMR highlighted findings by Fleurets which showed that indexing had increased the pubcos share of the divisible balance from 50% to a 55-60% share over a five-year period.[120]

75.  Our witnesses are divided over the merits of annual RPI rental adjustments. The pubcos claim this prevents lessees having to deal with a large increase in the five yearly rent review; lessees consider it a way of gradually increasing pubcos' share of the profits, and of reducing pubcos' share of the risk. The evidence is finely balanced, and we are not the appropriate body to resolve the question. Two things are clear; firstly, pubcos' greater bargaining power has enabled them in at least some cases to insist that upward only rent reviews are replaced by annual rental adjustments in line with RPI; secondly, if rental is linked to RPI it should be done in a way which enables reductions when appropriate.

52   RICS Valuation Information Paper No. 2: The Capital and Rental Valuation of Restaurants, Bars, Public Houses and Nightclubs in England, Wales and Scotland. Back

53   Ev 270 Back

54   Ev 84 Back

55   Making Pub Rents More Transparent, Rob May, 12 October 2005 Back

56   Passionate about Pubs, Punch, pg 15 Back

57   Ev 214 Back

58   Ev 272 Back

59   Ev 272 Back

60   Q 88 Back

61   HC (2004-05) 128-I para 145 Back

62   Ev 125 Back

63   Ev 201 Back

64   Ev 102 Back

65   Ev 244 Back

66   Q 91 Back

67   Ev 84 Back

68   Ev 301 Back

69   Ev 134 Back

70   HC (2004-05) 128-I para 145 Back

71   Ev 206 Back

72   Ev 102 Back

73   For example staff, cleaning, utility bills Back

74   Ev 84 Back

75   HC (2004-05) 128-I para 97 Back

76   Ev 298 Back

77   Codes of Practice Framework on the granting and operation of tied tenancies and leases, BBPA, Second Revision (2005), p6 Back

78   Passionate about our pubs, Punch, states that Punch supplies three years barrelage Back

79   Q 31 Back

80   Q 33 Back

81   Ev 274 Back

82   Ev 303 Back

83   Ev 106 Back

84   Ev 106 Back

85   Codes of Practice Framework on the granting and operation of tied tenancies and leases, BBPA, Second Revision (2005), p6 Back

86   HC (2004-05) 128-I, para 157 Back

87   Q 92 Back

88   Q 93 Back

89   Ev 245 Back

90   Q 91 Back

91   Ev 258 Back

92   Q 153 Back

93   Ev 283 Back

94   Q 93 Back

95   Q 152 Back

96   Ev 185 Back

97   Ev 102 Back

98   Q 273 Back

99   Q 137 Back

100   Q 55 Back

101   HC (2004-05) 128-I Back

102   Q 91 Back

103   Ev 244 Back

104   Ev 145 Back

105   Ev 144 Back

106   Ev 156 Back

107   Ev 203 Back

108   Ev 159 Back

109   Ev 247 Back

110   Ev 220 Back

111   Q 274 Back

112   Ev 302 Back

113   Ev 93 Back

114   Ev 246 Back

115   Ev 108 Back

116   Morning Advertiser, 13 February 2009 Back

117   Ev 108 Back

118   Ev 204 Back

119   Ev 245 Back

120   Ev 84 Back