2020/NO.01 - What should ordinarily be a straight forward, decision-making process, ends up by being one of the most easily manipulated to anyone not fully informed or aware. The establishment of ‘open market rental value’ is a straight forward issue of calculation reliant upon honesty, experience and skill. However, all too often the rent is dictated by the Freeholder or Landlord on a ‘take it or leave it’ basis. The open market rental value should represent what would be paid by the ‘Reasonably Efficient Operator’ (REO) and based upon Fair Maintainable Trade (FMT).
The REO is assumed to have reasonable knowledge and skill, acting in an efficient manner, having initially taken full professional advice in the formulation of the calculation to assess the affordability of rent. Background research should be undertaken of the local licensing authority to find out how often the licensee in occupation has changed and if it is, say, three times in the last five years, suspicion should be immediately raised over the success or profitability of the business opportunity.
Independent agents in the open market, will generally give a full background on previous trade in financial terms. Pub Cos and Breweries, however, are considerably more reluctant and will very often only divulge information on a verbal but non-written confirmation basis.
If actual accounts are used to assist in the formulation of an opinion on future trading potential, they will show only how a property is trading under the particular management at the time. Current and past performance is no guarantee as to the future turnover or profit.
All too often prospective operators work on the basis they can out perform the previous occupier and therefore they can ‘afford’ the rent. The previous operator, given the numbers of pub closures, may have suffered business failure. Pub companies, seeking to commit a new operator to one of their pubs, will not reveal what happened to the previous lessee, hiding behind the Data Protection Act.
There are many alternative tied agreements available at the moment, giving the impression of a prosperous future potential for the operator. Few agreements actually offer anything different in the form of improved prospects of lessee profitability.
In the beginning, any rent assessment is based on the likely turnover, or FMT. At rent review an operator should not be penalised for over trading, due to the unique goodwill they have created, their occupation or any legitimate improvements they have undertaken to the pub. Equally a pub owning company should not suffer for a lessee trading below the level of a REO. On a new lease, a prospective operator should be aware of the turnover established by the previous operator. Adjustments as appropriate should be made for personal goodwill, (leading to strong turnover), that may be lost on transfer.
Notoriously, pub companies seek to offer the impression of a higher than previously achieved potential turnover -check out any of their websites offering new leases. Some, but not all, provide historic barrelage data, and if they don’t you should ask for it in writing for the pub under consideration and any others in the locality. Be aware of estimated ‘future potential’ barrelage sales and target incentives, usually pub companies use 10-20% higher than the previous operators trading performance. A prospective lessee should consider that since 2007 the nation has seen around 25% drop in barrelage sales. Optimistic estimates of barrelage sales are often little more than a sales pitch to entrap the unwary new comers. Confirm EVERYTHING in writing.
Next look at gross profit (GP). Any successful lessee will have a stock taker in the future so why not establish a relationship prior to taking a pub? A good stock taker will be able to advise fairly swiftly on likely gross profits at given prices and will have a history of knowledge and databases of examples. Free of tie GP’s appear to be slowly but steadily increasing whilst typically, tied operators drinks (wet) GP’s have remained fairly static over the years, at around 50%. This can fall sharply in areas where the lessee has free of tie or managed house competition or customers are particularly sensitive to price increases, (quite often in community pub environments). The operators in such location seek to absorb some of the price increase from the supplier and thereby diminish their GP. Some agreements contain tied product price discounts this may have the effect of stabilising GP.
Operating costs are then subtracted from the GP. Again any sensible prospective operator would have an accountant to assist in the preparation of a business plan. Indeed many pub companies and brewers require proof that the operator has taken appropriate advice before signing the agreement. With the benefit of an accountants knowledge and experience in trade related properties a good estimate of the likely operating costs should be established.
Previous accounts and industry benchmarking information will help in the formulation of likely costs. According to the Association of Licensed Multiple Operators (ALMR) benchmarking, taken across multiple and single operators, the average overhead costs for a pub amount to around 40%. For pubs with food and accommodation this would be expected to be higher and for small single bar operations, with relatively low turnover, less.
The resultant is a ‘net profit before rent’ or ‘divisible balance’ which is the amount to be shared between the lessor and lessee. A rule of thumb is often used, but by no means is mandatory, a 50:50 split. In certain circumstances this split will vary. If the divisible balance is below about £60,000 then it could be argued the lessee would take a higher proportion of the figure, case law (Brooker v Unique) demonstrates just such an occurrence, the split being around 35:65 in the lessees favour. The lessee received c.£32,000 and the rent was c.£18,000. Pub Cos have a great deal of resistance to the influence of this judgement.
You may hear of another assumption, that the tied operator will be no worse off than if they were free of tie. This principle works on the basis that the tie itself was only permitted under European and domestic competition laws on the grounds that the disadvantage of being tied (primarily higher product prices) is countervailed by benefits. These benefits are claimed to be a combination of the unique services offered by the companies, operating the tied model, and a lower rent.
A prospective lessee needs to consider that cost subtracted from GP (as percentages of turnover) offer a divisible balance which will be split (not necessarily evenly) between the parties. Getting either of these estimates wrong can have a serious effect on earnings. For example, over estimating GP by just 1%, or underestimating costs by the same, can have almost a 10% reduction effect on earnings. E.g. (purely demonstrative numbers) -
As can be seen from the above example, a few minor variations on what may be the reality and a lessee can go from expecting a modest income of £29,700 to just £6,300. The pub company’s income however remains static at £29,700 and they achieve up to £250 a barrel profit due to inflated tied prices. If turnover is £300,000 this may amount to around, 280 barrels or an additional £70,000.
Great care should be exercised over how you treat the endless list of variables which in the past have been the backbone of lessee business failures. Sales data should be treated with great caution and examined and verified with care and attention. The lower the FMT and gross profit margin, often the greater the burden of overhead expenditure and a consequent increase in the hours that the new lessee is expected to put in to justify any sensible return.
Always do extensive research and if at all possible, contact the previous lessee and, if you can find them, the previous suppliers who will readily tell you how successful the business was in reality. Never take the lessor’s word for the potential or vision of the pub business. Always ensure that you take professional advice. That initial expense is often so worthwhile, set against the huge cost of business failure.
Always seek independent advice and be wary of accountants, surveyors and indeed solicitors who regularly act for Pub Cos. Always ensure that you have asked your professional advisor to reveal any perceived conflicts of interest in order that you can take a view over continuing to trust the advice offered.