The leisure sector has found itself out of favour with investors for a number of years now – particularly with the institutions – with the last deal of note being the disposal of the Corner House in Nottingham to the BP Pension Fund towards the end of 2000. Since then, a number of factors have contributed to a lack of investor interest.
First, macro economic conditions have created a period of great uncertainty. The key economic factor when considering a leisure investment is consumer spending growth. At the peak of the leisure investment activity, growth in consumer spending was between 4.5% and 8% depending on the location in the UK. The year-on-year change for 2003 is anticipated to be around 2% rising to an average of 3.5% and 4% over the next five years. This can be linked to a tailing off in the housing market, reduced earnings growth and an increase in the tax burden, all of which affect our ability to spend. The second problem facing investors is that there is no Investment Property Databank (IPD) performance indicator for the leisure investment sector.
The IPD index shows the returns on property within specific sectors, relative to the performance of all property. This data tracks relative performance over a 20-year period and represents the benchmark of investment for most fund managers. Although 2002 saw a significant improvement in the level of transactions from the previous year (with a total of around £300m worth of assets changing hands) and while leisure investment activity is expected to exceed £500m this year, the sector remains extremely immature, relatively illiquid and rather mistrusted or misunderstood by the institutions.
Well documented trading difficulties from a number of leisure operators over the last 18 months has added to investor unease, associated with which has been the high levels of gearing. Many operators carry a heavy debt burden due to high capital investment and rapid expansion. As a result of these financial difficulties, in addition to a possible change in ownership from say plc status to venture capital or private equity, there has been a perceived weakening of the covenant.
The leisure sector has generally offered institutional lease terms of a minimum of 15 years, but more usually 20 to 25 years. Other commercial sectors such as manufacturing or service industry continue to look for more flexible lease terms (such as five or10-year breaks).
Another key issue is the lack of rental growth, with fewer operators expanding and driving rents upwards. Why invest in an asset where relative values are at best static, if not falling?
Despite these apparent disincentives to potential purchasers in the leisure sector there remain certain fundamentals of the market, which should drive the investor to consider this sector seriously. Selectively, many operators still tick an acceptable covenant box but the owner must have a degree of faith in either the longevity of the sector, the operator themselves, or perhaps have some other reason for investing. For example, many health and fitness clubs on retail warehouse parks are situated in edge of town locations as some town centre sites have a higher residual land value under another use, subject of course to planning permission.
If growth is not market driven in all sectors, it can still be achieved artificially. Operators may still be prepared to offer fixed minimum uplifts or uplifts linked to the retail price index. Therefore, a reversionary profile can be guaranteed over a defined period of the lease.
Additional security implied by the high level of fit out costs associated with the leisure operators’ initial investment is another factor, i.e. the operator must have convinced itself and its financiers that this is the right location.
The principle drivers for the lack of supply of new sites has been twofold; firstly competition, mainly from retail and residential markets. Secondly planning, where the inability of the operator or consumer to divorce themselves from the car puts them into direct conflict with Government policy.
The leisure sector has never really featured on the analysts’ or institutional radar screens and as a consequence there has been a considerable lack of competitive demand for the product. To change this attitude, the sector and operators must drive performance – but how can this be achieved?
First, by demonstrating a stable leisure spend through an improving economy. Second, new entrants to the market within the D2 sector could improve demand and therefore demonstrate rental growth – such as children’s activity or childcare centres and gaming (bingo halls and casinos fall into the same Use Class Order). It is likely that these offers will be competing head to head for space with health clubs and other D2 boxes. Third, there is a widely anticipated prime yield shift. Leisure yields, given their discount of around 150 basis points over most other prime leisure property sectors, look attractive. Slowly, the funds are selectively taking notice of the sector which, to date, has been dominated by the private buyer.
Finally, the operators themselves must improve their own covenants and the trading potential of the business. Many of the quoted leisure operators have had an extremely difficult 12 months. The question must be is this a terminal decline or was the sector merely overrated in the first place? It is widely accepted that much of the dramatic decline in share value has reflected a re-rating of the sector, and of the stock market as a whole, since the heady days of 2000. Like the high-tech/dotcom companies, leisure was seen as a high growth opportunity but probably trading on unsustainable multiples.
The climate of high debt to cash flow is perfect for venture capital. Under new venture capital ownership there will be continued consolidation, operational streamlining and an improvement in management and services. Renewed expansion programmes will be required to encourage growth in what will typically be a three to five-year play for the private equity owner.
It remains to be seen whether this expansion will continue to concentrate on new generic sites, or whether the preference would be to trade assisting assets? Either way, the leisure sector needs to demonstrate a degree of stability to appeal to a wide range of investors.
In conclusion, new lending will become increasingly difficult in the short term, particularly against generic growth. Many banks have reached the limit of their exposure to the leisure sector which has not been helped by the short-term concerns about the future of the sector. Lending criteria will become more rigid about the individual covenant and the level of gearing that operators are already carrying. Lenders are therefore more likely to borrow against existing trading assets where there is an established track record.
The developers of new sites in an uncertain market for leisure will insist upon institutional lease terms to guarantee the best investment trading price. While it may be possible to bargain on the rent slightly, rents are still expected to be linked to open market value or fixed uplifts for a minimum of two to three reviews.
There is a possibility that in the continued low interest rate environment, prime leisure yields could harden. A margin of 150 to 200 basis points over the borrowing rate, and 100 to 150 basis points over say prime retail warehousing makes the leisure sector look relatively cheap.
Concerns over the lending market and leverage rates may force some operators to seek alternative ways of raising money for capital investment or expansion. Sale and leasebacks are an obvious source of finance where an operator can cash in on their freehold portfolio. There are likely to be a few such offers in the investment market this summer which, provided the lease terms are acceptable, could benefit from this hardening of yields.
Active asset management will become increasingly important to both the owner and the tenant. Growth has slowed as demand has decreased, therefore the management of the existing asset will be essential to drive performance.
The landlord will aim to manage a scheme in tune with the tenant and the consumer, putting greater emphasis on the relationship between the landlord and the tenant. After all, as I keep telling my clients: ‘a happy tenant will pay you more rent’.
The leisure sector has had another tough 12 months, but it may still be readjusting to a period of over-investment.
New lending in leisure will be slow as lenders are still concerned about the short-term stability of the sector.
Established funds with an active management policy may be able to drive higher profit margins.