Homebase’s CVA- An Oddity And An Explanation

Homebase is trying to organise a company voluntary arrangement, a CVA, in order to get out from under its rent bill. If this all sounds a bit extreme as a reaction to trading conditions there’s a good reason behind the decision and attempt. There’s also something of an oddity in the way The Observer reports on it but then that paper and business, right?

As a Homebase employee might say to a confused customer, this is not a drill. The DIY chain is approaching a crunch moment, with landlords set to vote this week on a company voluntary arrangement (CVA), designed to put the company on a sound financial footing.

CVAs have emerged as the theme of 2018 for struggling high street retail and hospitality sectors. They are designed to give businesses financial breathing space by asking landlords to agree to rent cuts, usually accompanied by the closure of some loss-making stores. In this case, that’s rather a lot of them. Around 70% of Homebase branches make a loss, according to a report in the Financial Times.

OK, yes, but what’s this?

The globe-straddling retail colossus could now benefit from the conditions it has helped to create. Amazon is reportedly keen to snap up some of the sites vacated by Homebase which, unlike town-centre retailers, owns many of its properties.

If it owns most of its properties then why such troubles with landlords? But onto the explanation, after that oddity:

The future of Homebase is hanging in the balance as a group of powerful landlords considers legal action over an attempt to slash its rents by as much as 90%.

The DIY chain has asked creditors to approve a three-year turnaround plan that would see 42 stores closed and rents cut by between 25% and 90% on 70 others.

Well, OK, we can see why landlords might not be best pleased with this. But why this entire formal arrangement of a CVA? Why not just point out economic reality to said landlords and make an agreement? That economic reality being obvious enough. Online sales are now some 16% or so of retail spending. There’s some 15% or so of commercial retail property empty. There’s an obvious enough connection between these two simple facts. Add in Ricardo on Rent and the solution is obvious. Landlords gain all of the position value of land as ever more marginal property gets used. As the process goes into reverse, as it is, they’re also the first people who should be losing income.

So, why isn’t it happening? A quirk of British property contracts. It’s not the law or anything, this is just how it has been done for decades. Upwards only rent reviews. Every so often everyone gets together to discuss what the rent should be for the next period of the contract or lease. Say, on a 25 years lease, there might be rent reviews every 3 or 5 years. Those details aren’t the important bit. What is is that in near all British leases that review can only bump the rent up. They expressly state that whatever has happened to the local property market the rent will never go down.

That’s a bit of a problem when we’ve a structural change like online shopping pushing down the value of all commercial property in the land now, isn’t it? Which is why the CVA. It’s the only method, short of outright bankruptcy, which will force those landlords to the table in order to discuss rent reductions. And thus the use of them rising as online keeps eating into retail spending.

Shrug, as online takes bricks and mortar spending then commercial property prices and rents should fall. They will, too, because that’s how markets work, markets will clear and prices will change. How difficult it all is can vary dependent upon market structure, but it will and is going to happen. Those upward only rent reviews? Well, if all insist upon them then CVAs will be used. Landlords can lower rents by agreement, can very grumpily agree in a CVA or have them forced upon them by business bankruptcy. But rents are going to get lower, we know that.

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Quentin Vole
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Quentin Vole

Inside property funds, most assets will appear with a book value that is a multiple of their rental value (the multiple being determined by some ‘secret sauce’). To accept a lower rent (on reletting) means a nominal loss, which fund managers are reluctant to accept – that’s why they’d rather the property stood empty.

Spike
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The secret sauce isn’t secret. The landlord wants a return on investment comparable to what he’d get if he used his capital for something other than being a landlord.

Letting the property stand empty replaces a nominal loss with a total loss (of income). This is not preferable, unless the landlord believes he can find a new renter at full price.

Quentin Vole
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Quentin Vole

Perfectly true, but in (many) property funds, the interests of the investor and the fund manager are not well aligned (in the short term, at least). Because they’re judged on fund value, which is (until the property is sold) a theoretical number directly calculated from the nominal rent. It’s better for the fund manager to leave it empty than accept a lower rent (and consequently a lower book value).

Spike
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“Here is what total rental income would be, um, if there were any tenants”? Remarkable.

Spike
Member

“There’s an obvious enough connection between these two simple facts.” — No, there is merely an obvious similarity between two figures. Given that 16% of shopping is done on-line, there is no requirement that a similar percentage of the High Street shut down. Alternatives are to offer experiences as well as goods, to change the use of certain properties to be profitable with lower gross sales, to take some properties out of retailing, or as mentioned, to have on-line winners become physical retailers too. If leases and the Building Code require that the amount of retail space be static (at… Read more »

BB01
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BB01

Aren’t those bricks and mortar stores heavily engaged in on-line sales, ergo contributing to their own demise?

Isn’t the answer to move the bulk of their business on-line, close their big sites which are unprofitable, move to out of town distribution and rent smaller properties just as show-rooms? Maybe I am missing something.

Spike
Member

A company can release a product that “cannibalizes” existing products, but I’ve never heard of a company worrying that one distribution channel cannibalizes another. In short, the company does not care about the well-being of its storefront; it just wants to sell a lot of Product. As Tim might put it, having a shop on the High Street is a cost, not necessarily a benefit.