Aligning risk in the rehabilitation of old residential buildings using full-repairing, long term leases

Full-repairing, long term leases—whereby tenants are responsible for taking care of all repairs on the property—can be an effective tool to keep older residential buildings in use, without too much up-front investment in terms of time and capital. This case study describes the application of this concept in Kenya, adapted from the common practice of full repairing and insuring leases in developed markets such as the UK, where the tenant takes the responsibility for repairing and insuring the property. In the Kenyan context, it is too risky for landlords to delegate insurance responsibility to tenants, and hence the lease is modified to a full repairing lease only.

Recently Global Property Advice plc (GPA), a development management company based in Nairobi and the UK, was approached by a Nairobi landowner facing the predicament of how to keep his property income producing. The property had been developed in the 1960s with four maisonettes measuring about 1 200 sq. ft. each. This meant the buildings were old, difficult to repair and lacked modern amenities such as an ensuite bathroom. On the plus side, they are well-located, within walking distance to a commercial node, and offer small gardens and ample parking – both very attractive features in Nairobi’s currently congested landscape.

For several years, the landlord had done ‘patchwork’ repairs to the ageing buildings. During this time, he earned about KES 50 000 (US$ 500) per unit per month in rent, and spent almost 20 percent of the rent received in repairs. The landlord then decided that the only solution was to take vacant possession from the tenants and do a full renovation.

The landlord proceeded to do a full renovation on one unit with disappointing results. He engaged a contractor to provide new plumbing, cabinetry and flooring at a cost of KES 1 million (US$ 10 000), with the expectation that the rent achieved upon completion would be KES 90 000 (US$ 900) per month.

Upon completion, the landlord found the work quality was poor as the contractor had taken several shortcuts which the landlord could not have detected until the unit was occupied. Furthermore, the rent achieved on the rehabilitated unit was much lower than expected – after three months of marketing, he only received offers of KES 65 000 (US$ 650) per month, which he accepted. This was only KES 15 000 (US$ 150) higher than the rent earned before the extensive repairs, and much less than his target of KES 90 000 (US$ 900). Part of the reason for the lower rent received was that the units were small and lacked modern amenities which were otherwise standard in higher priced residential units.

Our advice was simple and elegant, as it aligned the risk of undertaking the repairs with the rewards or benefits of undertaking those repairs. We suggested that the landlord enter into full-repairing, long term leases with tenants who had the capacity to undertake the repairs themselves. The terms of the leases were as follows:

• Long term leases of 5 years, with a break possible after year 3, to entice tenants. Landlords may only terminate the lease after three years, and then with a penalty.
• Tenants put in upfront cost of rehabilitating the units. The scope of the work to be undertaken and factors such as minimum standards and common elements were agreed to upfront and set out clearly in the lease e.g. the colour of the external paint. However, the tenant had leeway to make certain design and finishing choices themselves to create a home of their taste.
• A rent-free period of two months granted by the landlord during which time the tenants could do the majority of the repairs. Thereafter the tenants would be charged KES 40 000 (US$ 400) per month. Rents were relatively low as the tenants had invested the rehabilitation cost upfront. Nominal increments were agreed upon after the second year.

The landlord found suitable tenants who were attracted to this proposition and was happy to start earning revenue again. The tenants were willing to put in the money upfront to improve the properties, as they would get the reward of living in them at a lower rent.

This case study demonstrated that the advantages for landlords and tenants of such leases are:

Overall, landlords are in a cash-positive position compared to if they were undertaking the repairs themselves.

In this instance, the average cost each of the tenants incurred was KES 350 000 (US$ 350) per unit, compared to the very high cost of KES 1 million (US$ 10 000) the landlord had incurred on the one unit he had rehabilitated himself.

This case provides a clear illustration of two important advantages of a full-repairing, long term lease:

• Why was the tenants’ rehabilitation to a higher standard and a lower cost? The tenants were able to shop around for good quality building materials on sale which resulted in savings. The tenants typically hired labourers who they could supervise to undertake the repairs, which also brought down the cost, compared to hiring a contractor whose cost includes his supervision/management etc. As the tenants were going to live at the property, they paid great attention to how the building limited space could be used more effectively. For example, the tenants saw the potential of opening out the kitchen. One of the tenants had learnt about a new type of plumbing, called Pushfit plumbing, which can be surface mounted. Therefore, instead of fixing the old plumbing, the tenants simply terminated the old plumbing and laid the newer plumbing. The tenants formed a little community sharing their ideas with each other.
• What if the landlord wants to exit earlier? The lease has a built-in a clause that the landlord cannot break before three years, as it is only fair for the tenants to enjoy the work of their labour for that period. If the landlord breaks the lease between the third and fifth year, the landlord is required to make a cash payment to the tenant of KES 150 000 (US$ 1 500) to compensate for the early termination of the lease.

In conclusion, with the turn in the market and a lot of supply available, landlords need to look at innovative ways to keep earning a return from older housing stock. Full-repairing, long term leases provide a win-win solution for landlords and tenants.

Figure 1: The economic cost of conventional leases vs full-repairing, long term leases