This is on the house

As the pub sector reels from rising costs and fewer customers one chain may have found a solution, finds William Lyons.

WHEN James Doonan closed the doors of Tweedsmuir's Crook Inn it wasn't just historians who were complaining about the loss of 400 years of history. In a village of 134 adult residents, which had lost both its shop and post office, the pub (one of Scotland's oldest coaching inns) that counted Rabbie Burns and John Buchan among its former patrons was an integral community asset.

The move left locals reeling. "It was a focal point providing a venue for wedding receptions, Burns suppers, carols at Christmas and quiz evenings," said Richard Harrison, spokesman for the local branch of the Campaign For Real Ale (Camra). "Sadly though, through a variety of factors, pubs like these can no longer survive."

A combination of rising costs, alcohol duty, cheap beer in supermarkets and fewer customers because of the smoking ban has taken its toll on thousands of British pubs.

The British Beer & Pub Association estimates that four pubs are shutting down every day and that the rate of closure is 14 times higher than it was in 2005. There are slightly more than 57,000 pubs in Britain today, compared with 69,000 in 1980.

But as campaigners continue their battle to secure and reopen pubs such as the Crook Inn in the Borders, several hundred miles away in the City of London, Ted Tuppen, chief executive of Enterprise Inns, may have come up with the answer.

In what analysts have said could provide a sea-change in Britain's £20bn-a-year pub industry, Enterprise, the UK's second largest pub chain, has been given the Government green light to convert its 7,700-property portfolio into a tax-efficient real estate investment trust.

The pub operator has yet to confirm that it will go ahead with the move but analysts say it would effectively wipe out most of its £114m corporation tax bill, generating around £65m in savings thereafter.

For a sector that has struggled under the weight of rising rent, rates, fuel, property, taxation, the trend towards wine drinking and fierce competition from off-licences and supermarkets, the news was like a shot in the arm. Shares rocketed, with Enterprise closing up 29% while rival pub group Marstons climbed 34p, Punch Taverns 60p and Greene King 55p.

As Mark Brumby, leisure analyst at Blue Oar Securities, said: "There is a fair amount of excitement being whipped up in the sector and you can see why."

By allowing the pub sector to put its real estate in an investment trust (REIT), which enjoys a tax shelter if it pays 90% of earnings in dividends, the whole sector is due to gain. Soon after Enterprise, Punch Taverns also released a statement saying it was still considering its options.

"It's not going to save the pub industry," says Brumby. "Running pubs well is what is going to save the pub sector but it is an interesting development. They (Enterprise] have got past the first hurdle. The next hurdle is whether they want to go down this route and they have said it will take them several months to decide."

It is a view echoed by Douglas Jack, leisure analyst with City firm Panmure Gordon. He said: "It is not going to happen immediately and it is not a cast iron guarantee that it will happen either, but it looks increasingly likely that it will."

With beer sales falling a staggering 7.6% in March, despite two bank holidays falling in the month, many are now asking whether this move can save a sector that is looking precariously balanced.

"The pub industry is not dead," says Jack. "The bottom end is in a mess but the top end isn't. The supply of pubs will go down but the best pubs will still flourish; those in the middle will not do so well but, given time, it will sort itself out."

Today's tenanted-pub landscape grew out of the 1989 Beer Orders that were designed to release big brewers' strangleholds on pubs. Companies such as Enterprise Inns and Punch Taverns snapped up the vast pub estates while the deregulated market led to the creation of new businesses such as JD Wetherspoon.

In the past decade 'pubcos' have become the country's biggest landlords, enjoying the benefits of the rising property market and climbing pub valuations. This has enabled them to raise huge amounts of money on the debt markets, giving them the firepower to invest in acquisitions. They have trimmed their estates to offload "bottom-end" pubs they saw as unviable, and those have been snapped up by other investors looking to create their own pub empires.

The tenanted-pub groups' dominance has given them a powerful position, but in recent months pub companies have faced tougher market conditions. For many it is the first time these companies have traded through a heavy consumer downturn.

Some analysts are now predicting a wave of consolidation within the sector as the large companies come under pressure from shareholders to convert to REIT status.

"The climate for pubs is not good," said one analyst. "It gets a bit better in the short term during the summer months when the comparisons are easy with last year because it rained throughout the summer of 2007 and the anniversary of the smoking ban will have passed. But if you have a tough backdrop and something like a REIT environment, when you put the two together they are both catalysts for corporate activity.

"If you are not trading so well and are under pressure to grow, what do you do? You make acquisitions to generate synergies; you look for deals."

One deal that has been suggested is Punch Taverns reviving the abandoned sale of Spirit, its managed pub division.

Waiting in the wings is Mitchells & Butlers. The pub company recently had to announce a strategic review of its business after an abandoned property deal with Robert Tchenguiz, the dominant shareholder. It was also rebuffed from a possible merger with Punch Taverns after Punch's chief executive Giles Thorley called off any hope of a tie-up with M&B, saying that talk of a deal had been "mostly played out in the newspapers".

But M&B remains bullish on acquisitions. In a recent statement it said: "The board continues to believe that significant value from enhanced sales and profitability could be created by integrating Punch's managed pub business into M&B."

Thorley has also insisted there are plenty of ways in which Punch Taverns can grow its business by acquisition, other than through buying (M&B).

"There are plenty of other combinations that can work and we are pretty thoughtful about what those opportunities could be. To say that this (M&B] is the only deal in town is just rubbish, frankly."

Even before the smoking ban and the credit crunch, the British pub had been forced to adapt. Rapidly disappearing are the traditional boozers renowned for warm beer, poor food and a predominantly male clientele. These are being replaced by more family-oriented pubs with good food and service, where the drinkers are just as likely to be women sipping glasses of Chardonnay as men downing pints.

The situation was compounded by the liberalisation of the licensing laws in 2005, when the Government scrapped legislation that limited pub opening hours – a measure introduced during the First World War to try to ensure that munitions workers turned up for work. But the move hasn't led to a rise in business.

Tuppen himself says that pubs will have to adapt further. He says: "Looking ahead, the pubs at risk are those where people do little more than hang around drinking draught ale.

"But that's not the same as saying there isn't a market for pubs that specialise in serving quality beers and lagers. The key is to do things well."

At the Crook Inn at Tweedsmuir, locals have recently won a campaign to prevent the pub being turned into luxury flats. The council decision to reject the plans has been welcomed by Camra and the local MP. But campaigners know they still have a battle to secure and revive what was once the heart and soul of the community.

The REIT way to ease your tax burden
Enterprise Inns' decision to pursue the option of placing its property portfolio in a real estate investment trust (REIT) could open the door for a flood of new listed vehicles in Britain's property sector.

In short, a REIT is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return, REITs are required to distribute 90% of their income, which may be taxable in the hands of the investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.

Like other corporations, REITs can be publicly or privately held. Public REITs may be listed on stock exchanges like shares of common stock in other firms.

On the surface, the decision to convert is logical, owing to the huge tax advantages of REIT status. However, the investment market still regards the property sector with some suspicion and analysts argue that share prices could fall by another third before they reach their cyclical bottom.

There are other obstacles to conversion, not least the need for restructuring to meet the requirement for 75% of its income to be derived from property rental.