Beyond Covid-19: How will the shifting balances of power in the commercial real estate sector in England and Wales affect financial institutions?
2020 十月 6
As the economic ramifications of Covid-19 are felt across society it is clear that the implications for financial institutions as lenders and investors in commercial real estate are significant.
There has been considerable Government intervention to assist tenants, particularly in the retail and hospitality sectors, but as yet little by way of support for landlords. Will this result in a shifting balance of power between investors in and financiers of commercial real estate assets and their tenants? What are the implications for financial institutions?
To pay or not to pay?
Rental income flows are fundamental to most real estate asset class investments and yet, during the Covid pandemic, rent recovery rates have been greatly reduced. According to data from Re-leased (a commercial property management platform which collated data from 35,000 leases), commercial landlords received 22.1% of the rents due on the 29 September 2020 quarter day, up slightly from 18.2% on the June quarter day but down from 25.3% on the March quarter day. The British Property Federation has estimated that the total unpaid rent in the UK commercial property market between late March and the end of December will be around £4.5bn. Yet, without specific government intervention most tenants will not have a right under their leases to withhold rent, have their rent suspended or reduced, or alter the way in which their rent is paid as a result of the Covid-19 pandemic. Indeed, most leases expressly prohibit the withholding of rent in any circumstances and, while rent suspension clauses are common, they are usually limited to situations where there has been damage or destruction to the property. UK Government intervention has, however, increasingly removed the ability of landlords to pursue the non-payment of rent, and this has arguably shifted the balance of power in favour of tenants at least in the short term.
The key remedy in the event of failure by a tenant to pay rent is the forfeiture of the lease. However, a moratorium on the ability of landlords to exercise any rights of forfeiture (or continue with any existing forfeiture proceedings) for non-payment of rent (including service charge and insurance premiums) was introduced in March. Initially this was to apply until 30 June 2020 but it was subsequently extended until 30th September 2020 and then recently extended further until 31 December 2020. Whilst it has been a cause of concern for both investors and financiers active in the real estate sector, it is important to note that the moratorium does not amount to a rent holiday. Landlords are still owed the rent (usually together with interest) and will be able to bring forfeiture proceedings at the end of the moratorium where the rent and other sums have not then been paid. The moratorium also does not prevent landlords from forfeiting where a tenant breach does not relate to non-payment of rent. Furthermore, in the current climate, forfeiture may not be a landlord’s preferred course of action in any event, due to concerns over the ability to re-let in the near future.
Further restrictions on the ability of landlords to pursue tenants for the payment of rent have also been introduced. The Corporate Insolvency and Governance Act 2020 temporarily removes the threat of statutory demands and winding up proceedings where any unpaid debt is the result of Covid-19. Statutory demands will be void if issued against a company between 1 March 2020 and 31 December 2020. During this period, winding-up petitions presented claiming a company is unable to pay its debts will be reviewed by the court to determine the cause of non-payment. If this is because of Covid-19, no winding up order will be made. The Government has also introduced legislation to provide tenants with more breathing space to pay rent by preventing landlords from using Commercial Rent Arrears Recovery (CRAR) unless they are owed at least (a) 90 days’ unpaid rent where the notice of enforcement is given on or before 30 June 2020, (b) 189 days’ unpaid rent where the notice is given on or before 30 September 2020, (c) 276 days’ unpaid rent where the notice is given on or before 24 December 2020 and (d) 366 days’ unpaid rent where the notice is given on or after 25 December 2020. As a result of these Government interventions, the hands of landlords are increasingly tied when it comes to demanding rent and this has resulted in an immediate, if temporary, shift in the balance of negotiating power.
Consequently, many tenants (particularly in the retail and hospitality space) have demanded rent and service charge concessions, even in some cases where they could afford to pay rent. Many landlords have been accommodating legitimate requests by tenants to pay rent monthly rather than quarterly in advance in order to preserve cash flows, as well as allowing some tenants rent free periods (i.e. rent holidays) of up to three months and/or rent deferrals (i.e. where the rent is deferred for a specified period but will ultimately still be paid). A number of retailers are also pushing for turnover linked leases in an attempt to share the risk. In some cases, however, requests to share the burden are turning into opportunities for tenants to completely restructure leases. CVAs and pre-pack administrations are being used or threatened in an attempt to reset more onerous leases. Landlords face unenviable commercial decisions as to how best to proceed. Whilst it may arguably be in their best long term interest to help keep key retail tenants solvent, agreeing to rent suspensions may cause substantial issues particularly where tenants were already liable to fail before the advent of Covid-19. In these circumstances, landlords may prefer to regain possession of their properties. Landlords may also have financing payment obligations of their own or be reliant on lease cash flows to meet payment obligations under complex financial structures. Alternatively, they may be operating investment funds with the expectation of returns to investors. Parties will need actively to manage their portfolios to try to optimise the outcome.
A new Code of Practice
On 19th June 2020, the UK Government published a new voluntary Code of Practice for commercial landlords and tenants which encourages transparency and collaboration. Critically, it confirms the legal position that tenants will remain liable for rent arrears and encourages tenants to pay as much rent as possible (noting that where tenants have received funds or savings from Government support schemes, these should be put towards liabilities including rent). Equally, landlords are expected to show leniency where they can afford it, taking into account their own financial arrangements. The Covid-19 legislation does not suspend obligations owed by landlords to their lenders. How much effect this voluntary Code is having in practice remains to be seen. However, it is worth noting that although the September 2020 rent recovery rates remain low, according to Re-leased in all sectors other than retail there was an improvement in comparison with the previous quarter. This may be testament to the ongoing efforts by landlords and agents to maintain occupier relationships during a volatile period. Indeed, given the ongoing landlord/tenant negotiations which have been taking place since March, the stated recovery rates may not be reflective of the true position. Given that many tenants have moved to a monthly payment schedule, two thirds of the rent for the September quarter may not yet be due. In other cases the headline rent may already have been reduced by agreement. The true position may therefore take some time to emerge.
What does this mean for financial institutions in the future?
The days of institutional investor landlords having an arsenal of weapons to employ against a defaulting tenant in order to maintain income stream are currently therefore gone, at least in the short term. However, once the immediate Covid-19 crisis has passed, financial institutions active in the real estate market will be re-evaluating their positions and their relationships with tenants and borrowers alike. Litigation claims are likely to follow where a consensual option has not been pursued (or appropriately documented) and parties would do well to keep that in mind.
For the retail sector in particular, Covid-19 has in some ways exacerbated pre-existing structural weaknesses; future challenges were already being discussed by the larger retail landlord investors and funds well before any form of pandemic was envisaged. By contrast, logistics and industrial warehousing could become net beneficiaries of the Covid-19 fall out, whilst demand for office space may be reduced as working from home becomes more culturally normalised. Risk sharing provisions relating to future pandemics may become more common with parties agreeing contractually to share the risks associated with future lock downs, in a similar way to other uninsured risks.
Financial institutions will find a real estate market much altered by Covid-19. However, falling asset values will create significant opportunities for well-funded players and proactive asset management will become increasingly fundamental to success. Any compromise position should also be formally documented to mitigate the risk of subsequent disputes. Given the symbiotic nature of the relationships between financial institution investors and lenders and occupational tenants, financial institutions will need to tread carefully, balancing the commercial imperatives and their own risk appetite against the constantly shifting balance of power caused by Covid-19.