What next for commercial landlords and their debt?

By Emma Cordiner, Real Estate & Data Centre Leasing at Conexus Law

Commercial landlords and the lawyers acting for them have spent nigh on a year, documenting temporary, more favourable rent arrangements to help tenants, particularly those in the retail and leisure sectors, through the havoc wreaked by the pandemic. There have been rent holidays, holidays with pay back later, and discounted rents. Turnover rents are back in fashion – they can suit this situation well, allowing for the alignment of income and rent.

Landlords lucky enough to be granting new leases are agreeing to heavily discounted rent periods – structured as exactly that, rather than rent free, to keep the cash flowing. Some (even in the office sector) are agreeing ‘Covid clauses’ – pre-agreed rent arrangements in case of further Covid-related disruption.

It has all been about compromise this last year.

Tenants are not relying on goodwill alone. Laws to help protect commercial tenants remain in place: the right to forfeit commercial leases by reason of non-payment of rent or other sums was extended to 31 March 2021; the right to exercise commercial rent arrears recovery (CRAR) remains restricted – there must be a minimum of 366 days’ worth of rent arrears to exercise CRAR during the period 25 December 2020 to 31 March 2021. Restrictions on winding-up petitions were also extended to 31 March 2021.

Landlords are compromising seemingly quite readily: they want to maintain landlord-tenant relationships, particularly with ‘good tenants’ who it is preferable to keep on side and have around when all this is over, but key too, is cash flow.  They are working to keep existing tenants intact, getting in whatever rent they can instead of pushing them over the edge (remember, tenants still have to pay rent), and to bring in new tenants on favourable terms so that incomes are maintained, in part, with built-in scope to return to more normal levels of income in due course.

While all quite necessary no doubt, this is all very tenant-friendly, and as we all pass the one-year Covid anniversaries – the first case, the first lockdown, ‘how long can all this go on for?’ becomes the growing question. Furlough, tax deferrals, grants: the government’s answer to the question seems to be that it will go on for as long as is necessary. Some landlords may have benefitted from one form of government assistance or another to keep paying the bills (to a degree), even where their tenants have not quite managed to pay theirs.

Which brings us to a conversation around landlords servicing their debt and complying with loan covenants, with their rental income significantly reduced, and asking, which loan covenants may be an issue here?

First, the requirement to pay interest, fees, and repay the loans themselves. If a landlord can no longer make payments, what are the options? First, to consider whether it is possible to ‘cure’ a breach i.e., is there anything that can be done to avoid triggering an event of default, which could have the effect of making the loan and any interest immediately repayable in full? Cures might include paying down a loan (‘prepaying’), or depositing funds into a blocked account, or providing some form of additional security, in all cases where such cures are available under the terms of the loan.  

If cures are not available, landlords should speak to their lenders (as far in advance of an event of default being triggered as possible), with a view to seeking temporary waivers, or to renegotiate loan terms and covenants to strike balance of what the landlord can manage, and what the lender can live with.

Real estate financing arrangements may also include interest cover ratios (ICRs). These require certain rental income thresholds to be met throughout the term of a loan and look at net rental income over a specified period (after the deduction of certain property outgoings) versus the fees and interest payable in respect of a loan during the same period. These ratios are calculated looking at actual or projected income, and each one has its difficulties just now: recent rental income may have been low or non-existent, and projecting rental income is currently more difficult. ICR covenants could easily be the trigger for an event of default just now.

There is also loan to value (LTV) covenants to consider – breaches may take a little longer to crystalise and be acted upon, when the dust has settled, and valuations can be done in the context of the ‘new normal.’ But there can be little doubt that these covenants may increasingly be an issue.

So, what can a landlord approaching its lender expect? Certainly more leniency than during the GFC when issuing reservation of rights letters (with a good amount of intent), and calling defaults, was much more the order of the day. Granted, the banks were much more exposed to the commercial real estate sector back then and had been taking a less cautious approach to speculative development lending.

Banks will favour landlords who endeavour to maintain any degree of cash flow and have been kept busy over the past year negotiating loan extensions with landlords – showing them the same grace that landlords have been showing their tenants.

But while landlords and banks can probably meet halfway, for the time being when it comes to income-linked covenants, the response to LTV breaches as they come to the fore will be an area to watch – they may start to look a little more aggressive as lower-than-would-have-been commercial property valuations inevitably materialise in increasing number. Or, they may be able to take a slightly longer-term view, continuing to rely on the relative stability that comes with secured lending.

Finally, some considerations for landlords making rent concessions for tenants. Get consent – not just from lenders where lack of consent could breach the terms of a loan, but from superior landlords too. Seek professional advice on documentation. Are the arrangements to be binding on successors? Is any guarantor formally signed up to the arrangement? Clearly disregard concessions for rent review purposes. Consider if the lease is due for renewal and beware the accidental ‘carrying over’ of existing terms. Lastly, concessions will inevitably be temporary, so be crystal clear when documenting end dates, and any ‘catch up rent’ payment provisions.

This feature was first published in Retail Destination Fortnightly

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