The Covid-19 pandemic has provided a shock to commercial real estate investments – how can tenants, landlords and lenders best navigate the difficult road ahead?

The impact of Covid-19 on businesses has been widely reported in the months since the pandemic forced countries into lockdown, and companies to close their doors. In the UK alone, well-known high street retailers and hospitality firms, including Debenhams, Carluccio's and Oasis, have gone into administration whilst big names like John Lewis and Boots are planning to rationalise the number of stores they operate. And more broadly, businesses have turned to the government for support just to pay the bills.

Such financial distress has inevitably affected landlords. The most notable casualty has been shopping centre owner Intu, which fell into administration in June, having already been struggling with huge debts prior to the onset of the pandemic. And in the same month, Travelodge entered into a company voluntary arrangement and subsequently agreed terms with its landlords.

Emergency legislation introduced by the UK government in the form of The Corporate Insolvency and Governance Act 2020 has led to forced forbearance from landlords in the face of accelerating tenant defaults since March. This was an area that Claire Massie, Head of Banking and Restructuring at law firm Pinsent Masons, addressed in our recent webinar 'Real estate in distress - examining likely scenarios arising in Q3 and beyond'. "One of the government's key objectives here is to prevent a tidal wave of insolvencies" she says.

Yet, has government action merely delayed the inevitable? Commercial landlords secured just 18.2% of rents owed on the June English quarter day (24th June). This compares with 25.3% collected on March rent day, according to figures from property management platform Re-Leased. The ability of cash-strapped, geared landlords to fund their own interest payment liabilities to lenders is likely reaching a critical pitch.

As Simon Burgess, Head of Alternative Investments at Ocorian, notes in the webinar: "It's clear that the current stress that's developing between landlords and tenants, and also between landlords and lenders, is only going to get worse. Even with the government's intervention that we heard [on July 8th] from the Chancellor."

Moreover, much of the legislation and regulation that the government has adopted to protect the wider economy is aimed to protect business tenants. One temporary measure the government brought in was restrictions on winding-up petitions, aimed in part, to protect tenants from landlords. Claire Massie notes that this is due to expire on the 30th September. "What we might see at the end of the period is a flurry of winding-up petitions. But what the government might do is extend that protective period, perhaps through to October/November. So, watch this space."

With next quarters' rents typically due on 29 September and landlord interest payments due in October, a cliff edge appears in sight.

Though such an extension would buy time, it's hardly a panacea, given the current state of the market. Gerry Mulholland, Partner, Real Estate at Pinsent Masons, explains that with the clearing banks showing "no huge appetite for additional liquidity", should there be wide-scale default in interest payments in October, problems that have been successfully avoided to date are going to need to be addressed. 

"We might very well then be moving into a period where we see transfers of ownership beginning in the final quarter of this calendar year and into the first quarter of 2021," he says.

Mulholland's thinking is that the main clearing banks could end up selling down their non-performing loans to well advised borrowers, investors with loan to own strategies or, perhaps, private debt funds and he confirms: "Most debt funds that we interact with see the current circumstances as an opportunity." Indeed, he is already starting to see private equity opportunity funds and debt funds provide bridging finance.

The need for communication

For landlords, who currently lack the usual tenant management toolkit (such as statutory demands and lease forfeiture) individual negotiations with their tenants are crucial. Nick Terry, Executive Director at Ocorian, advises that they use any negotiations, such as rent concessions, to try to gain some benefit in return, "whether that's an extension of the lease or removal of a break clause" and ensure it is documented.

Where possible he also suggests landlords consider drawing down on rent deposits in order to be able to make their interest payments to lenders, "because making the requisite interest payments makes any discussion with the banks about other covenant waivers much easier". 

Furthermore, effective communication and negotiation is crucial for landlords in relation to their debt. "Having a very open dialogue with the lender is key because they recognise everyone is under stress," says Terry. "They are looking for open channels of communication. You may well not be their worst problem so just make it clear to them what you are trying to do, the steps you are taking and the negotiations you're having."

Mulholland similarly advises investors to make an early approach to their lenders. "Lenders, in circumstances where debt is problematic, may well be open to conversations around discounted payoffs. So there is always an opportunity to have a conversation with the bank to see if they are prepared to sell their debt to you at that discount. And that may well help you with your asset's workout strategy."

Pressure on developers

In the area of development finance, Mulholland explains that some development schemes are failing because finance may no longer be available or the cost of re-engaging with development lenders may be a challenge. Confronted with this problem, developers and investors are opening discussions with private equity and opportunity funds. 

"We're seeing the resurrection of a previously old strategy: recapitalisation and refinancing of both schemes and projects, where new capital is invested in a business and either the developer or the property company essentially stands to the side into a management fee and promote scenario," he explains.

Where attempts to resurrect failed or stressed schemes don't work out, administration becomes a likely outcome. To avoid this, Alan Booth, Ocorian's UK Managing Director, advises that early intervention is key. "Lenders don't want the keys to a property or to take control of an asset, this is by far one of their least favoured and pursued options," he says.

To avoid such an outcome, Booth states that lenders need to actively monitor their portfolio and appoint a competent fund administrator with directors who are familiar not just with corporate governance but with the real estate asset class. They should also have robust reporting and accounting platforms.

Should lenders need to restructure the debt they should "appoint an effective, agile and competent legal counsel and trustee," he adds.

Clearly, to successfully navigate the choppy waters over the coming months, it's crucial that real estate managers, developers and investors have expert guidance. Moreover, effective communication will maximise the likelihood that all interested parties can agree a workable solution.

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