The current circumstances have created tension between commercial landlords and their business tenants. Oliver Haunch believes landlords should start thinking more like a lender than a landlord.
Since we first heard of COVID-19, commercial property landlords have proven themselves overwhelmingly supportive of the companies renting from them as tenants. In most instances, this support has involved either formal or informal rent deferrals at the March quarter date. But as we enter June, both commercial landlords and their tenants are looking anxiously at the long-term picture and a more-protracted disruption than was perhaps anticipated back in March. Many commercial landlords find themselves with the prospect of tenants struggling to meet the June rent quarter and beyond.
Commercial landlords concerned about business tenants’ ability to pay rent
With social distancing now a way of life, it is increasingly doubtful whether some industries will return to normal in the near term, or whether businesses forced to run at much lower capacity for the foreseeable future will be viable. But just as many of these businesses are forcing themselves to adapt to survive, commercial landlords need to adapt as well.
Rent deferrals since March mean that the relationship between landlord and tenant has evolved into something more like lender and borrower. Therefore, ahead of June’s quarter-end, and with more rent deferrals likely, commercial landlords need to start thinking like a lender.
In our experience, commercial landlords wish to remain supportive of their tenants and are sympathetic to the situation. However, like a lender, they should seek to protect their future position as much as possible when being asked to extent new credit. This means approaching the request armed with queries regarding the long-term position.
Commercial landlords should start with fact-finding
No mainstream lender would extend unsecured credit terms to a borrower without assessing what additional security can be obtained or without querying how much the borrower can afford to repay. Not to mention, when and whether the amount being borrowed will solve the borrower’s liquidity constraints, or if additional funding will be required in the future. Failing to do this could mean ending up with a larger, unsecured debt in any future insolvency.
With businesses facing concerns over their medium- and long-term viability, commercial landlords should adopt a similar approach with their tenants. Despite the difficulties in producing meaningful projections in light of the current uncertainty, tenants - or borrowers - should make efforts to forecast their future cashflows and run several scenarios in order that commercial landlords are able to determine the likely risks and re-payment horizons.
Exploring consensual options
It’s entirely natural for lenders to request some additional security in exchange for any new borrowing. Therefore, this is the first option for commercial landlords to explore.
This could include taking a first or second charge over the business’s assets. Perhaps this would be in the form of a debenture as a floating charge over all assets, or as a fixed charge over specific, particularly valuable, assets. Should the worst happen, this, at least, places the landlord higher up the list of creditors in the event of insolvency further down the line and with the best chance of maximising their recovery of unpaid rent.
Even a second charge, behind existing lenders, would give the landlord a potentially better outcome. Taking a first or second charge would also give the landlord the ability in the future to appoint an administrator and gain an element of control, and timing, over an insolvency process, if required.
Approaching senior lenders
However, commercial landlords should be mindful that in most instances, there will already be an existing senior lender, and current security documents will contain negative pledges, prohibiting or preventing the tenant from creating any security interest over certain property or assets.
In these cases, the landlord can try to persuade the senior lender to agree to subordinated security being granted in favour of the landlord. In this scenario, it is natural to assume the existing lenders have no appetite to extend additional support to allow the rent to be paid. If the senior lender is willing to agree to such a request, the parties can enter into an intercreditor deed, which makes clear the respective rights and priority ranking of two or more funders.
Corporate and personal guarantees
If obtaining securities, such as a debenture or a legal charge, proves difficult, commercial landlords can suggest obtaining a corporate guarantee from an alternative entity in the tenant’s group structure, provided that the existing lender is not already fully cross-collateralised. Asking the directors of the entity for a personal guarantee is another option, although most would be reluctant to offer up their personal assets as collateral.
Asking for corporate and personal guarantees may have previously been refused at the time the lease was initially granted. But again, this is about commercial landlords recognising that the relationship with their tenants has changed, so it is reasonable and sensible to at least explore these possibilities in exchange for rent deferrals or extensions.
Other options to enhance the commercial landlord’s position
Even if security and guarantees are not forthcoming, commercial landlords have other options available to them. For example, they may want to consider using the extension of credit terms as an opportunity to enhance existing lease terms, for example, rental uplifts in the future or extending the duration of leases. Both of which could improve the value of the real estate in the future.
Due diligence and monitoring
When dealing with financially distressed borrowers, lenders often insist on a third-party review of the borrower’s financial projections, known as an Independent Business Review. This helps the lender understand the underlying risks to the business and to determine the best lending options, accordingly.
As commercial landlords are being asked to support their tenants with rental holidays or flexible-lease contracts, it is reasonable for them to suggest some due diligence is carried out. Landlords can even suggest making further rent support conditional on the tenant being willing to undergo ongoing monitoring after an initial review.
The challenges presented by COVID-19 make this ongoing monitoring particularly relevant. Commercial landlords should be weary of businesses that require large amounts of working capital to grow their revenue.
Some businesses may appear to be able to bounce back as the UK emerges from lockdown. However, those faced with a negative working capital cycle may face further liquidity constraints and require more cash as revenue recovers. Having visibility of the tenant’s business could give the landlord a degree of comfort that good progress is being made.
Ensure any agreement is properly documented
Of course, whether commercial landlords and tenants agree to a formal variation to the lease or not, it makes sense to ensure any agreement made between both parties is properly documented. The agreement should clearly state which actions constitute the tenant breaking the terms of the agreement, and what actions can be taken by the landlord. In all instances, it’s important for landlords to seek advice early, preferably before any heads of terms are drawn up.
Uncertainty for commercial property
Although lockdown restrictions have been eased across England and the rest of the UK, the commercial property sector still faces a great deal of uncertainty. As the pandemic crisis enters its second quarter, it is vital for commercial landlords and tenants to keep working to achieve the best-possible outcome in what is an unusual and highly challenging situation. All of the consensual options we’ve mentioned are designed to be supportive of tenants, while giving landlords the ability to safeguard their own position.
To discuss any of the issues facing commercial landlords further, contact Oliver Haunch.