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Landlords in limbo – what options for retail real estate?

Oliver Haunch Oliver Haunch

Landlords of retail real estate and their lenders have been left in limbo by restrictions imposed during the pandemic. Oliver Haunch reviews their options now.

In providing support to businesses over the past 18 months, the government restricted landlords from enforcing their rights against tenants for non-payment of rent. This left many landlords in limbo, unable to enforce their rights but faced with ongoing defaults and accruing significant arrears.

New requirements for winding-up petitions

The government has now implemented the Corporate Insolvency and Governance Act 2020 (Coronavirus) (Amendment of Schedule 10) for winding-up petitions where the debt owed is commercial rent or is under £10,000.

From 1 October 2021 to 31 March 2022 “a creditor may not present a winding-up petition in respect of commercial rent that is unpaid because of a financial effect of coronavirus".

The government also intends to legislate to ring-fence rent accrued from March 2020 for commercial tenants affected by enforced business closures. A binding rent arbitration scheme is due to be introduced, intended to be used as a last resort when negotiations on how to deal with this rent accrued have failed.

The Government has published draft legislation for an arbitration scheme, and landlords are encouraged to waive ‘some or all’ rent arrears where possible where their tenants are unable to pay in full.

Challenging time for retail sector

These continued restrictions on landlords regarding commercial rent come at a difficult time for the retail real estate sector.

Although the hotel and leisure sectors are beginning to bounce back, the environment for many retailers remains challenging. Before the pandemic, many in the retail sector were already faced with high levels of debt, pressure on margins and a shift to online sales. The restrictions have therefore served to accelerate longer-term structural change. With supply chain difficulties and wage inflation adding to the pressure, it is inevitable that the future for some retailers will be bleak.

Where does this leave the landlords who own retail real estate, as well as their lenders?

Retail property values under pressure

It has been estimated that £6.4 billion of rent has gone unpaid due to pandemic related restrictions, putting severe pressure on landlords’ cash flows. Shopping centres, high streets and other city centre locations are suffering from changing footfall patterns. Property values are falling due to empty units and the closure of several linchpin tenants. In some cases they have halved in value, and are not expected to fully recover in the near term.

Over the past 18 months landlords have been flexible. They have offered rental holidays and covenant waivers to help retailers get through the immediate consequences of the pandemic. But the situation is becoming increasingly untenable. Landlords are experiencing their own liquidity issues and loan-to-value (LTV) ratios of over 100% – in some cases handing the keys back to the lenders.

What can landlords or their lenders do?

To understand the options open to them, landlords or their lenders need a very clear picture of the asset that they own.

For many, the continued restrictions will have little consequence. Seeking to wind up a tenant for non-payment of rent will simply result in a vacant unit that, in many cases, will be difficult to re-let.

Landlords or lenders may consider holding on to assets long term, hoping to benefit from a return of capital values and a tightening of yields. For this strategy, it is important to fully understand what any standstill capex and related risk would be. For example, the owner of a shopping centre may face a significant proportion of its tenants having break clauses in the next two to three years. Tenants could demand further rent-free periods. Or the owner may need to fund a refit of the units to attract new tenants and retain existing ones. A rigorous cost-benefit analysis is vital before embarking on this strategy.

Landlords or lenders may be able to redevelop or repurpose an asset. Could retail units be turned into a residential offering? Would converting an outlet into more experience-led destination improve footfall? Significant development costs and planning consents would be involved in this scenario, and investors would need to be confident in future projected cash flows.

There are no easy answers right now.

What legal options could landlords pursue?

There are very few legal options at present.

Commercial landlords could sue for rent arrears, as well as on any guarantees and enforce security. Or they could seek to put a tenant into administration with a view to the business being sold and getting a better tenant, or perhaps benefiting from a liquidation of the company. The reality is, however, that landlords are unlikely to recover anything in a formal insolvency process, whether liquidation or administration.

Those in the sector will be aware of recent high-profile New Look company voluntary arrangement (CVA), and the Virgin Active Part 26A restructuring plan challenges. The decisions in these cases show that the court’s current approach is increasingly favouring the recovery culture of the tenants against the rights of the landlords. They make for difficult reading for many commercial landlords. (Note that landlords in the New Look case have been granted permission to appeal against the court’s dismissal of their CVA challenge, which is due to be heard in March 2022.)

New power dynamic in negotiations

Despite many in the industry calling for guidance from the government, the onus for sorting out issues between tenant and landlord in the most equitable way has been pushed back to the market.

In the draft legislation on the rent arbitration scheme, the government has made it clear it expects the landlords to share the burden of any COVID-19 impact with tenants – waiving ‘some or all’ rent arrears. But many questions remain. Details will be important here. For example, how do you deal with rent arrears for retail premises which are part essential, part non-essential, and were able to continue to trade to some extent throughout the pandemic? How exactly do you calculate the cost of the pandemic and determine what level of rent should be paid for the impacted period?

One thing is clear, however: landlords now face a change in the dynamic of any negotiations. When leases come up for renewal, power has shifted towards the tenant who may look for break clauses, rent-free periods, or require the landlord to fund refit of the unit. As such, many retail CVAs and restructuring plans may get through even though the rights of commercial landlords could be severely curtailed. For example, the New Look case shows that reductions below market rent can be approved and validates what appears to be a shifting market towards turnover-based rents.

How to achieve the most equitable outcome

Retail real estate landlords feel bruised by the increased use of CVAs and restructuring plans.

As a consequence, we are seeing parties incentivised to work together, with landlords having productive bilateral discussions with their tenants to get through any immediate problems. For example, in exchange for writing off rent arrears or providing covenant waivers, retailers may agree to extend their lease for five to ten years, providing surety of tenure for the landlord, and potentially having a positive effect on the capital value of the site.

Working together can often be the most positive way forward. In our experience, it is possible for landlords and retailers to find solutions that work for everyone –, without the threat of a CVA, restructuring plan or administration. The key to this route is a full understanding of the economics of any particular site, to find an equitable way of splitting any projected income between retailer and landlord.

Whichever way landlords turn, longer-term hold strategies will likely require capital investment from the landlord to execute.

Further restructuring activity likely

Working together to get through immediate challenges is one thing. But the underlying issues in the market will not be resolved any time soon. With LTV ratios at unsustainable levels, refinancing will pose significant problems. There is no doubt we will see more retail real estate transactions and restructuring activity in the market. And once the restrictions on landlords are removed at the end of March 2022, we may yet see a further increase in insolvent solutions.

This situation provides opportunities for those with capital to deploy and an appetite to redevelop and re-purpose assets. Real estate landlords and lenders are key to investing in regeneration projects for the government’s ‘levelling up’ agenda, as well as saving the UK’s high streets.

For more information on these issues or real estate restructuring, contact Oliver Haunch.

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