REAL ESTATE FINANCE AND INVESTMENT ALERT
The domino effect of the Covid-19 Leasing Changes
Welcome to our newly named Real Estate Finance and Investment Alert. The addition of the reference to “Finance” is to better reflect the nature of our business, which is to assist commercial property investors and developers improve their finance and investment outcomes.
We do this by:
- guiding them through the complexities and often misunderstood legal terms of their funding documents to ensure they:
- are aware of the commercial consequences of such terms, including the impact on their proposed investment structure, and
- have the best opportunity to negotiate such terms before being bound by them, and
- assisting them in negotiating changes to term sheets and formal documentation to achieve their desired commercial outcomes.
We also offer clients the opportunity to meet with potential funders.
Following on from our Special Edition in April dealing with the NSW Regulations implementing the Federal Government’s Mandatory Code of Conduct relating to Commercial Leasing (Code) – see HERE, it has become clear that the objectives of the Code and Regulations are not necessarily being realised.
The main problems relating to the Code are:
- some tenants are not complying with their good faith obligations under the Code,
- tenants who are not entitled to benefit from the Code are nonetheless using it as justification for reductions or withdrawals of rent and are ignoring the terms of their leases,
- the Code does not sufficiently account for the circumstances of landlords, and
- the lack of uniformity between the State and Territory Regulations passed to date to implement the Code is creating difficulties for both landlords and tenants which operate in more than one jurisdiction to agree on one set of changes.
The above matters, combined with the general economic uncertainty flowing from COVID-19, are causing significant short and long-term problems for landlords (including in respect of their financing arrangements).
In this edition of our Alert, we consider:
- practical difficulties faced by commercial property investors arising from Covid-19 and the Code, and
- some current trends in the property finance market.
PRACTICAL DIFFICULTIES FACED BY COMMERCIAL PROPERTY INVESTORS ARISING FROM COVID 19 AND THE CODE
The Code has emboldened tenants to disregard their legal obligations under existing leases.
The fundamental importance of the rule of law and compliance with binding contractual terms underpins the confidence of all parties which enter and operate in the Australian property market. It is one of a number of factors that makes Australia an attractive destination for offshore investors.
In the Covid-19 world, the Code and its associated State and Territory regulations have overridden the terms of existing leases. Although the reason for doing so is understood and justified, the practical consequences of this were perhaps not fully appreciated.
Although the Code’s overarching principle is for parties to act in good faith and in a transparent manner to achieve mutually acceptable outcomes, it is clear that the leasing principles benefit tenants and not landlords.
Although some States have expressly acknowledged that in determining the level of rent relief to be agreed the financial ability of the landlord to offer rent relief (including any relief provided to the landlord by its financiers) must be taken into account, such provision is the exception rather than the rule.
As increased unemployment, lack of consumer confidence and escalating vacancy rates continue, the increased difficulty for a landlord to find an alternative tenant (should an existing tenant leave or the landlord determine to evict the tenant where the Code does not apply) has worsened the position of landlords in their negotiations with tenants.
The avalanche of tenant requests or demands for rent relief has resulted in additional costs being incurred by landlords. These costs include:
- diversion of management time from running and growing their business to focussing on dealing with these requests/demands, and
- for larger landlords, the costs of establishing committees or similar groups to deal with rent relief requests/demands, including recruiting additional resources, establishing protocols and procedures and engaging external advisers where necessary.
The need to maintain social distancing and enhanced hygienic standards and implement government-backed protocols/rules in relation to such matters can also involve significant expenditure by landlords.
Valuers, vendors and purchasers are finding it difficult to value commercial property due to the uncertainty associated with Covid-19 and the fall-out from the Code.
Without knowing the rent that can be achieved from a property or the period for which such rent will be paid, commercial property values have been, and will continue to be, adversely affected. In addition, valuations have or will become less useful to vendors, purchasers and lenders due to the valuation either referencing a broad range of possible values, containing expanded disclaimers, removing reliance wording and/or potentially giving the valuer the right to withdraw the valuation at any time.
The uncertainty as to when life will go back to “normal” (including what “normal” will look like) as well as the impact of the Code, both in the short term and the long term, will prolong adverse valuations and their flow-on effects.
The possible long-term shift in working habits
There has been a lot of commentary on the possibility that working from home will become more accepted even after the pandemic is over. Whether or not this will have a long-term effect on the nature and location of office buildings will not be known for some time.
Nonetheless, commercial property investors will need to consider this matter and determine how/if it may affect their current portfolio and future projects. This raises further market uncertainty.
Fundraising adversely affected
Given the above matters, it is not surprising that the ability of landlords to raise funds has been adversely affected.
Without clarity around income streams, valuations and the legal position of landlords in respect of tenants’ lease obligations and landlords’ rights, investors are likely to hold back on their property investment decisions.
Changes to FIRB rules requiring all investments in property to be subject to approval, which can take up to 6 months, is another possible obstacle for landlords seeking to raise capital or sell-down their interest in property in the current market.
Don’t forget your financiers
Although not unexpected, the focus on dealing with tenants seeking rent relief is, in many (if not most) cases, diverting the attention of landlords from another key stakeholder in their business, their financier.
In most finance arrangements relating to commercial property. variations of leases (or at least material leases) require financier approval. In addition, failure to pay interest or satisfy financial covenants (such as interest cover ratios) are events of default which can trigger enforcement by the financier and the application of default interest.
If new rent arrangements agreed with tenants have a material adverse effect on the landlord, this can also trigger an event of default or financiers' review rights.
As each of these will have a major adverse consequence to a landlord, it is recommended that landlords discuss their position with their financiers before agreeing to new arrangements with their tenants.
As the 4 major banks have an average exposure to commercial property of approximately 25% of their loan book, they will be keenly interested in understanding what rent relief arrangements are proposed. They are also likely to be receptive to considering amendments to loan facilities to minimise loans going into default.
SOME CURRENT TRENDS IN THE PROPERTY FINANCE MARKET
Based on our research, the following are some of the trends that have become apparent in the commercial property finance market as a result of Covid-19 and the Code:
- Financiers are willing to consider deferring compliance with financial covenants and obtaining fresh valuations and are open capitalising interest (although ultimately this will cost the borrower more than if it was able to keep paying interest as originally required),
- Banks and Non-bank lenders (NBL’s) are more conservative in their lending,
- Banks are rationing capital,
- As mentioned above, Valuations are difficult to obtain due to market/economic uncertainty and are not likely to be as useful, e.g broad price ranges and/or more extensive disclaimers by valuers and/or non-reliance clauses,
- Pricing by both banks and NBL’s have increased due to additional risk, including issues arising from the Code and Regulations,
- Pricing differentials between banks and NBL’s have increased,
- LVR’s are dropping,
- ICR’s are increasing, and
- Some NBL’s are not lending due to higher risk concerns and/or unavailability of funds.
Given the above, it is clearly important for a landlord to work with its current financier to ensure that any changes to leasing arrangements are acceptable to the financier. Refinancing of any existing loan (in the current market) is likely to be very difficult, if not impossible and if it was available it would no doubt be on more onerous terms.
We trust you enjoyed this Alert.
Please feel free to contact us about any of the above matters.
Please also contact us if you would like to discuss our fixed fee loan document health check which will assist you;
- understand your financier’s rights under your loan arrangements in the current challenging climate; and
- help you in determining the strategy to adopt in your discussions with your financier.
Best Regards, Peter
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The comments made in this Alert do not constitute the provision of any legal, tax or accounting advice by Peter Faludi Consulting or any Director or employee thereof and therefore you should not rely on this Alert in making any decisions relating to present or future transactions in which you are involved. We strongly recommend that you seek legal, tax and/or accounting advice (as relevant) in relation to the same.
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