As the June quarter date fast approaches and the economic impact of COVID-19 begins to be felt across all sectors, what steps should landlords be taking to vary their lease arrangements with tenants who are unable to meet their rental obligations, and could a reduction in rental income due to COVID-19 put landlords in breach of their own obligations under their loan facilities?
The action taken by the government to help UK businesses minimise the financial difficulties they face as a result of COVID-19 has been wide-ranging and includes a number of initiatives aimed at helping commercial tenants that are suffering with cashflow issues due to the pandemic so that they can avoid further financial difficulties and/or eviction. Whilst such action is widely welcomed to help provide some protection to UK businesses as the economy slows due to the pandemic, it could have a serious adverse impact on the landlords who have their own financial obligations to meet. This blog looks at what action landlords can take to document lease variations with tenants and mitigate the risk that they end up falling foul of their own financial arrangements with lenders, due to a decline in rental income.
Variation of Rent Payment Provisions
As the June quarter day approaches on 24 June, landlords may be concerned about whether their tenants will be in a position to pay this quarter’s rent in full or in part. With the March quarter day falling just as lockdown restrictions were being put in place, commercial tenants had the benefit of the previous quarter’s trading and yet many failed to settle their rental liabilities in full. Any ‘rainy day’ funds are likely to be more depleted coming into the June quarter, and so this is a critical time for both landlords and tenants to consider and formalise a revised rent payment strategy to suit the times.
A statutory moratorium on forfeiture of leases for non-payment of rent (and other sums) is currently in place, as well as a ban on statutory demands and limited debt recovery under the Commercial Rent Arrears Recovery (CRAR) procedure. Rent deposits may have already been drawn down, and with guarantors potentially suffering the same financial pressures as tenants, landlords will want to consider options that lie outside the terms of the existing lease arrangement.
For a more detailed look at the issues touched on above, see the following articles:
- The Coronavirus Act 2020 – The moratorium on forfeiture explained
- Update to the Government’s advice on home moving during the coronavirus (COVID-19) outbreak
So what are the options in terms of varying the rent payment provisions under a lease? This can be documented by way of a deed of variation or side letter. A deed of variation will vary the provisions in the lease for the remainder of the term so that the lease will be read and construed as if the terms set out in the deed were contained in the lease itself. By comparison, a side letter will operate parallel to a lease, and will often be personal between the parties to the side letter and only in effect for a specified period of time. A side letter would therefore be a more appropriate way to record a temporary rent concession arrangement.
It is important to bear in mind that, under the statutory moratorium rules, although a landlord is limited in its ability to take forfeiture or debt action against a tenant for non-payment of rent, the rent continues to accrue as a debt during this period. The landlord is also protected during the moratorium from inadvertently waiving its right to forfeiture by ‘dealing’ with the tenant, by, for example, continuing to issue rent demands.
Despite this somewhat tenant favourable default position granted by the moratorium, as the longevity of the economic impact of COVID-19 becomes clearer, landlords and tenants may turn to side letters to proactively manage the risks. This is particularly prevalent in the retail sector where landlords will be conscious of the unfavourable position voluntary arrangements such as CVAs can put them in as landlords.
The drafting of these supplemental documents needs to be given careful consideration to ensure that the outstanding debt is not inadvertently waived. The new rent payment terms, service charge payments, debt accrual and debt repayment terms should be clearly set out. For example, in the retail sector where turnover rents are more common, parties may want to consider if base rent deferral is appropriate, together with adjustments to the turnover rent provisions as part of the concession and used as a mechanism to recoup arrears later on.
When dealing with accrued arrears, parties should also consider the interest provisions in the lease and whether these provisions need to be amended in line with the concession arrangement. This is particularly the case where the parties have expressly agreed a deferred payment scheme.
The content of these supplemental arrangements need not be limited to an amended amount and frequency of rental payments. Landlords may also want to consider options such as taking equity in the tenant company. This may be in return for a reduced rent and/or waiving a debt, or in return for a cash injection by the landlord so the tenant has more freedom to allocate funds where they are needed most.
Whatever arrangement landlords and tenants are seeking to negotiate, if the property is charged, it is highly likely that the lender will need to consent to any concessions, variations or side letters. If there is a guarantor, it is advisable to make them party to the arrangement so that they are not inadvertently released from their obligations. While this may be more of a rubber stamp exercise for a guarantor, lenders will want to satisfy themselves that the terms of the arrangement are acceptable.
From a landlord’s perspective, it is therefore advisable to: (a) check the terms of any facility agreement and associated security documents, as these are likely to contain provisions dealing with lender’s consent; and (b) engage with the lender early on in the negotiation process, assuming that such consent is required.
Where a landlord has a loan facility covering several properties, it may be advisable for the landlord to try and agree a form of waiver with the lender before engaging tenants in discussions.
Financial Covenant Breaches
Not only is it important for a landlord to ensure that any necessary consents have been obtained from the lender before agreeing to any lease variations, landlords should also consider whether a fall in rental income could place them in breach of their financial covenants under their loan facilities.
Such covenants are financial thresholds within which a borrower must operate during the term of the loan to allow the lender to monitor the borrower’s financial condition. Such provisions also usually give the lender the right to demand repayment of the loan if the agreed thresholds are not met, triggering an event of default.
For example, many real estate finance facilities will contain interest cover ratio financial covenants which require the borrower to meet certain rental income thresholds to service the interest payments and fees payable on the loan. This is calculated by measuring net rental income (after any necessary deductions such as service charges or taxes) against the relevant interest and fees payable under the loan, over the same period. This can be calculated on a ‘look back’ basis, which means that the net rental income figure used is the actual net rental income collected in the preceding period, or on a ‘look forward’ basis which uses projected, future net rental income receivable as the basis for the calculation.
From a landlord’s perspective, if a tenant has advised that they are unable or unlikely to be able to pay the rent in full or in part when it becomes due, it is important for a landlord to check whether accepting a reduction in rent is likely to result in such a financial covenant breach under any facility agreement. If it is likely to result in a breach, the landlord may have certain ‘cure rights’ to remedy the breach, before an event of default is triggered. For example, the borrower may be permitted to inject further equity, deposit cash into a blocked account, prepay some or all of the loan or provide additional security to the lender, so that an event of default is not triggered, meaning that the loan can remain in place.
If there are no cure rights available, the simplest approach will be for a landlord to open discussions with its lender and seek to re-negotiate the relevant financial covenants (or to ask the lender to waive them for a period) and/or amend the reporting requirements. Such arrangements should be formally documented by away of amendment agreement or side letter to the facility agreement. It is however important to engage with the lender as early as possible, to minimise the risk of an event of default being triggered which in turn would enable the lender to demand immediate repayment of the loan and/or enforce its security before the landlord has had an opportunity to consider its position and ways to mitigate any breach.
About the authors
Anna Shonfeld is an Associate in the Corporate and Commercial team. Anna regularly advises borrowers on development finance, investment finance and refinances in respect of various property types. She often acts for high net worth individuals in connection with the acquisition financing or refinancing of prime and super-prime residential properties, and has experience of acting for both on-shore and off-shore structures.