Over the course of a number of articles, we have explored the impact of the COVID-19 pandemic on a number of business sectors. In this article we will discuss the possible impacts to the real estate market, both investment and development.
Investment
Following Government advice issued in mid-March and the subsequent passing of the Coronavirus Act 2020 and associated Health Protection regulations, we have already seen announcements of requests from high-street retailers for rent holidays and, on the recent March rent quarter day, reported substantial reductions in collected rents. Although this is nothing new in the retail sector, we would anticipate business big and small across all sectors will face similar pressures.
How will this impact loan transactions?
Leases and cash flow
As we have described in previous articles, it is unlikely a lender would look to default an otherwise performing loan on the basis of a ‘material adverse change’ in the shape of the pandemic. However, any business subject to cash flow covenants (such is an interest or debt-service ratio), in particular forward-looking covenants, will need to consider whether there is likely to be any pressure on rental income down-stream from defaulting tenants (or tenants requesting rent holidays) or, equally fundamentally, how any such pressures will impact upon its ability to service the loan. We have already seen lenders agreeing to wholesale waivers of cashflow covenants as well, in some cases, of amortisation payments.
Equally, borrowers will need to consider whether requests to reduce rent, or even consent to a ‘rent holiday’, can be given without funder consent; many loan agreements will restrict the agreement to any waiver, amendment or rent review without lender consent. Those same provisions often preclude a borrower from commencing forfeiture or irritancy proceedings against a tenant, if such action ultimately becomes necessary.
Value and valuations
Although it is anticipated that there could be an immediate impact to cash flow, the impact to asset value (and consequently valuations) is less certain. As the situation unfolds, it seems inevitable that there will be an impact to asset values as market conditions, and perhaps more importantly investor sentiment, react to the pandemic. RICS has issued a specific COVID-19 disclosure which we have seen adopted in valuations since the middle of March.
How this will impact the fundability of new loan transactions is unclear, although we would not anticipate – at this point – lenders to be looking to default loans solely on the basis of a marginal loan to value breach whilst this uncertainty pervades.
Development/construction
Although government has continued to advise that, provided suitable 'social distancing' measures are followed, construction sites may remain open and development work continue, since the outbreak of the pandemic, large numbers of sites have been closed. We have begun to see sites reopen and work restart, however the risk remains that available workforce may be diminished due to illness, self-isolation or potential quarantine. Even where sites have reopened, disruptions to supply-chains and shortages of raw materials (we have seen reports of only two weeks' worth of materials) mean that work on site is likely to slow. In either case, there may be delays or additional costs.
What will lenders and borrowers need to consider?
A typical development facility (whether documented on an LMA or in-house basis) will include, amongst other things, obligations on a borrower:
- to exercise its rights under each development document
- to ensure that the development is (and, in some instances, certain milestones are) completed by specific dates.
Under normal conditions, a borrower’s obligation to complete the development on time will dovetail with its contractors’ obligations under the various development documents. The effects of the COVID-19 pandemic, however, have the potential to impact this protection.
Most funded developments in the UK will be documented with a suite of construction documents, with the building contracts likely based upon the JCT Design & Build Contract 2016 (JCT) or the NEC4 Engineering and Construction Contract (NEC). Whilst neither of these standard form contracts expressly envisages a pandemic of the type we are facing, they do provide mechanisms to deal with circumstances beyond the contemplation of the parties.
Under a JCT contract, the occurrence of force majeure will, typically, be a ‘Relevant Event’ giving the contractor the ability to call for an extension of time for the performance of its obligations (but no additional costs). Whether COVID-19 will be considered force majeure will be dependent upon the specifics of each contract and development, but it certainly has the potential to be. It should also be noted that the continuance of force majeure for more than two months may give the parties the right to terminate the contract.
Under the NEC, by contrast, whilst there is no specific force majeure clause, the impact of the COVID-19 pandemic may result in a ’compensation event’ giving a contractor a right both to additional time and costs.
In either case, assuming COVID-19 does result in a Relevant Event or compensation event (as applicable), a borrower may be unable to enforce any obligations to complete the development by a specific date leading to a potential mismatch between the borrower’s obligations under the facility agreement and its rights under the construction documents.
At its extreme, the effects of the COVID-19 pandemic may be so severe that it may become physically or commercially impossible to complete a development, in which case it is possible that a contractor may look to terminate the contract as a result of frustration, although it is likely that the threshold to do so will be much higher than force majeure.
What should lenders and borrowers be doing?
Although there will, inevitably, be specific pressures for specific borrowers, assets and loans, it is likely that any issues resulting from COVID-19 will, to a greater or lesser extent, be market-wide. As a result, it is likely that there will be no ‘quick fixes’ or exits for a lender and, as we advised previously, the key in all this we think will be communication.
For more information please contact Richard Leeming or Alistair Rattray.
*This article was originally published on 19 March 2020 and updated on 8 April 2020