There has been much concern in the investment community about the value of commercial property, and whether it is viable in the long-term, given the pressures retail and office space is under with remote working, and the huge decline in footfall over the past few months.
But perhaps before looking at market pressures it is worth assessing the legal context providing the background for much of the debate over rent arrears, moratoria and such like.
The basic concept of a lease of commercial property as an investment product is the contractual bargain by the occupant tenant to pay the owner landlord a rent on a periodic basis. Failure to make such payments on time puts the tenant at risk of losing the lease (by a process of termination by the landlord known as ‘forfeiture’) or being made insolvent by the landlord. In addition, a landlord could also legally confiscate and sell assets at the let property to put towards the unpaid rent by way of a process known as ‘distraint’.
The regular payment pattern of rent over a relatively lengthy period of years coupled with the ability of a landlord, generally, every five years during that term to review rent payable on an upwards only basis, has rendered investment in commercial property popular and, relatively, safe.
In an effort to mitigate the consequences of the Covid-19 pandemic, the Government has intervened quickly and materially to impose regulation on the, previously largely unregulated economic relationship between landlords and their tenants. This is in marked distinction to the state reaction to the credit crisis in the late 2000s, possibly the nearest comparable in terms of the magnitude of disruption to the property market, outside wartime. During the period of that crisis, the commercial property market was by and large left to its own devices by Government.
The pandemic is also distinct from previous crises in that it is not the virus itself which has, certainly in the short term, damaged the commercial property market, but the measures that the Government has introduced to combat the spread of the virus.
The imposition of a national lockdown had obvious and foreseeable consequences for those who rent in order to trade. The forced closure of all but essential business and leisure premises meant a total and immediate loss of income to tenants leading to a commensurate crippling effect on the ability of most tenants to meet their contractual rental commitments. In a perfect storm of timing, the lockdown was announced only a few days before the occurrence of one of the quarter days on which the vast majority of tenants would be required to pay their landlords one quarter of the annual rental payable under their leases.
Left unchecked, the consequent tsunami of tenant default would have been met with a brutal wave of enforcement action from landlords seeking to recover unpaid rent by forfeiture, insolvency proceedings and distraint. Given the self-evident proof of breach by non-payment of rent, the potential result of this would have left all but the most cash rich tenants with little or no choice but to pay the arrears or submit to the consequence of their failure to pay and lose their premises.
Allowing that to happen would have had a materially adverse effect on the commercial property market. Large swathes of such properties would have become empty at a time when finding a replacement tenant would have been all but impossible.
Consequently, in March the Government introduced moratoria on the institution of forfeiture or insolvency proceedings by landlords to recover rent (together with similar restrictions on the exercise of distraint). These may, in the future, be viewed as a sensible and proportionate response to a potential catastrophe. However, in the short to medium term, the introduction and the subsequent extension of the moratoria until the end of the year are having an effect on landlords who are growing increasingly restive. From their perspective the moratoria have given to tenants, in all but name, a charter not to pay rent.
The principle issue is that the moratoria make no distinction between those tenants who are capable of paying rent and those whose businesses have been so ravaged by the rapid decline in footfall caused by the lockdown and simply cannot pay their rent. The economic reality being that the former class of tenants have been able to re-open to a degree and operate, if not at a profit, in an economically viable fashion whereas the latter group are simply unable to operate at all.
In contrast the effect on landlord investors has been uniformly grim. This is illustrated by the recent publication by the Crown Estate, one of the UK’s biggest and most prestigious property investors, of its results for 2019-20 (only a small part of that period falling within the lockdown period). The Crown reported:
- A write down of the value of its property portfolio by £552.5 million to £13.4 billion;
- Only 52% of rents due from its retail tenants in central London and 53% outside the capital and 88% of rents from its offices in central London being collected; and
- Provision for bad debt of £12.9 million.
It is to be expected that these figures will be replicated going forward as investors report in the coming months. Institutional landlords (such as pension funds and insurance companies) seem to be best equipped to survive the coming storm. Those investors financed by debt face anxious times as they wait to see how lenders will react to falling asset values and, therefore, decreasing loan to asset value ratios.
In practice, advisers now have to advise their landlord clients that they have two choices if tenants are not paying rent, either:
- To wait until the moratoria is lifted and, then, immediately enforce by threat of forfeiture and/or insolvency proceedings, for the recovery of the unpaid rent; or
- To offer temporary concessions to tenants by agreeing to grant rent free periods or reducing rents for an agreed time.
Neither of these choices is attractive to a landlord. The first because the period of the moratoria can easily be extended by statutory instrument. Given the worsening climate, both in terms of the onset of a second wave and of winter, the further extension of the moratoria to the end of March 2021 is foreseeable. At that point, an unpaid landlord will have nearly a year’s worth of arrears of rent accrued. There is also the risk that in lifting the moratoria the Government might feel it necessary to restrict the amount of such arrears that can be recovered. That would be legally unprecedented in modern times, as the state has tended to avoid (save in times of war) to introduce statutory constraints on private sector contracts. However, if the prevailing economic climate is still gloomy when the moratoria are lifted the Government may still need drastic interventionist policies to assist tenants.
By default, therefore, many landlords (particularly smaller private investors) are increasingly agreeing to forgive rent arrears and/or reduce rents in return for their tenants agreeing to resume paying some rents.
The present situation leads to a consideration of the effects on the longer term future of commercial property as an investment grade asset, both in terms of popularity and safety. Two thoughts occur here. The first is that investors should be careful not to make decisions to address the short-term issues caused by the pandemic by adopting solutions which have a material effect on their asset in the future. The second is summed up by the Mark Twain’s quotation ‘buy land as they aren’t making it any more’.
Undoubtedly, some permanent structural changes in property use will be brought about by the pandemic. Retail accommodation seems to be the worst affected category of property asset and the combined effect of the pandemic has added to the growth of online shopping in reducing the need for retailers to have a physical presence on the high street. This will bring about changes in lease terms for retail premises, particularly:
- Smaller units on shorter lease terms (five rather than ten years may become the norm); and
- Rents being based on a percentage of turnover rather than open market rent (either alone or in combination with a turnover rent).
Obviously, such changes will affect rental returns and, therefore, asset values.
The future of office accommodation as an asset class is more difficult to predict until some certainty is reached as to what level of normal will be normal. Large scale office development will probably be unattractive to investors but refurbishing existing office space may increase in popularity.
Mark Twain’s words also resound in the property investment market in the United Kingdom. The country still has a massive, demand for new residential housing. To date the constraints of the national planning system have meant residential development is difficult in terms of where it can be done and how long the process takes. However, the Government’s changes to the planning system are designed both to extend the type of land that can be developed and the speed at which that could be done. Any consequent increase in housing development will, therefore, favour those who own land required for such development whether that be by inheritance or prudent investment.
Diversity in property investment is also important. Specialist sectors such as providers of accommodation for care for the elderly and those with mental health issues are interesting examples as both are demographic growth areas. However, investors need to be quick in identifying such opportunities to exploit a gap in the market before it starts to be filled.
It is undoubtedly the case that the property investment market will change post-pandemic. But it should not be forgotten that similar, if less seismic, crises in 1973, the early 1990’s late 2000’s were all encountered and, by and large, survived by the property industry.
The size of the market may well decrease following the pandemic, but the fundamentals of property investment will remain as they have always been. Find a property in the right place, pay the right amount for it, let it to a tenant with a good covenant and an investor will probably get a good return and reasonable capital growth come what may.
This article was originally published in FTAdviser and can be accessed here.