Investment risks of tenant insolvency

It is reported that only 18% of rent that fell due was paid on the June 2021 quarter day. This was the worst performing rental quarter day to date in the pandemic. It is no surprise that tenants in the retail and leisure sectors were running low on cash, because retailers have been unable to trade for three months of the year, and trading in the leisure sector has been severely limited – or, in the case of nightclubs and large-scale hospitality venues, non-existent before mid-July at the earliest. It is not a stretch of imagination to think that, with trading conditions so challenging for retail and leisure operators, they will avail themselves of the forfeiture moratorium. Many of these businesses will be in survival mode and will worry about clearing their rental arrears at a later date. Many landlords are already concerned that they will not see these arrears being paid due to tenant insolvency. These fears are heightened where tenants occupy multiple units across the UK, and beyond. As we know, the moratorium is effectively providing – at the expense of landlords – working capital facilities, enabling tenants to run their businesses without the need to pay rent until the moratorium ceases. Landlords will be concerned whether provision has been made for these unpaid rents. As rental arrears across the real estate sector continue to increase due to the extension of the moratorium on forfeiture to 25 March 2022, the risk of tenants entering into Part 26A arrangements under the Companies Act 2006 increases. At some point in time these arrears will need to be paid and Part 26A offers an opportunity for tenants to subordinate their rental arrears behind secured debts and for landlords to be exposed. The investment risks Part 26A processes are expensive to undertake, but the benefits to the tenant can be significant in effectively disposing of leasehold liabilities that ordinarily they would need to manage and discharge. The implications for landlords and the real estate market are as follows: reduction in investment values where investors see a genuine risk of tenants defaulting on lease terms; adverse valuations to reflect the risks posed by Part 26A and/or company voluntary arrangements; potential breach of banking covenants; and lack of development finance where anchor tenants are viewed as risky from a secured lending perspective. Any reduction in investment values attributable to perceived solvency risks of tenants will see pricing decline in affected sectors. The knock-on impact of decreased investment in affected sectors is that there will be a flight of money to those sectors perceived to be at lower risk (eg industrial and logistics) and those markets will see increased capital returns and greater yield compression. There is concern that perceived insolvency risks will see adverse valuations and make it difficult for investors to renew or refinance existing loans without an adverse risk on pricing. Investors have already faced a hardened market post-Brexit and post-Covid and many lenders have not been interested in taking on new borrowers. While the market has no doubt improved over the course of 2021, investors with exposure to the retail and leisure sectors will again find pricing on debt facilities – and refinancing and renewal of existing facilities – a challenge. Since 2008 in particular, some lenders have looked at breaches of loan-to-value covenants as a reason to review investors’ banking facilities. Any investor with exposure to the retail and leisure markets could find themselves at risk of breaching their loan-to-value covenants if the lender chooses to value its security. These factors will no doubt affect the new supply of retail and leisure space to the market. It appears to us that any new schemes will need to be largely funded by the developers themselves rather than traditional bank lending, because the risks associated with Part 26A will create huge challenges from a valuation perspective. What can be done? Investors can do nothing about deals that have been done but they can, subject to their bargaining position, protect themselves legally going forward. I anticipate that rent deposits and personal guarantees will become increasingly popular. Where there is competition for space, landlords will be able to impose their terms on tenants and in the process protect their own position. Corporate guarantees are a less attractive option, as those guarantors can enter an insolvency process themselves. A personal guarantee may be unrealistic because the people expected to give guarantees will know all about the inherent risks of business and why should they expose their personal assets to landlords? A rent deposit is the perfect middle ground, as it gives the landlord a guaranteed minimum level of income but effectively caps the tenant’s liability. Commercially, landlords can select tenants who are unlikely to avail themselves of Part 26A and CVAs (eg independent cafés and restaurants) because they cannot afford to appoint insolvency practitioners to undertake such an exercise for them. The outlook for landlords in the retail and leisure sectors may be more uncertain than ever, but knowledge of the risks associated with Part 26A and CVAs together with the continued moratorium on forfeiture can enable them to focus their efforts towards managing risks by focusing on tenant selection and taking appropriate security. Darren Hamer, real estate partner, Hill Dickinson Photo: Guy Bell/Shutterstock