We have begun to see how the COVID-19 crisis has had an impact on the real estate market in the UK. The Government, the FCA and lenders have responded in various ways to deal with issues such as non-payment of rent, repossessions and the need for further debt for many to survive. In this article, we explore the impact that the COVID-19 crisis is having on borrowers of investment and development finance and how this feeds into documentary and practical issues.
Each transaction has its own bespoke components and so the following is a guide (rather than an exhaustive checklist) of things to consider.
2. General finance issues
There are several issues that apply to borrowers generally whether or not they operate in the real estate space. These include:
- the timing of drawings and accessing undrawn facilities;
- the need for waivers and amendments;
- the impact of a change or a halt in business on covenants and representations; and
- whether amendments need to be made to material adverse change or material adverse effect clauses.
For more detail on these points please click here.
3. Investment finance
Different sectors have been performing in different ways since the crisis began. The already struggling retail sector has clearly been hit hard by the social distancing measures as footfall in shops has been reduced to almost nil, whereas, other sectors, such as logistics, are thriving given the demand for home deliveries. There is market speculation on how the forced working from home arrangements will impact on office space assets; will there be a surge in demand as employees realise the value of face to face contact with their colleagues or will working from home become the new normal? There is also discussion regarding the value of healthcare assets given the focus on the need for an increase in healthcare provision. Lenders will take this into account when reviewing their loan portfolios and this will also mean that some borrowers experience difficulties sooner than others.
The unprecedented nature of the crisis means that the property investment market is experiencing serious upheaval and this has had a negative impact on borrowers. The points below look at some of the issues that may need to be addressed in the finance documents that borrowers have entered into.
The common financial covenants in investment finance facilities are Loan to Value covenants and Historic and Projected Interest Cover Ratios.
Under the LMA definition, Loan to Value is driven off market value at the time of testing. Given that valuers cannot access properties and the current market uncertainty, RICS has published material uncertainty wording that valuers can include in their valuations should they have concerns. Part of this wording states:
“Our valuation(s) is / are therefore reported on the basis of ‘material valuation uncertainty’ as per VPS 3 and VPGA 10 of the RICS Red Book Global. Consequently, less certainty – and a higher degree of caution – should be attached to our valuation than would normally be the case.”
As a result, lenders may take a more cautious approach when reviewing valuations and there is a likelihood that loan to value thresholds will be set or reset (for new and yet to complete transactions).
Valuers may also, as the crisis continues, value properties more conservatively (in addition to the market uncertainty provision) which will impact existing transactions if a revaluation is called for by a lender. Borrowers should be aware of this risk and discuss with their lenders how best to deal with a Loan to Value breach, for example, by curing the breach by placing monies on deposit or paying down part of the loan. As a result, lenders may take a more cautious approach when reviewing valuations and there is a likelihood that loan to value thresholds will be set or reset (for new and yet to complete transactions).
For Projected Interest Cover Ratios, lenders may evaluate rental income projections more rigorously if tenants are in sectors that are struggling. In addition, the LMA definition discounts projected rent from tenants that are in arrears and therefore as the crisis progresses, if some tenants are unable to pay rent, these forward looking ratios may not be capable of being met.
Currently Historical Interest Cover Ratios should not trigger breaches as they are based on rent already received but as the crisis continues, Historic Interest Cover Ratios may become compromised as rental income is reduced. Given the lag in measurement, if not addressed, this will lead to Borrowers being in default well into 2021.
If borrowers have concerns regarding the creditworthiness of their tenants then they should discuss this with their lenders as early as possible with a view to changing ratio levels, looking at alternative measuring criteria and methodology, or obtaining a waiver whilst the crisis continues.
There are strict restrictions on the amendment, supplement, extension, waiver or change of use of tenancies in the LMA investment facility and lender consent is required unless carve outs have been negotiated. Consequently, borrowers who are landlords, must be ready to consult with their lenders:
- if a tenant is in financial difficulty and is unable to pay the rent, as borrowers may find that they need to waive breaches. The likelihood of this happening has been increased by the introduction of section 82 of the Coronavirus Act 2020 which places a moratorium on the enforcement for non-payment of rent by landlords on commercial tenancies by way of forfeiture until 30 June 2020. This provision does not waive the obligation on the tenant to pay the rent but without the threat of forfeiture available to landlords, it may force them into negotiations. Furthermore, as of 23 April 2020 the Government has temporarily banned the use of statutory demands and winding up orders where a tenant company cannot pay their bills due to Coronavirus, to ensure they do not fall into deeper financial strain. The measures will be included in the Corporate Insolvency and Governance Bill, which the Business Secretary Alok Sharma set out earlier this month. The Government is also laying secondary legislation to provide tenants with more breathing space to pay rent by preventing landlords using Commercial Rent Arrears Recovery (CRAR) unless they are owed 90 days of unpaid rent
- if a tenancy is coming to an end, as it may be impossible for the tenant to vacate the premises and therefore an extension may be necessary (read more about our leasehold premises here); and
- where tenants are looking to adapt their businesses to maintain cashflow during this period, for example; as certain companies are now producing products that are helping tackle the pandemic where demand for their current product is low, a change of use consent under the tenancy may be required.
Borrowers that occupy their property as tenants should also remember that there are restrictions on amendments to arrangements under headleases in the LMA investment facility agreement and so lender consent should be sought in advance before any amendments are agreed with their landlord. In addition, as explained above, none of the emergency legislation currently in place excuses non-payment of rent and therefore lender and landlord consent must be obtained before any rent is withheld.
Role of the Lender with Breaches of Property Covenants
In most of the scenarios above there are obligations on the Borrower to take action to prevent or to resolve any defaults. For example the obligation to collect rental income, exercise their rights under leases and importantly to ensure that tenants comply with their obligations under leases. The starting point for Borrowers should be an assumption that they will need lender consent to make changes to any pre-existing arrangements with tenants. Lenders in turn should be mindful about withholding consent (even absent the “not to be unreasonably withheld or delayed” formulation) as what was unthinkable a few weeks ago may now be both a reasonable and prudent course of action. Consideration should also be given to conflicting provisions in the document before acting on a breach; for example where there is a cessation of business (typically a breach) which may have been required by law.
Events of Default
Other than the standard Events of Default (e.g. the Borrower’s own non-payment and insolvency) that are considered in the article referred to above, a key Event of Default to note is the Major Tenant insolvency. This can occur when a tenant, whose rental payments are a fundamental component of the Borrower’s cashflow, becomes insolvent. As a landlord, the borrower could suggest that the tenant explores relief options that have been made available by the Government such as the business rate holiday and the HMRC Time To Pay scheme, as these will help reduce the tenant’s outgoings.
4. Development Finance
On 31 March 2020 the Department for Business, Energy and Industrial Strategy wrote to the construction sector supporting the continuation of construction projects provided that Site Operating Procedures and social distancing measures are complied with.The Construction Leadership Council has published and updated its Site Operating Procedure (at version 3 at the time of writing) setting out what protocols to observe to keep workers safe on site so that works can continue. However, in some cases, there have been difficulties with supply chains and obtaining building materials and social distancing has not been possible meaning that some construction sites in the UK are under pressure. Below are some of the issues that borrowers of development finance facilities should consider.
In addition to the covenants discussed above, development facilities often include a Loan to Cost covenant. The “Cost” element is typically the latest estimate by the Project Monitor of the costs and expenses specified in the Budgeted Costs incurred at that time. Delays caused by absences and interruptions to the supply chain will lead to cost increases which will need to be funded by sponsor equity, subordinated debt or a change to the debt terms.
Site visits appear to be able to go ahead at present and the NHBC, for example, are still able to issue Building Control final certificates and therefore breaches of the monitoring requirements in the LMA development facility should not be a key issue unless the Government guidance changes. However, the two main threats to development financings during this period are delays and development parties’ solvency and as a result, the following development covenants could cause issues for borrowers:
- Milestones, Longstop dates and Development Documents – If a development party is in financial difficulty then they, their contractors and / or suppliers may not be delivering the required services on time or to the required standard; this could result in a missed milestone or the Lender’s monitoring surveyor may determine that any Longstop date for achieving PC may be missed. Borrowers should therefore monitor the various development parties at this time to anticipate whether there could be a delay or a failure to comply with a Development Document as any amendment, supplement, waiver or extension of a Development Document will need lender consent.
- Delays to Completion - It is likely there will be delays to projects because fewer staff may be able to enter the site, building materials from within the UK and abroad may not arrive when expected and the Government may change their view on construction sites completely. Depending on how long the build programme is and the current stage of the development, it may be that these delays can be caught up on once lockdown is relaxed if this is not the case then the required completion date may need to be extended. Borrowers with development facilities that convert into investment facilities after Practical Completion should consider the impact of a delayed completion date as this may mean that they are compounding interest for longer, which is more expensive, or this may have an impact on their future earnings harming both sides of a debt service ratio. For example if student accommodation is not ready for the start of the new academic year this could impact the income generated by the asset and consequently the capital value of the asset until September 2021.
- Abandonment - Disruption may become so severe that it leads to an abandonment of a significant part or all of the site for 28 days. This is typically an event of default in development facilities.
- Cost Overruns – Borrowers are under an obligation to not incur Cost Overruns i.e. additional projected costs that exceed the development budget. Given the current uncertainty, calculating projected costs may become controversial especially as under the terms of the LMA development facility, the Project Monitor (the lender’s agent) makes this calculation. If a Cost Overrun does arise and it is unfunded in the Budgeted Costs, this must be funded by equity or a contribution by subordinated debt. So borrowers should consider whether these payments would be available and permitted by any intercreditor agreement.
- Extensions of Time – Depending on the terms of its Building Contract, a Borrower’s Contractor may be entitled to claim an extension of time due to force majeure (the pandemic may qualify subject to the exact timing of the delay and the Contractor’s duty to constantly use his best endeavours to prevent the delay as per the unamended JCT for example). The Borrower will need to carefully check whether its completion dates under the Facility are set to automatically mirror an extension properly granted under the Building Contract. It is likely that they do but also likely that there are hard long stops in the Facility which do not and will need to be revised to avoid an Event of Default.
- Solvency - As with a Major Tenant, many loan agreements include an Event of Default that occurs on the insolvency of the Main Contractor or other significant development parties. Borrowers can take the same action and may be able to rely on the Government initiatives set out above but it is important to monitor the financial health of the contractors so that borrowers can anticipate the insolvency of a development party.
In conclusion, these are difficult times for borrowers and it is likely that discussions with lenders regarding the obligations in most finance documents will have to occur. However, we have seen lenders being amenable to borrower requests and with careful management when issues do arise, we believe that catastrophic situations can be avoided.
If you would like to discuss any of these issues further please contact Jon Bond (Banking and Finance), Isobel Young-Herries (Banking and Finance), Michelle Noble (Real Estate) or Fiona Thompson (Construction).