20 Oct 2020

What does the second wave mean for commercial property?

Hayley Scott

Investec Structured Property Finance

After a national lockdown was announced in March, we watched our high streets and city centres transform. Much of the nation’s workforce quickly transitioned to remote working, leaving commercial offices unoccupied, while the hospitality and retail industries saw consumer footfall and in-store spending all but vanish overnight. 

Since then, we have emerged - albeit tentatively - from lockdown, with eased restrictions seeing some employees able to return to work (and indeed encouraged to do so) and business activity increase as shoppers returned to the high street, eager to spend.

 

Now, of course, there are strong indications that this may have been but a brief respite, as new Government precautions and multiple local lockdowns come into place, along with the very real possibility of another national lockdown on the horizon.

 

In the face of this uncertainty, both commercial landlords and their corporate tenants are having to make some difficult decisions.

Re-assessing requirements

Many businesses have already re-assessed their need for commercial space - with some, such as the law firm Slater & Gordon, choosing to entirely close their London offices, or to seek more flexible leasing arrangements. Others have taken a completely different approach, such as Google which recently leased an extra 70,000 square feet in new office space despite telling its staff to work from home until July 2021.

 

Commercial property specialists Instant Office predict that the demand for office space in the UK could drop by up to 50 per cent, as more businesses have realised the viability of working from home during Coronavirus. Although long-term commercial leases still make up the majority of the UK’s market, Instant Office notes that we should expect the demand for flexible office space to rise as companies turn away from long-term leases.

 

For those in the retail sector, meanwhile, the latest developments will have resurfaced - or exacerbated - difficult questions as to the need for physical locations not only now, but in the much longer-term future.

 

Despite targeted government interventions introduced to support the struggling sector - from the Eat Out to Help Out scheme, to Coronavirus Bounceback loans and a ban on commercial evictions - even some of the largest high-street businesses have begun to feel the pinch.

 

Retailer John Lewis, for example, is now considering converting half of its flagship Oxford Street store into office space to help prevent further business losses. Meanwhile, its main competitors, Debenhams, Beales and House of Fraser are now all undergoing administration.

 

With Coronavirus restrictions enforcing pub and restaurant closing hours of 10pm, and tiered restrictions in certain regions, many warn that the hospitality businesses will struggle to bounce back. The risk for tenants is that they will struggle to pay their rent, making them reliant on government intervention to prevent eviction by landlords. In a recent interview with the BBC, Next boss Lord Wolfson cautioned that investment from landlords will be needed "If city centres and town centres are going to regenerate.”

Hayley Scott, Investec Structured Property Finance
Hayley Scott, Investec Structured Property Finance

There may certainly be opportunities to not only buy property at rebased prices, but also to create value in a severely disrupted market, and Investec aims to support them on that journey

Balancing future relationships

While tenants should typically have a certain degree of protection in their leases to prevent unwarranted evictions, equally, landlords should be able to invoke similar powers in the case of unruly tenants.

 

Even before the crisis this was prevalent, as evidenced with the widely-publicised dispute on the future of Debenhams which saw the business requesting reduced rental fees from landlords as it tried to keep afloat.

 

For most businesses, difficulties brought on by the pandemic have surfaced significant challenges, with many requiring genuine support from landlords. However, experts from law firm Farrer & Co warn that some organisations have been using the crisis to their advantage to avoid paying rent during lockdown. This has been most notably seen with Travelodge’s landlords challenging its refusal to pay rent during the crisis, despite its ability to call on wealthy backers - which include Goldman Sachs for support.

 

In light of this, it's unsurprising that some landlords may not feel inclined to offer support to tenants and shoulder their financial burdens.

 

If the UK is to face a second national lockdown, cooperation and commitment from both sides will be crucial. Mark Gauguier, Partner at Farrer & Co argues that while it may be tempting for landlords to “flex their muscles”, they should consider taking long-term collaborative approaches with their tenants.

 

“The ability to foster and sustain good landlord and tenant relations is one of the real skills (if not the hallmark) of good asset management, and the pandemic presents an excellent opportunity here,” he explains.

 

He adds that “Another key benefit of a less aggressive approach is that a deal done now to help ease a tenant’s short-term financial pain may help avoid, or at least delay, the need to engage an insolvency rescue procedure that the tenant might otherwise have felt compelled to fall back on.”

 

However, this approach will only work if tenants are to also uphold their end of the bargain and adhere to the terms of their rental agreements.

 

Drawing the short-straw?

However, where does the growing list of anticipated disruption and tenant issue leave landlords? While the media can often position landlords as being greedy, the reality will see them facing their fair share of financial struggles as a result of the economic climate.

 

In most cases, landlords are using debt to finance their property investments and relying on net rent from portfolios for their personal income. As we see more tenant voids and Company Voluntary Agreements (CVAs) coming through, this will see many landlords in difficult situations where not only their liquidity deteriorates, but also the intrinsic capital value of their assets and portfolios. And despite this looming challenge, there is still little support in place for landlords other than the short-term Coronavirus Business Interruption Loan Scheme (CBILS).

 

To add to this, while banks have been typically geared at more conservative loan-to-value ratios on mortgages since 2007, with stronger capital liquidity to fall back on, it begs the question of where the fall away in capital values of larger commercial assets leaves larger institutions - particularly those managing pension funds, and thus the public’s hard-earned savings.

 

Nevertheless for wider and well capitalised investors, there may certainly be opportunities to not only buy property at rebased prices, but also to create value in a severely disrupted market, and Investec aims to support them on that journey.

 

Looking forward

While the future of the market may seem bleak for the retail and office sectors as more Coronavirus restrictions are introduced and uncertainty of a second lockdown looms, it will be important for landlords and their tenants to take stock in anticipation of further disruption.

 

If a second wave sees further restrictions across the country, there will be crucial decisions to be made by both businesses, and their landlords - from businesses assessing their requirement for commercial space, to landlords having open discussions with tenants about existing leases.

 

Fostering improved tenant relationships and meeting each other halfway when it comes to financial struggles may prevent further headaches in the long-term, and - most importantly - support businesses until they can get back on their feet.