Navigating Unknown Waters
The Covid-19 crisis has thrown the commercial property world into disarray and many landlords are floundering. Commercial property manager Jeff Brill gives a rundown of the current situation and offers some advice.
1 June 2020
As the Covid-19 virus spreads across the world, investors are desperately trying to forecast which direction yields will go in. Looking back, they will see that following the SARS and H5N1 bird-flu outbreaks, in 2003 and 2005 respectively, the property market bounce back trend occurred in a “V” shape.
However, as we are all now well aware, the Covid-19 pandemic and the response of leaders around the world to it is unprecedented in modern times. This means that when it comes to the impact of Covid-19 on the economy and the property market, we are dealing with quite a different beast to that of those past virus outbreaks.
The effects of the previous outbreaks did not even come close to the looming economic impact of Covid-19. In turn, this makes picking what might happen next for commercial property particularly difficult.
Investors might decide to look to the aftermath of the global financial crisis (GFC) in 2007-2008. If so, they will see that there was a lag in the commercial real estate drop in New Zealand. But when the values did fall, they fell by approximately 30% - which was nearly on par with the UK and USA.
The reason for that lag is not tagged to only one variable. However, a significant cause came down to business owners hanging in there for as long as they could until the effects of subdued demand finally took its toll and they had to close down.
When a tenant disappeared in the post-GFC environment, the timely replacement of the tenant without significant discounts was highly unlikely. Property values subsequently fell.
The Value Of Cashflow
The big difference between the GFC and Covid-19 is that the GFC did not discriminate on who it was going to take down. In contrast, Covid-19, unlike the people it infects, does have a specific taste on the business type and, therefore, the commercial class that it favours.
Commercial property values have always been tied to the risk of the future cashflow of the investment, and that in turn is innately linked to the success of the tenants and their business.
So in a changing world where Amazon is supplying wholesale goods to our warehouses and Alibaba makes importing from a “free trade” China nearly as easy as buying an item on Trade Me, the manufacturing sector in New Zealand - with its relatively higher labour cost - faces some challenges.
Commercial property investors who are trying to accurately forecast the security of their income need to seriously look at trends of this nature and decide on the strength of the tenant covenant.
‘Many landlords have managed to work out arrangements with their tenants around rent, but the situation has been difficult and problems remain’
Going forward, some sectors that are tied to immigration and tourism will undoubtably be hit hard as countries around the world are going to be slow to re-open their borders. Commercial tenants such as accommodation providers, travel agencies, airlines, tourist operators, souvenir shops, as well as cafes, restaurants and bars are going to find it hard going. Many of them may require rent relief from their commercial landlords beyond the offerings from the Government and lenders.
Conversely, landlords with “essential services” and/or government funded tenants have been able to sit back to a degree, knowing that their investment is relatively recession proof. The lower cap rate and, indeed, the higher price they paid for the investment in the first place is now paying off.
Given that there are now less prime commercial property investments in the market, coupled with a low-interest environment, these types of gilt-edged investments will only increase in value.
So what are we to do with the significant number of commercial investors around New Zealand that are housing compromised tenants, some of whom are
now teetering on the edge of bankruptcy?
As many tenants were unable to operate their business during the Level-4, and even Level-3 stages of the lockdown, many have struggled to pay the rent on their business premises. And many have looked to a previously little-known clause that can be found in many commercial leases.
That clause came about due to the Christchurch earthquakes. Following the earthquakes, a new “no access emergency clause” (clause 27.5) was inserted into the sixth edition of the Auckland District Law Society’s (ADLS) Deed of Lease. It was designed to provide guidance for times when tenants are barred from entering and operating in their premises.
ABOVE Following the GFC, commercial property values dropped by 30%, but the impact of Covid-19 may be more severe.
Following the Christchurch earthquakes a new “no access emergency clause” was added to the ADLS deed of lease, which some retailers tried to invoke during the Covid-19 lockdown.
The relevant part of clause 27.5 states: “A fair proportion of the rent and outgoings shall cease to be payable for the period commencing on the date when the tenant became unable to gain access to the premises to fully conduct the tenant’s business from the premises until the inability ceases.”
Since the clause was inserted into the ADLS lease, the New Zealand courts have not defined the words “fair proportion”. I have no doubt that this will change post Covid-19 but it has meant that, during the lockdown period, there was a lot of confusion around how the clause could and should be interpreted.
Many commercial landlords have managed to work out arrangements with their tenants around rent. But the situation has been difficult and problems remain.
Banks are offering deferments in mortgages to take the pressure off landlords. Yet the “mortgage holiday”, as touted by the media, has created more confusion. That’s because the word “holiday” in commercial circles relates to a “rent holiday” where the rent has been forgiven.
It’s fair to say many landlords don’t see mortgage deferments as a “holiday”, which means some are reluctant to go down that path. Additionally, many parties don’t actually have the sixth edition lease with the “no access emergency clause” in place. All such affected parties are now looking towards the Government for more guidance.
Not unlike many other democratic governments around the world, the New Zealand Government are not keen to interfere in the free market system in this regard. Instead they have tried to provide help by:
• Allowing depreciation and other tax incentives for this 2020/21 financial year.
• Extending the time period that landlords can cancel leases from ten to thirty days.
• Funding business with staff with a wage subsidy to help keep businesses running.
• Encouraging banks to provide loans to businesses that have at least a $250,000 turnover.
• Providing, through the IRD, a loan of up to $10,000 from May 12 to June 12, 2020.
• Establishing a Business Finance Guarantee Scheme for $500,000 if a business has turnover of $80 million plus.
On top of that, the Reserve Bank has removed its loan-to-value ratio (LVR) restrictions for the next 12 months and has slashed the OCR to the current record low of 0.25%. It is also encouraging banks to be “courageous” but responsible in their lending to support businesses.
However, the banks rightly still remain cautious on this front and most borrowers would be very lucky to find a bank that would actually follow these guidelines. After very little regulation in past prefinancial crashes, banks are now starting to think for themselves and taking their own precautions. That means most lenders are keeping tight servicing criteria in place.
While this assistance is appreciated by commercial property participants, many are calling for more. Australia, for example, has adopted a mandatory code of conduct around commercial leases and this has been cited as something New Zealand could do. To date, the New Zealand Government has not made such a move.
While the uncertainty of the current environment means it is more difficult to navigate the rental relationship, there are a few pieces of lease management advice that I’d like to offer.
First up, while tenants can apply for a loan and landlords can defer their mortgage, the scale is slightly skewed in the tenants’ favour due to the lower interest rates offered. Therefore, in my view, the fairest option is for a portion of the rent to be deferred over a period of time, with the length of time limited to the end of the lease term.
Secondly, landlords should be empathetic towards their tenant(s). The situation is not of their making, just as it is not of yours. Remember, when it comes to leases, there are other variables that can be negotiated such as term and rent reviews.
*Jeff Brill is the author of the only book on commercial property investment in New Zealand in many years. His book, The Sophisticated Property Investor, is available from all major booksellers throughout New Zealand.