The commercial property market during COVID-19: a reflection

Economic pressures since the start of the Coronavirus pandemic has resulted in increased difficulties and complications for both landlords and tenants.

Many commercial property owners will have been impacted by tenants being less able to keep up payments – particularly those in the retail and hospitality sectors – with many left considering the provision of concessions relating to rent (including deferrals, rent holidays and rent reductions).

Covenant waivers and improved terms regarding loan repayments were introduced in an attempt to provide support to commercial property landlords, however these require careful planning with banks and tenants, and lenders’ outlook towards these developments have recently begun to change. The reasons above, amongst others, have resulted in the fluctuation of commercial property valuations throughout the pandemic.

This article goes some way into exploring the impact of the pandemic on the commercial property market and offers an auditor’s perspective on managing developments.

The immediate impact of the Coronavirus pandemic on the commercial property sector

When lockdown restrictions were announced by the government, the majority of commercial property owners were immediately affected, with restrictions particularly impacting the hospitality and retail sectors. Although, with the government’s ‘stay at home’ order, many office spaces and manufacturing businesses were also left abandoned. In the year to June 2021, Morgan Stanley Capital International (MSCI) data stated that rental value growth for office and retail remained between -0.2% and -6.2%, compared to 2018 where rental value growth for retail was between +0.5% and -3%, and rental value growth for offices remained above +1.5% and below +2%.

The low levels of retail rental growth experienced prior to the pandemic is in part due to changing consumer habits and low consumer confidence levels. However, a decline in growth for office rentals represents the immediate impact of the pandemic on office landlords and tenants alike.

all property capital value growth chart

The circumstances of COVID-19, alongside the low growth in commercial rental values left commercial property landlords in a difficult position. They faced uncertainty around the future viability of their tenants, further uncertainty around their ability to find new tenants should their current tenants close/ fail, and thirdly, the overall value of their main assets i.e. the properties, was stagnating and potentially threatening to shrink given the 2021 rates referenced above. Consequently, numerous landlords had to be creative about how they dealt with this sudden shift in their market, through both reviewing their position, and working in collaboration with their tenants and banks to mitigate any negative impacts.

What was the effect of the restrictions?

  • Property valuations became increasingly challenging

The uncertainty in the market created by the COVID-19 pandemic and the resultant shrink in rental values made it increasingly difficult to value property both during the lockdowns and subsequently as restrictions have eased.

For surveyors, this meant including large caveats in many valuations, particularly with regard to the economic impact on the market and the future viability of the properties. All major valuers subsequently introduced a material uncertainty qualification for valuations dated 31 March 2020 and onward.

Auditor’s perspective

As valuing a property is more difficult than ever, this means that auditing these valuations is equally difficult. Auditors have therefore either had to rely on other means to assist in substantiating values, such as reviewing the strength of tenants, the yields, and other factors in more detail. In many cases, particularly at the outset of the pandemic, auditors were unable to adequately quantify the valuations, resulting in a ‘Limitation of Scope’ or an ‘Emphasis of Matter’ paragraph being included in the audit report in respect of the property values.

As valuations stabilise in the future, auditors face three major issues

1. Being sure surveyor’s valuations of commercial properties are accurate
2. The ongoing concern in light of liquidity restrictions, covenant breaches and tighter lending
3. The recoverability of rent arrears as a result of new restrictions that will be imposed

  • Defaulting tenants

As a result of the Coronavirus pandemic many businesses were forced to close their premises, which for the majority of these businesses meant temporary closure of operations too – particularly if their business model could not easily be adapted to be online or virtual. This resulted in a number of businesses defaulting on their rent payments or making use of rent deferrals and repayment holidays, due to cash shortages.

Defaulting tenants, unfortunately, also have a negative impact on the value of commercial property. When a surveyor is valuing the property, amongst other factors, they analyse the quality of the tenant and the length of the lease, as this provides an indication for future uses of the property. If you have a strong and established client in the premises with a longer lease, this will likely increase the valuation of a property compared to less established tenants on shorter leases.

Auditor’s perspective

Currently, there are a significant number of rent arrears in the market with landlords often unable to enforce debt collection. From an audit perspective, they have to audit recoverability of those debts – this will be a difficult judgement on the part of directors – and auditors will need to ensure they are as comfortable as possible that these judgements are sound and based on robust assumptions.

At the start of the pandemic, the government recognised the initial risks of cash shortages and defaulting payments, and responded efficiently by introducing varying legislation and schemes to support tenants, including; rate rebate, Furlough, Coronavirus Business Interruption Loan Scheme (CBILS) and the Bounce Back Loan Scheme (BBLS). In addition, the Corporate Insolvency and Governance Act (CIGA) which covered areas such as a moratorium protecting tenants facing problems with rent repayments as a result of COVID-19, included other specific legislation regarding the rights of tenants and landlords during this period.

Corporate Insolvency and Governance Act (CIGA)
On a larger scale, the CIGA hindered the ability of landlords to recover any unpaid rent from tenants. So whilst tenants received vital support from the government, some landlords were left feeling ignored and under financial pressure if they faced cash flow issues themselves.

Whilst the Government saw CIGA as vital for preventing wholesale eviction of tenants, it has created apparent problems for landlords – with commercial landlords leveraged to varying degrees and still having to make their loan repayments; many relied on their banks to be understanding and agree repayment holidays. The Government have recently extended the restriction on rent related forfeiture of business tenancies until 25 March 2022, which means commercial landlords will continue to have limited powers until then.

The Government have also announced that a new Act of Parliament may be enacted to address the rent arrears that have built up since the start of the coronavirus pandemic. The details of this Act of Parliament remain relatively unclear for now, however it is likely that landlords will have to take a rent cut where tenants were forced to close during the pandemic. It appears that this is an attempt by the Government to further reduce the chances of a surge in insolvencies as soon as the CIGA restrictions are removed. This fear of insolvencies once the CIGA restrictions are removed, is particularly prevalent in the retail and hospitality industries.

  • Impacts for landlords
    The limitations of CIGA regarding actions landlords could take against tenants for non-repayment of rent left many feeling disappointed, with many commercial property landlords also highly leveraged with tight banking covenants that pre-dated the Coronavirus pandemic. In the event that tenants defaulted on rent to the extent that loan repayments on the part of the property owners could not be met, there was (and still remains, given the extension of CIGA) the risk of covenant breaches. In many cases, a breach of this nature often triggers a clause that means the loans technically become repayable immediately. Whether or not this is enforced by the bank – the effect is that the loans often move from ‘creditors due in more than one year’ to ‘creditors due within one year’. On paper this significantly weakens the landlord’s balance sheet, potentially putting the business at risk. If however, the landlords is proactive and is able to obtain a waiver from their bank in advance of the year end, then the loan can continue to be reflected as due in more than one year.

For commercial property owners that were at risk of the knock-on effects of their tenants not being able to pay their rent, they were advised to sustain open communication with their banks in relation to the landlords defaulting on any loan repayments. Banks, under pressure from the Government and realising the extent of the situation, were initially sympathetic to covenant breaches and provided waivers and improved loan arrangements to commercial property businesses. However, banks are now generally becoming more risk averse to the property sector and as well as having a lower inclination for lending in the sector, are also beginning to restrict covenant ratios i.e. decreasing loan to value ratios.

Auditor’s perspective

Many businesses had tight banking covenants prior to the Coronavirus pandemic, and the pandemic meant that they were in breach immediately. This technically means that loans were due within one year of the breach. For auditors, they needed to assess what steps businesses and bankers took when, or ideally prior, to these breaches occurring, and whether any waivers were received, before assessing the impact in going concern.

What should commercial property owners be doing/thinking about with regards to their properties now?

Alongside an increase in covenant waivers and improved terms for loan repayments for commercial landlords, there has been a surge in progressive lateral thinking regarding alternative uses for property, including the conversion of premises to residential property and the conversion to serviced offices – which provides certain flexibilities to tenants. Whilst many commercial property holders have a diversifying portfolio anyway, some may take this as an opportunity to develop their existing holdings into residential property, given that this market is expanding. The ONS have reported that 41% of people are still working from home exclusively or part-time (time of writing: Sept 2021), which raises the question if offices will ever reach the levels of demand they were in before lockdown. However, because serviced offices offer short-term leases, they are great for tenants that want to be flexible and expand/contract as needed in line with their business plan. However, the exact outlook and what it will mean for valuations in the market remains unclear at this time.

Alternatively, there has been an increase in demand for different leases – including turnover based leases. This is where a part of the tenants rent is based on the level of turnover they achieve and are a great mechanism for engaging both the landlords and the tenants in a symbiotic relationship – when the tenant succeeds so does the landlord, and when the turnover the tenants generate is lower, this often incentivises the landlord to support the tenants. These types of leases have become popular recently in the UK in the retail and hospitality industries – and we suspect, will continue to gain traction – as a result of the pandemic, and tenants’ progressively growing bargaining power.

What is likely to happen next?

The economic downturn over the past 18 months has certainly affected some sectors more than others, including the hospitality and retail industries. The future for some commercial property tenants will be challenging as they will still need to repay their rent deferrals and bank loans, furlough will be withdrawn and full rates will need to be paid again. However, legislation such as the Act of Parliament will provide some protection to tenants that were forced to close during the pandemic. Commercial property landlords may also face a challenging time ahead; lower valuations and a change in outlook from the banks is likely to put more pressure on covenants and make it harder for landlords to obtain finance.

It is likely that both tenants and landlords will face a continuation of difficulty ahead with regards to ongoing uncertainty in the property industry, legislation developments and restriction of covenant ratios, amongst other factors. It is important that as a commercial property owner, you are proactive in communicating with your stakeholders. If you have defaulting tenants or are concerned about their continued ability to meet rental payments, it is advised that you speak to your bank and advisors as soon as possible. This should be in advance of a potential breach with the view to obtaining a waiver before the year end, to avoid unnecessary negative impacts on the company balance sheet.

If you are a tenant or a commercial property landlord, and require any further support regarding anything discussed above, then please contact Darren Amott using the form below.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.


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