CHAPTER ONE – LEASES IN UNCERTAIN TIMES – IDENTIFYING THE ISSUES
The impact of the Covid-19 pandemic and associated lockdown upon the commercial property world has been sudden, dramatic and wide-ranging, and what the landscape will look like in, say, two years’ time, is impossible to know.
The retail, leisure and hospitality sectors were hit by a wave of voluntary closures prior to the lockdown, and have since been almost completely closed down by government action. All retailers other than those identified as essential were required to close under the Coronavirus Act 2020. Local Data Company has estimated that 69% of all retail premises in the UK are non-essential; taking into account stores which, though falling into the essential list, closed voluntarily, around 83% of retail stock has been closed down. At the date of writing, garden centres, car showrooms and open-air markets have recently been permitted to re-open, other non-essential retailers will be permitted to re-open from 15 June, and the government hopes to allow more businesses to re-open in coming weeks, though social distancing, staff shortages and hygiene requirements will affect the operation of shops, restaurants, hotels and others.
Of those workplaces not required to close by government action, many have been closed voluntarily anyway as a precaution. Some office occupiers have chosen to remain open, though with many staff furloughed or working from home; while many factories have continued to function with adjustments to working methods and hygiene arrangements. The logistics sector has been crucial to the continued functioning of the economy, and logistics sites have remained open. Some businesses which closed voluntarily are now re-opening, though for them, as well as for those which never closed, social distancing requirements and staff shortages may limit their operation.
The effect upon business has necessarily been severe, though not uniformly so. Grocery sales have seen significant increase, as have sales of computers, office equipment and bicycles, but other non-food retail has suffered badly. Indications are that only a small proportion of the sales which would have been made in-store have transferred to online. The supply chain infrastructure which might enable that is insufficient, and many retailers have suspended online sales out of consideration for the safety of warehouse staff. High-profile insolvencies on the high street so far include Carluccio’s, Cath Kidston, Debenhams, Warehouse, Oasis, Frankie & Benny’s, Monsoon and Accessorize, and more may be expected.
Both landlords and tenants will be anxious over the sustainability of tenants’ businesses. Dealing with rental liabilities and funding the provision of services are obvious headaches, but one thing is plain: a landlord and tenant relationship which is administered in all respects in accordance with the lease terms is likely to be the exception rather than the rule, for some time to come. The obligations in leases may now appear to both sides as obstacles to be side-stepped, or hurdles to be overcome, rather than matters for enforcement come what may. Certain landlords may be subject to superior lease obligations or banking covenants which require them to enforce occupational tenant’s obligations, but it is equally unlikely that those covenants will be insisted upon.
In the interests of long-term stability, sustainability of businesses and protecting investments, many landlords and tenants are working together to find ways through the crisis. Intu has supported occupiers with an 11% reduction in its service charge budget for the year; British Land, Network Rail, TfL and Gentian have delayed or cancelled rents due on 25 March 2020, and many more landlords are agreeing concessionary arrangements with their tenants to help them survive the crisis.
On the other hand, ukactive, representing gyms and leisure centres, has reported a growing number of cases of landlords seeking to enforce payment of rent by the use of commercial rent arrears recovery (CRAR), court proceedings, or statutory demands and insolvency proceedings. Government has responded with a number of restrictions on the exercise of the available rent recovery methods.
The Covid-19 pandemic and accompanying lockdown have understandably dominated news and commentary for the past two months and more, and Brexit may feel like yesterday’s issue. But the deadline is still approaching, and so far the British government has resisted arguments for an extension of the transition period, whether prompted by the impact of Covid-19 or otherwise. At the time of writing, the United Kingdom is due, on 31 December 2020, to cease to be part of the EU single market and customs union.
Whether this picture will change should become clearer very shortly, since any extension of the transition period must be agreed by 1 July 2020. The EU’s position to date is that any wider free trade deal is dependent upon agreement being reached on future fishing arrangements, and that that must occur by 1 July in order to agree any extension. No deal on fisheries appears likely. In any event, the British government presently maintains that whether or not there is an agreement on fisheries by 1 July, no extension will be agreed.
As things stand, it appears a real possibility that the UK and EU will not achieve a free trade deal by 31 December, and that from 1 January 2021 our trading relationship will be governed by World Trade Organisation rules. That means cross-border movement of goods would be subject to customs checks, and not, therefore, ‘frictionless’. Tariffs would be payable at WTO levels, which may lead to a loss of competitiveness. Immigration into the UK would be a matter of British government policy, and the EU’s principle of free movement of people would no longer apply.
It would be what has been variously referred to as a ‘cliff-edge’, the ‘worst-case scenario’, a ‘no-deal Brexit’, a ‘WTO Brexit’, an ‘Australian-model Brexit’ and a ‘clean Brexit’. The range of terminology signifies to what extent the economic consequences of such an outcome are uncertain and hotly debated. To some it is an opportunity to take the brakes off the UK economy and build a new future as an independent global trading nation. To others it can only lead to a diminished future, with a shrinking economy and reduced international status and influence. There may, of course, be some sort of free trade deal, in which case the consequences can only be forecast once the outline of such a deal is known.
Business must be prepared for a no-deal Brexit, should it happen. Leaving aside concerns as to security, climate change and other political matters, and focusing on the economy, predictions of adverse consequences include an immediate recession, with increased unemployment. Paradoxically, there may also be labour shortages, since it is considered by many that British workers will be unwilling to fill the need for unskilled, low-paid manual work, principally in agriculture, but in other sectors as well, including fisheries. Labour shortages, in combination with trade barriers and tariffs, may disrupt supply chains and lead to a shortage of various types of goods. Significant currency fluctuations may push up inflation. In the 1970s, dire economic circumstances and a three-day working week led to power cuts, and it is not impossible that that could happen again.
The striking thing is the extent to which the Covid-19 crisis has already brought, or seems likely to bring, some of those consequences. Travel restrictions, self-isolation and social distancing have all led to labour shortages, particularly in agriculture. With a predicted shortfall of 80,000 workers to help get the harvest in, the government suggested earlier this year that furloughed workers could be encouraged to help out. A ‘Pick for Britain’ campaign had 50,000 responses; however, only 6,000 completed the video interview, and only 112 have taken up jobs. This suggests that perhaps the unflattering stereotype of the British worker has something in it, and that filling labour shortages resulting from Brexit may be an uphill effort.
Disrupted supply chains and shortages of goods have been very much part and parcel of the Covid-19 experience, and while it remains to be seen what the economic consequences will be, recession, inflation and increased unemployment seem almost certain to be among them. It may be that if ‘the worst’ has already arrived, politicians will see no significant downside to a WTO Brexit.
There are other background pressures affecting particular sectors, too, which have been a feature of commercial life for a while, and which may give a clue as to some likely responses to the twin events of Covid-19 and Brexit.
Flexible office space has seen significant growth over recent years, and the trend shows no sign of slowing down. On one estimate, by 2030, 30% of all office space in the capital will be let under non-traditional, flexible leases. In part, the desire of office occupiers to retain agility and flexibility has been a signal of uncertainty over Brexit, but that one-off anxiety aside, the pace of technological change simultaneously enables and demands agility. Employee working patterns have shifted significantly, with IT infrastructure enabling home-working and hot-desking. The enforced mass experiment in adopting home-working technology as a result of Covid-19 is likely to accelerate this trend.
Business plans are increasingly drawn up for short periods: a year, or perhaps a quarter. In this context, commitment to a lengthy institutional lease is highly unattractive, particularly taking into account the impact of International Financial Reporting Standard 16, bringing lease commitments over 12 months onto an occupier’s balance sheet.
A few years ago, serviced office suites were the principal solution, particularly for Small and Medium-sized Enterprises. Many new SMEs are in the financial technology, media, telecoms and creative sectors, which are particularly open to new thinking as regards office space, and which increasingly look to co-working solutions provided by the likes of WeWork and Workspace. Flexible arrangements encompass not only serviced space, but also co-working and so-called ‘vertical campuses’, in which occupiers may take one or more floors as core offices but also benefit from sharing centralised services and other facilities such as social space.
Larger corporates are also beginning to use flexible arrangements for their own occupancy, as well as seeing opportunities to offer flexible accommodation in surplus space to which they remain committed over a longer term. The big institutional landlords are increasingly ready to let space to co-working providers such as Workspace, and British Land has its own flexible working brand, Storey. WeWork experienced well-publicised difficulties at the end of 2019, but these seem to have arisen from management issues rather than from any lack of demand for flexible space.
As regards the retail sector, the high street has been under pressure for a number of years. Major retailers entering into insolvency procedures has become a regular feature of the press. High levels of vacancies of retail units are there for all to see. Much of this has been to do with the challenge from online retailing, of course. Retail Economics reported in 2019 that growth in online sales over the previous decade had been over 400%.
Figures published by the Valuation Office Agency for the year to 31 March 2019 indicated that 394,000 m2 of retail space in England and Wales was lost in that year. To adopt the time-honoured measure, that is the equivalent of 55 football pitches. The figure relates to space which has been taken out of retail use permanently, rather than just space which is temporarily vacant. Those retailers who are successful have a much reduced appetite to take up space which has become available as other retailers have become insolvent, while landlords often decide to change the usage of vacant space rather than continue efforts to let it out to retailers.
Government has made efforts to help, with a one-year rates holiday from 1 April 2020 for businesses with premises of rateable value less than £51,000 – sectors benefiting being retail, leisure (including cinemas and music venues), and hospitality (including restaurants and hotels). The establishment of a £3.6bn Towns Fund was announced in the March 2020 Budget, to support the regeneration of high streets, town centres and local economies. In response to Covid-19, the one-year rates holiday has been extended so that there is no rateable value limit restricting its application. In addition, a business rates grant has been introduced, worth up to £25,000 for retail, hospitality and leisure businesses operating from smaller premises, with a rateable value up to £51,000. It is widely considered that the business rates scheme as it stood prior to the Covid-19 outbreak will not return, and that the crisis will force government to grasp the nettle of re-casting the tax, something for which pressure has been increasing for some time.
The impact of government action will necessarily be limited, however, and retailers and landlords must try to find new routes to sustained viability. Retailers have responded to pressure by trading in different ways, which require more flexible lease terms. They increasingly seek to share space with concessionaires or franchisees, sometimes irrespective of restrictions in the user clause, thus allowing the tenant to freshen up their offer by livening up the mix of occupiers. ‘Experiential retailing’ has become commonplace, with retailers offering classes in crafting, cookery and so forth.
Pop-up lettings have been a feature of the retail landscape for some years now, and have become mainstream. Christchurch, New Zealand, has a shopping mall comprised entirely of pop-ups, called Re:START. This came about with the aim of starting the regeneration of the city, after earthquakes destroyed existing shops. Shopping centre owners Westfield now dedicate space to pop-ups in all their centres worldwide, and they are used by luxury travel brand Kuoni and BMW (to promote its Mini brand), for example.
Some key issues
With this background, some key issues are apparent, which are as much issues of future lease drafting as they are of negotiating the crisis on the basis of existing lease terms:
When faced with a public health crisis, or widespread closure of premises by tenants, what are the options for landlords? Can they close multi-let premises such as shopping centres or office complexes? Alternatively, can they reduce or suspend provision of services? The other side of the coin is: where such circumstances prompt landlords to additional expenditure on services, will the increase be recoverable from tenants?
Can an event such as the Covid-19 pandemic or Brexit, leading a tenant to close its premises, relieve it of liability under the lease? In other words, what routes to lease termination will be open to tenants?
What issues arise for tenants that have closed their premises, but whose leases remain on foot? There are practical issues of day-to-day management of the property, but also legal issues of continued liability in relation to lease covenants.
For the landlord, what actions are still available, or effective, to enforce tenants’ lease obligations?
Where landlords wish to take an approach which is supportive rather than enforcement-based, what issues arise in relation to concessionary arrangements?
Finally, how do these experiences influence the negotiation of leases in future?
These are the issues which will be addressed in the following chapters.