Post Covid-19, Commercial Landlords and Tenants may need to accept that rent is no longer a “fixed cost” but a “variable cost” for the foreseeable future – the parties need to accept they are “joined at the hip“, so to speak, and allow common sense to prevail. The solution in my opinion, as an expert in the tourism sector, is to adopt a VRP process. As background:
For the tenant, strangled by rental obligations in an environment where there is no income, the outcome is obvious and disastrous.
For the landlord, who on the face of it may be protected by rental obligations and personal guarantees in leases, there is in fact also little immunity from current business risk. Without a tenant in place paying rental, plus outgoings (rates and insurance premiums), there is income disruption and depending on the nature of the property, potentially also a prolonged period of vacancy. Landlords should be under no illusion that if a good tenant falls over due to market crisis, there won’t be a queue of other prospective occupiers. In these circumstances, the market value of the property will see illiquidity and value erosion.
Accordingly, in this situation there is merit in the argument that some rent is better than losing a good tenant and the prospect of no rent at all until the worst impacts of COVID-19 have abated.
There are other options for landlords and tenants such as getting a bank loan based on the NZ Government rules where the Government guarantees 80% and the loan and the Bank writes off 20% of the loan if it goes bad (https://www.business.govt.nz/covid-19/business-finance-support-and-mortgage-holidays/#e-20794), however this requires an approved cash flow statement and a business plan post Covid-19 which will be nearly impossible to establish currently.
The VRP Solution
What is potentially required is an “open book” process where the tenant pays an adjusting “percentage rent to turnover” – that is, at the end of each calendar month, the actual percentage of turnover for that business is confirmed (perhaps by an accountant) and that proportion applies as the adjusted rent payable for the following month. This continues until the tenant gets back to the prescribed rent in the current lease. This basis is well advanced in Australia.
The transparent process of the “open book” rental calculation being certified could be done using the free services of https://www.regionalbusinesspartners.co.nz/ and an Accountant could sign off the turnover and the agreed percentage rent to be paid each month.
Historically, market rents for accommodation, hospitality and retail tenancies were firstly assessed by direct comparison ($/sqm or $/room) but they must also fit within a framework of perceived affordability, that is, rents also need to represent an acceptable percentage of turnover or net income. Ultimately a prudent tenant will only offer a rental that is deemed to be sustainable and a landlord will accept this necessity if it wishes to lease the premises.
Accommodation rents generally equate to around 22% – 28% of expected turnover;
Food & beverage/hospitality business rent generally equate to 6 – 8%;
Retail % turnover rents vary widely depending on the business sector as adopted in Shopping Malls.
1. Most current leases have a “ratchet clause” that holds rent at a certain level and may need to be restructured in the new environment to provide an acceptable level of certainty and confidence for both parties to remain committed and further invest in the premises.
2. Another consideration is whether the landlord has enough protection from losses. That will be driven by:
- Whether or not the lease has any goodwill value;
- The financial position of the lessee;
- The financial position of any guarantor.
3. Where the business is insolvent, the guarantor is insolvent and there is little goodwill in the business then the landlord and the lessee are truly joined at the hip because both are facing losses if the business fails.
If the lessee and the guarantor are sound and the lease has value (e.g. a decent motel) then the landlords can quite happily dig their heels in and expect full payment. There is little financial motivation to make concessions.
I think you have to also separate lessees who have a cash flow problem against lessees that have a viability problem. Cash flow problems can be solved by deferrals, but viability problems can’t. Viability problems call for agreed reductions.
4. One of the difficulties is that the landlord would have to adjust the revenue multiplier rent for each tenant. Sourcing a new tenant under this regime would become more complicated and most businesses would rather have a fixed rent than face a disincentive to grow their business. So, it might make some sense for existing tenants in these uncertain times. But because these times are so extremely unusual it would not be wise to adjust pricing models to largely account for something which happens once a century
5. Clause 27.5 in the widely adopted Sixth Edition 2012 ADLS lease, was inserted after the Christchurch Earthquakes to deal with restricted access to a tenant’s premises and require agreement to a fair abatement of rent and outgoings.
6. The residual elephant in the room is the pre and post COVID-19 valuations of buildings. The value is established by a function of the capitalising the rent (cap rate) for the asset class and location. There is potentially two problems, firstly the rent will be lower and thus capitalisation of the lower rental will value the building lower. The second problem is the capitalisation rate will probably increase to reflect the lack of demand in the market place from new property investors.
A Landlord has a building where the tenant is paying rent of $100,000 per annum and the cap rate was 5% pre Covid-19, the Building would have been valued at $2m
The rent drops by say 25% to $75,000 per annum and the cap rate increases from 5% to 6.5% post Covid-19, the building is now valued at $1,153,846, a decrease in value of $846,154.