The three-tier system for Covid regulations in the UK has created a patchwork of areas under special measures across England.
The introduction of this system (and the realisation that we may be living with it for months to come) has acted as a catalyst for many corporate occupiers to have further discussions with their landlords, not just about interim rent reduction measures (the recurring theme for many landlords and tenants over the course of the summer), but about the nature and extent of their long-term lease obligations. These arrangements come in many guises, but there are some fundamental principles which need to be considered when they are documented.
Can’t we just send them a side letter?
Measures designed to reduce a tenant’s current rental liability take many different forms, including rent free periods, rent holidays and a switch from paying rent quarterly in advance to monthly in arrears. So too, do the legal mechanisms for giving effect to them, which include formal deeds of variation and side letters, sometimes together with reversionary leases where the quid pro quo of the deal is that the tenant will commit to a longer term, in exchange for short-term concessions.
Anyone involved in the landlord and tenant market will appreciate how wearing the past few months have been for those at the sharp end of these discussions. The appetite for further negotiations, and another round of documents is – to put it mildly – limited. However, while the temptation for landlords may be to document these kinds of arrangements informally, there are potential traps involved which may outweigh the perceived benefits of avoiding formal documentation.
Extending the term
One point which cannot be made clearly enough is that any attempt to extend the term of a lease must be dealt with by way of a formal reversionary lease. Otherwise, this will almost certainly have the unintended consequence of operating as a surrender and regrant, which releases former tenants and guarantors. As the current moratorium on various forms of enforcement action does NOT apply to former tenants and guarantors, this is certainly something which any landlord ought to avoid at all costs. It may also have SDLT implications for the tenant and unwelcome Landlord and Tenant Act 1954 Act consequences for the landlord, i.e. by creating a new tenancy which has not been validly excluded under the 1954 Act. Cutting corners on documentation is therefore to be avoided at all costs.
A concession letter which allows the tenant to pay a temporarily reduced rent, but (conversely) allows the landlord to recover the shortfall between the lease rent and the concessionary rent in the event of default (a relatively common mechanism), could be construed as a penalty and be unenforceable. This is a complex area, but landlords need to be aware that a challenge is conceivable should they seek to enforce these provisions. In a similar vein, a rent concession letter which is drafted as a temporary waiver, rather than a variation, may cause uncertainty in connection with the exercise of a break right. While more an issue for tenants than landlords, any uncertainty has the potential for future conflict, potentially leading to costs being incurred unnecessarily.
Landlords also need to give careful thought to the circumstances in which they may want any concession to fall away. If, for example, a tenant proposed a CVA, the landlord will want to ensure that its voting rights are not diluted by any concession which has been given (since its proportion of the overall debt will have been reduced). Likewise, care needs to be taken where lenders are involved, as some concessions will invariably trigger a requirement to obtain consent. Granting sizeable concessions may even cause an inadvertent breach of banking covenants.
Turnover leases – not necessarily a silver bullet...
Now, more than ever, landlords are having to explore the possibility of entering into non-standard leasing arrangements. Turnover rents and less traditional rent review mechanics are being brought to the table for discussion, along with a myriad of other measures designed to share risk and preserve the future business relationship of the parties.
But a degree of realism is required. While ripping up your existing lease and moving to a turnover lease or a hybrid turnover lease may sound like the perfect solution to the rent conundrum created by the pandemic, this approach is not without its difficulties for both parties, but particularly for landlords.
For one, a standard lease cannot be ‘converted’ to a turnover lease with a few minor amendments; significant redrafting of the lease is required. And having your legal team grapple with thorny issues such as whether sales generated online and click and collect will form part of store turnover and what will happen upon the assignment of the lease or underletting of the premises (to name but a few), takes time and costs money.
For those landlords who do not have the infrastructure in place to capture and analyse their tenant’s sales data in real time (EPOS systems), turnover leases are even more of a potential minefield. Those landlords are wholly reliant upon the turnover data provided by the tenant. While landlords can and should require their tenants to have an independent third party (accountant/auditor) certify this data, such certification will likely be infrequent (quarterly at best, more likely annually, for reasons of practicality and cost to the tenant). A situation where a tenant is paying an on-account amount calculated by reference to historic data and an annual balancing payment clearly presents challenges for both parties in a volatile market.
In addition to banking covenants, portfolio valuation is another obvious challenge for landlords considering turnover arrangements. Valuing turnover leases requires an analysis of previous years’ sales evidence rather than an analysis of guaranteed rental income over the life of the lease. In a lumpy market, this has the potential to cause a depressive effect on the value of the landlord’s interest.
These issues are obviously retail specific, but what of offices premises? Although the full effect of COVID-19 on the office market has yet to be felt, the impact of the pandemic is inescapable. When the time comes, will landlords receive similar requests for turnover leases from office tenants? If they do, how will turnover be calculated? It is not as simple as substituting “gross receipts” with “gross revenue” or “EBITDA”.
Let’s be sensible
Ultimately, the keys to success when it comes to rent concessions, rent rebasing or lease re-gearing discussions are transparency, mutual understanding and a recognition of commercial reality. It is readily apparent that tenants who are very open about their financial position and come to the table armed with hard data about how a concession from their landlord will benefit both parties, are seeing more favourable results than those demanding concessions as of right. Moratoriums aside, it is often forgotten that existing leases are binding contracts which the parties willingly signed up to. Equally, it is clear that, in today’s market, landlords who simply demand that rent is paid in full without acknowledging the impact of the current lockdown measures, are seeing their tenants vote with their feet (in some cases, marching straight to the offices of insolvency practitioners). Where deals are agreed, it is the landlords and tenants who take the time to carefully think about the short, medium and long-term consequences of the concessions which they agree, and who take the time to get the drafting of those agreements right, that are the winners.