The Real Estate Law Review: Covid-19 and Real Estate: a UK Perspective
At the start of 2020, it became apparent that the whole world was about to come under unprecedented attack from the rapid spread of a deadly new disease. What started off in a market in Wuhan, China did not take long to cast its shadow over every part of the globe. The covid-19 pandemic has affected the global economy like nothing this generation has previously faced. Not since World War II has the entire world been so adversely affected by one event. As of November 2021, only the remote Pacific island nations of Tuvalu and Nauru had not reported a single case of coronavirus (covid-19). Similar statistics from North Korea and Turkmenistan have been treated with healthy scepticism. Every major jurisdiction has been forced into implementing a series of lockdowns and other measures to ensure the health and safety of its population, while at the same time seeking to limit lasting financial damage. What started as a global health crisis has transitioned into an economic crisis that will leave its mark on the global economy long after the pandemic has run its devastating course. Lest we forget, the covid-19 pandemic is first and foremost a human tragedy of epic proportions. At the time of writing, there have been more than 250 million cases and over 5 million deaths. Vaccination programmes have progressed at a remarkable speed, but the global task of manufacturing, distributing and administering an effective vaccine against a constantly mutating coronavirus remains enormous. Although the process of dealing with the economic, social and political fallout is finally underway, the pandemic has fundamentally changed aspects of how we live, work and play.
II Real estate
Real estate has been badly hit by the covid-19 pandemic with a sharp decline in values across all markets and sectors. Confidence in the UK property market had already been knocked by the uncertainty surrounding Brexit. Although Brexit has been sharply put into perspective, leaving the European Union has not helped the United Kingdom to address severe labour and material shortages as well as crippling supply chain issues.
The retail, hospitality and leisure sectors were already in difficulty, as key players sought to adapt to changing consumer behaviour. These sectors have suffered the most, and many household names have joined the seemingly endless list of companies collapsing into administration. It has been a time to forget for traditional retailers, and the United Kingdom's high street will emerge from the crisis looking very different. The dearth of overseas visitors has hurt central London's normally resilient luxury retail and hospitality offering, and a stable increase in international travel volumes is still eagerly awaited. Not surprisingly, the major supermarkets, online retailers and delivery companies have fared much better. From a broader economic perspective, the increase in online shopping volumes during lockdown fell well short of making up for the collapse in overall sales.
The industrial sector has remained resilient with strong competition for well-connected, high-specification distribution centres in the right locations. The logistics sector has continued to attract investment from both overseas and domestic investors, and this trend seems destined to continue. We are also likely to see the repurposing of redundant retail space for storage and distribution purposes. The film and television industry has also been active with a surge in demand for new and repurposed studio space.
The covid-19 pandemic has had a profound and lasting effect on occupier demand as all businesses have revisited their UK and global requirements. There has been an overwhelming urge to right-size as remote working has become an established part of how we all live and work. The immediate knee-jerk reaction to simply reduce space has been replaced by long-term plans to repurpose existing premises to meet the rapidly evolving requirements of staff and customers. Although we are likely to see increasing vacancy rates in the second-hand office market, large corporates and major international professional services firms have remained active in their quest for flexible space in new, high-specification London headquarters buildings. In addition to incorporating facilities to meet the expectations of their workforce, new buildings must meet environmental, social and governance (ESG) targets and provide a safe and healthy place in which to work and do business. Corporate occupiers are under increasing pressure to implement challenging green policies as part of their corporate identity. In most cases, the obvious place to start is with their office premises. COP26 confirmed ESG's position at the top of the business agenda. Paying lip service to climate change is no longer possible as investors, governments, landlords, tenants and funders come under social and political pressure to develop strategies and meet targets. The built environment must play a key role in reducing the world's carbon footprint. The gap between modern, safe and sustainable buildings and tired, second-hand space is set to widen. Connectivity, of course, remains essential. Although investment volumes have been badly affected, a resurgence in activity towards the end of 2021 indicates that London and the United Kingdom will remain attractive to overseas investors looking for a safe haven for their capital in difficult times.
III Legal implications
The government has sought to address the difficult task of offering sufficient protection to otherwise healthy and viable businesses that struggle to survive in the face of the pandemic and periods of compulsory closure. Commercial premises from pubs to retailers form a fundamental part of the wider economy. The government recognises that the businesses operating from them have a crucial role to play in the post-pandemic recovery. A new regime has been launched that aims to help and protect those businesses forced to shut by covid-19 regulations, and to resolve, once and for all, the issue of how to deal with the significant rent arrears accrued during the pandemic. The regime is the latest in a series of protective measures introduced by the government since the United Kingdom first went into lockdown in March 2020. The Commercial Rent (Coronavirus) Bill (the Bill) provides for the ring-fencing of arrears of rent owed by those businesses, such as retailers, bars and restaurants and leisure facilities, adversely affected by legally mandated periods of closure or restricted opening since March 2020. The ring-fencing will allow the parties more time to reach a negotiated settlement as to how the arrears are to be dealt with. In the absence of agreement, there will be a new binding arbitration process in an attempt to finally draw a line under the issue. The Bill is expected to become law by the end of March 2022.
The ring-fenced arrears can include principal rent, service charge, insurance rent, interest on such arrears and VAT. The government's existing protection package will continue beyond March 2022 in respect of the ring-fenced arrears. In addition to protection against forfeiture for non-payment of rent, the exercise of commercial rent arrears recovery and certain limited restrictions on winding-up, landlords will not be able to issue debt claims or look to rent deposits in respect of such arrears. The revised and extended package will continue until arbitration proceedings have concluded or the deadline for reference to arbitration has passed.
Either party can make a reference to arbitration within six months of the Bill becoming law. The arbitrator's role is unusual. Instead of simply confirming the amount of the ring-fenced arrears, the arbitrator has the unenviable task of determining whether the tenant is entitled to relief from paying the whole or part of those arrears. In doing so, the arbitrator must consider whether the tenant's business is viable, or would become viable if relief from payment were granted, and then consider whether any relief should be granted. The aim of the arbitrator's award should be to restore or preserve the viability of the tenant's business, but only to the extent that is consistent with the landlord's solvency. The tenant is not expected to take on additional debt or enter into a restructuring in order to make payment. The award can provide the tenant with such relief from payment as the arbitrator considers appropriate, including writing off all or part of the debt. The tenant can be given a maximum of two years to make the payment or payments determined. The government will approve arbitration bodies and those bodies will maintain a list of suitable arbitrators. The appetite to take on responsibility for deciding the potentially complicated issues of tenant viability and landlord solvency remains to be seen.
The government has also published a new Code of Practice (the Code) for commercial property relationships following the covid-19 pandemic. Similar to its predecessor, the Code seeks to encourage open and fair negotiations between the parties. The Code is also intended to support the arbitrators appointed to resolve outstanding disputes. Whereas the new arbitration regime only applies to disputes relating to ring-fenced arrears, the Code also applies to all rent arrears accrued since March 2020. In many cases, landlords and tenants have already reached a settlement and these agreements remain binding and are unaffected by the new regime. The Code encourages the parties to work together collaboratively to agree a shared recovery plan and the negotiations should be transparent and fair. The Code also contains a summary of the mandated periods of closure and restricted opening, as well as those businesses affected. The significance of the new arbitration regime might just prove to be its role in encouraging those landlords and tenants still in dispute to return to the negotiating table and thrash out a settlement, with arbitration itself being pitched as a last resort to achieve certainty and allow businesses and the economy to move forward. Either way, the Commercial Rent (Coronavirus) Act will amount to a significant piece of statutory intervention in an industry where, company voluntary arrangements and restructuring plans notwithstanding, the parties have traditionally been bound by the terms of their lease.
Coming on top of the government's proposed review of commercial landlord and tenant legislation and proposed reform of the business rates regime, these make for unprecedented times for real estate practitioners, the property industry and corporate occupiers. The main piece of commercial landlord and tenant legislation is Part II of the Landlord and Tenant Act 1954 (the 1954 Act), which confers security of tenure on business tenants. Many commentators have long called for a reform of the 1954 Act on the grounds that the landlord and tenant relationship has changed significantly since the legislation was introduced nearly 65 years ago. The covid-19 pandemic has accelerated many of these changes and confirmed the need for a long overdue review of the statutory regime.
The courts have also been required to consider various issues arising from the pandemic. In a series of cases involving high-profile tenants in the retail and leisure sectors, the courts confirmed that the government's initial tenant protection package did not prevent landlords from making debt claims. In each case, the court confirmed that there was nothing to relieve the tenants of their liability to pay rent and summary judgment was awarded. Landlords are now prevented from bringing debt claims in respect of ring-fenced arrears.
The courts have also had to consider the impact of the covid-19 pandemic on lease renewals under the 1954 Act. Unsurprisingly, these unreported cases have involved tenants in the struggling retail sector. In WH Smith v. Commerz Real InvestmentgesellSchaft, the County Court considered WH Smith's application for a new lease of its premises at the Westfield Centre. The store contained a post office and remained open as an essential retailer while the units around it were forced to close. WH Smith's customers disappeared as footfall in Westfield Centre sharply declined. Most of the terms of the renewal lease had been agreed, including a new pandemic rent suspension clause. The Court was asked to determine the trigger for the rent suspension, as well as the amount of the new rent. The Court accepted WH Smith's argument that the trigger should be the mandatory closure of all non-essential retailers and not just the WH Smith store itself. The Court ordered a new annual rent of £404,666, well below the pre-pandemic figure of £953,000.
In Poundland Limited v. Toplain Limited, the County Court was required to consider another pandemic rent suspension clause. The County Court refused the tenant's request for a new clause that would reduce the rent and service charge by 50 per cent if the tenant was required to cease trading. The Court was able to distinguish the WH Smith case on the basis that, in that case, the parties had already agreed to the inclusion of a pandemic clause and had simply asked the Court to determine the appropriate trigger for its operation. In this case, the Court decided that it was not fair and reasonable for the landlord to share the risk of a future pandemic and the tenant was likely to be entitled to government support in the event of enforced closures.
A further case demonstrates the significant impact that the covid-19 pandemic has had on rental values, particularly in the retail sector. In S Franses Ltd v. The Cavendish Hotel (London) Ltd, the County Court was required to consider the new annual rent on the renewal of a lease of business premises on Jermyn Street, one of the West End's prime retail locations. The Court considered expert evidence on the health of the retail market and the number of vacant shops on the street in determining a new rental value of £102,000, less than half of the previous passing rent of £220,000. The case serves as another stark reminder of the effect of lockdown on London's West End and the wider retail sector.
The need for flexibility, including shorter contractual terms, break rights, options to renew and rights of pre-emption, have become an established part of a business's requirement for space. Rental structures are also evolving as landlords and tenants look for a viable model that meets both their requirements. This has led to a resurgence in the use of turnover rent models that allow an element of the rent to match the success of the tenant's business. The increasing importance of data, not only in relation to the calculation of turnover rents but also in relation to the respective ESG priorities of the parties, has led to the emergence of a new breed of property professional, focusing on the obtention and use of data as part of the landlord and tenant relationship. Covid-19 rent suspension provisions have become an accepted part of lease negotiations and their inclusion has been priced into the commercial letting market. The pandemic has forced property practitioners to adapt to new working practices, and the use of electronic signatures and virtual completions has become an essential part of day-to-day transactions.
In the past two years, the world has become a very different place. We have not witnessed a global crisis of this magnitude in modern times. To think, this time in 2020 we were still obsessed with Brexit. Although the covid-19 pandemic has well and truly put leaving the European Union into perspective, Brexit does remain bubbling away in the background and potentially adds an additional layer of complication as we look to continue on the long road to recovery. Global markets have been encouraged by the rapid development and rollout of covid-19 vaccines. However, the task of manufacturing, distributing and administering sufficient doses of an effective vaccine is not an easy one as science chases after the rapidly mutating SARS-CoV-2 virus. Vaccination rates inevitably vary between countries with economic, political and social factors coming into play. Although there is still some way to go before the covid-19 pandemic is safely under control, there will undoubtedly be opportunities for investors in the UK and global real estate markets. A heady cocktail of Brexit, the covid-19 pandemic and climate change has accelerated the evolution of the real estate industry. Investors will need to keep up to speed and remain agile if they are to take full advantage.
1 John Nevin is a partner at Slaughter and May.