Part I

It’s not so long ago that the commercial property sector was tempting lots of residential investors to switch their allegiances. In the face of sky-high house prices, low yields and a swathe of tax and tenancy law changes, the higher yields and less troublesome tenancy arrangements were highly attractive.

But as the weeks of struggle against Covid-19 continue, it looks as though it could take a particularly heavy toll on the commercial property sector. While much attention has focused on the arrangements between residential tenants and landlords, it’s actually those between commercial landlords and their tenants which are more precarious.

That’s because people always need somewhere to live. But if a business is not able to operate, or is put out of business permanently, it does not need a premises. Forecasts for how hard the economy will be hit by the Covid-19 crisis vary widely, but it is certain that many businesses will not survive – and, in turn, that will impact on many commercial landlords going forward.

Lease Dilemmas

Already though, commercial property has been given a mighty shock by the lockdown. The forced closure of non-essential businesses left both landlords and tenants scrambling to establish what that meant for rental payments over the lockdown period.

There was public indignation at reports of major landlords like Kiwi Property Group, which owns a number of shopping malls including Sylvia Park, telling tenants they were expected to keep paying rent throughout lockdown. Equally, there was outrage at big corporate tenants like Harvey Normans and The Warehouse refusing, at least initially, to pay rent.

Understanding of the situation has been complicated by a little-known clause in the sixth edition of the widely used Auckland District Law Society lease. That clause (27.5) deals with situations where there is no access to a property in an emergency.

It provides for a fair proportion of payment of rent to stop temporarily if a property is unable to be accessed in an emergency. Additionally, it gives rights for the landlord or tenant to terminate the lease if the no access situation continues for over nine months.

‘The hope is that landlords and tenants can negotiate something that works for both of them. Having a long-term view is key for landlords as it will be harder to sign up new tenants going forward’ JOANNA PIDGEON

Born from the aftermath of the 2011 Canterbury earthquakes, when many “red zone” tenants were left having to pay the full rent for premises they could not access, clause 27.5 was expanded to cover other civil emergency situations. The Covid-19 pandemic qualifies as such a situation.

Not all commercial landlords have this particular version of the ADLS lease in place. Bigger retail and office landlords often use the Property Council lease or a bespoke lease. It’s not known what proportion of leases have the clause, but ADLS property law committee member Joanna Pidgeon thinks it’s likely to be a majority of them.

She says they are seeing a range of behaviours from landlords in response to the situation. “Some landlords – regardless of whether they have the clause in their lease – have given rent-free periods, or deductions, or relief in some form, to their tenants. Others have not.”

It’s worth noting that every lease is unique to its particular situation. Pidgeon says that, in many ways, it comes down to the tenants and if they can continue to operate going forward. “The hope is that landlords and tenants can negotiate something that works for both of them. Having a long-term view is key for landlords, especially as it will be harder to sign up new tenants going forward.”

A big sticking point seems to be assessing what constitutes a fair proportion of rent to deduct. Inevitably, it will differ on a case-by-case basis but any assessment should be fact-based. While there is no New Zealand legal precedent, in Australia they have looked to turnover as evidence.

Pidgeon says that if parties can’t agree on the terms of how the clause should be interpreted, they can go to mediation or arbitration. “But it’s important for both parties to be fair and honest and to communicate. It’s a two-way street after all.

“Tenants have to be transparent about what their turnover is. For an accounting firm who is still billing out at 90% and using the server in their leased property to say they only want to pay 10-20% rent is simply not fair – and their turnover would show that.”

Remember, neither landlords or tenants are at fault in this situation and most will be exploring different solutions to work this out, she adds. “This is not going to be a quick fix situation, so it’s a matter of getting through it. We need to realise that we are all in this together.”

Calls For Support

Issues to do with rent have dominated the discourse around commercial property in the time of Covid-19 and this has prompted calls for government support. In fact, the Government has announced some measures intended to offer some relief to commercial landlords.

For a start, there are the various wage subsidy and leave payment schemes. These are meant to help tenants financially to ensure that they can both make rental payments and support their employees. Then there’s a range of tax measures which are intended to boost business cash flow. These include reintroducing depreciation on commercial buildings from 2020/2021.

More recently, the Government also announced that the timeframes required before commercial landlords can cancel leases and mortgagees can exercise their rights to sale or repossession have been extended.

The timeframe for lease cancellations has been increased from 10 working days to 30 working days, while those for mortgagees have gone from 20 to 40 working days for mortgaged land, and from 10 to 20 working days for mortgaged goods.

But the new measures have had a luke-warm response from commercial landlords and tenants alike, with many saying rent relief is needed.

Property Council chief executive Leonie Freeman welcomes the measures but believes they are unlikely to significantly lessen the economic impact of the crisis on New Zealand’s $145 billion commercial property sector.

Reintroducing depreciation on commercial buildings is a positive move, she says. “But it is not an immediate cash injection and therefore does not solve the immediate situation of supporting those landlords and tenants needing assistance during this lockdown period.”

Likewise, extending timeframes required before landlords can cancel leases and mortgagees can exercise their rights will give tenants and landlords some additional time to resolve contractual issues. And the tax measures will act as a buffer for some businesses by providing additional cashflow,

But Freeman says that if a business was not previously making a substantial profit there’s little relief in the new measures. “The question remains, will this help tenants pay some or all their rent and fulfil their contractual obligations?

“Small businesses are struggling to pay rent and in turn many commercial landlords, particularly mum and dad landlords, are finding it difficult to meet their mortgage obligations. While the new rules are commendable, they won’t stop this from happening, they simply give everyone more time before lenders can act.”

More support will be needed and the Property Council has already proposed a support package for commercial tenants facing a 50% loss of revenue [to Government], she says.

The Property Council’s proposal would provide immediate relief to tenants so they could continue to meet their contractual obligations. “It includes a deferral of rent by landlords facilitated by the tax system and a targeted rent tax credit for tenants with direct financial assistance via a mechanism similar to the Government’s wage subsidy.”

TOP Commercial property in Queenstown will likely feel the biggest impact, as many of its businesses centre around tourism.

ABOVE As most retail premises have been forced to close over the lockdown, this sector will likely be the worst hit.

Going forward, the Property Council is encouraging the Government, landlords and tenants to take a long-term view and to negotiate in good faith, Freeman adds. “The ramifications of letting property owners bear the brunt of this crisis are dire as there’s little point in having a tenant survive with the landlord foreclosed on and vice versa. We must work together to get through this period of unpredictability.”

An Uncertain Future

So where does all this uncertainty leave the outlook for the commercial property sector? There can be little doubt that the Covid-19 crisis has led to softer assumptions around net cash flow, vacancies, rental growth and trading conditions going forward. There’s also widespread acceptance that certain sectors will be hit harder than others.

JLL NZ managing director Todd Lauchlan is very cautious around any forecasting as the level of uncertainty can date predictions very quickly. “It’s not possible to make bold statements on what could happen going forward at this time. It really is all about ‘wait and see’.”

Businesses that have successfully trialled remote working during the lockdown may cause a reduction in the need for office space down the track.

However, the reality is that properties associated with tourism, particularly hotels and motels, as well as smaller retail properties with businesses that rely on people coming through the doors, are likely to run into problems, he says.

“Out of lockdown, the domestic tourism market might start to move, but it’s a bit of an unknown. So impossible to say what might happen. There will be a big increase in vacancies on the high street and in malls. And that will impact on landlords with retail properties.”

What happens with the office sector is even harder to pick. Lauchlan says it will all depend on how different industries get along in the post-lockdown world. Some industries – like tech firms, lawyers, accountants – are likely to get along ok, while others – like tourism-related business and export education – won’t do so well.

‘It’s not possible to make bold statements on what could happen going forward at this time. It really is all about “wait and see”’ TODD LAUCHLAN

“If businesses survive, they might move to smaller office buildings or ones in less central locations that are more affordable. There’ll be challenges for office landlords. They will encounter rent collection issues and vacancy rates will go up.”

On top of this, lockdown has meant many companies have now given remote working a proper go. If companies feel it has been successful, it could mean a longer-term change in behaviour which could also reduce the demand for office space in the future.

Lauchlan says it is the industrial sector that will be the least affected. After all, businesses will still need buildings for storage, packaging, distribution, and so on. “Some businesses might look to downsize or restructure their leases though. There will still be some increase in vacancies and a reduction in demand.”

While there are many unknowns in this whole situation, it’s safe to say there will be a broad impact across all sectors of commercial property - it’s just a question of degree, he says.

“There is a market there still, but a lot of the risk hasn’t been properly priced in. So a lot of people won’t do anything until the market settles down a bit. Smaller deals are more likely to happen. With bigger assets, we’ll just have to wait and see.”

He’s optimistic that the Government is on the right track but, once the country gets through the lockdown, it will all be about how to safely navigate the recovery.

Investors should take a view on what the recovery might look like and think about what the best thing they can do for the future of their investment and portfolio is, Lauchlan adds. “In the past, savvy investors have navigated through recessions and have invested for when the upturn will be. There are plenty of investors out there who have the liquidity to do that if they want.”