Commercial property finance in troubled times

In an earlier article  we discussed issues for lenders in the Construction Development Sector, including for residential construction projects. In this article we turn our attention to Commercial Property where there is a completed project that is subject to tenancies.

Some of the issues raised in our article on the Construction Development Sector have application to commercial property, including the fact that lenders have moved quickly to reassure borrowers, large and small, that they will be supportive of their customers. In the case of corporate and commercial borrowers that support is likely to take the form of:

• restructuring of facilities
• amendment to existing facility terms
• forbearance, and
• waivers (conditional or unconditional).

This article assumes that there is in place a committed existing bilateral facility agreement.

What to do?

The starting point, as ever, is a review of the facility agreement and related security package. Typically, the security package will include:

• a property mortgage(s)
• a general security agreement (GSA), and
• possibly guarantees either from directors or perhaps a parent company.

So what should you focus on in your review? Consider the following:

Covenant breaches    

A typical commercial property facility is likely to incorporate, in addition to general corporate status style covenants, one or more of the following:

• a Loan to Value Ratio (LVR)
• an Interest Cover Ratio (ICR), and/or
• a Debt Service Cover Ratio (DSCR).

Covenant testing

• To test the LVR under current market circumstances, you will need to get an updated valuation. It is possible that there will be push back from valuers on the basis that in such unusual times about “what constitutes market?”. Nevertheless, some indication of both valuation ‘as is’ as well as ‘on completion’ will give the lender guidance on where the market may be.
• Testing of DSCR and/or ICR ought to be more straight forward, given that the elements of the covenant (EBIT/EBITDA, Interest Expense and Total Finance Costs—or some variant of those) are a matter of fact. Generally, a facility agreement will permit you as lender to call for a director’s certificate confirming compliance on a quarterly or half yearly basis or perhaps, in the event of a material adverse change, on demand.

If the covenant testing discloses a breach, then there are a number of options:

• Check the cure regime under the facility agreement, both as to timing and the right of the borrower to undertake an equity and/or security top up.
• Agree to forbear/reserve rights regarding the breaches, subject to the borrower’s compliance by a certain date.
• Waive the breach, possibly subject to conditions such as an equity injection by the borrower or security top up.
• Re-set the covenant.
• Issue a default notice and impose the default rate of interest.

Events of default

A breach of any of the obligations referred to above will (subject to any cure period) constitute an event of default. In addition, there will typically be some or all of the following:

• Cessation of business
• Subject to our comments below relating to the Mandatory Code of Conduct – SME Commercial Leasing Principles during COVID-19:
  • tenant default
  • amendments to the [material] terms of an existing [material] lease (without lender consent), and/or
  • waivers of a [material] term of an existing [material] lease (without lender consent).

Mandatory Code of Conduct (the Code) – SME Commercial Leasing Principles during COVID-19 (Leasing Principles)

The primary source of revenue for a commercial property borrower is the rent paid by tenant(s) under their leases of the security property. As a result of action by the Commonwealth Government in concert with the State and Territory governments, certain commercial, retail and industrial tenants will (once legislated at State level) be entitled to significant relief under their leases.

Our real estate colleagues have produced a most helpful table analysing, from both a landlord and a tenant perspective the impact of the Code of Conduct – SME Commercial Leasing for all parties. It is fair to say it has a very material impact on commercial, retail and industrial tenancies with two key threshold tests for its application, namely:

• Has the tenant’s business had a reduction in revenue of at least 30% for not less than one month compared to the same period in the previous year?, and
• Does the tenant have a turnover of not more than $50 million?

Here is the link to a very helpful table that sets out the Leasing Principles and the consequences of each such principle for Landlords and Tenants alike.

Two significant Principles to Landlords and their financiers are:

• Landlords must offer qualifying Tenants (see the threshold tests above) ‘proportionate reductions’ in rent payable in the form of waivers and deferrals of up to 100% of the rent ordinarily payable, based on the reduction in the Tenant’s trade during the COVID-19 pandemic period and a subsequent recovery period.
• A Landlord should seek to share any benefit it receives due to deferral of loan payments, provided by a financial institution as part of the Australian Bankers Association COVID-19 response (or any other case by case deferral of loan repayments offered to other Landlords) with the Tenant in a proportionate manner.

The impact of these Principles and the major downturn in sectors, such as retail, would suggest that lenders should undertake comprehensive lease audits of their commercial property clients.

No doubt, as part of the initial due diligence process for the establishment of loans, lease reviews were undertaken. Depending on how recent those reviews are, they may need updating. Any updating will need to take account of the Leasing Principles—where they apply. 

Borrowers will also need to ensure that they obtain lender consent to any material amendments or waivers of their lease terms, where required under their facility agreement. As mentioned above, some such amendments and waivers to lease agreements may be required by law.

Borrowers that operate a portfolio of properties may have a mix of Tenants, some of whom qualify for relief under the Code and others who don’t. It may be necessary to employ a mix of approaches as a lender when faced with:

• Tenants that have closed their doors and ceased trading
• Tenants that are continuing to trade but with reduced revenue, to whom the Code applies, or
• Tenants that are continuing to trade but with reduced revenue but do not qualify for Code relief.

A comprehensive up-to-date lease audit will provide lenders with a better understanding of the borrower’s cash flow and capacity to meet its commitments to lenders, as well as providing the necessary information for lenders to make informed decisions about whether to provide concessions and relief to borrowers.

These are indeed very challenging times. They call for a considered approach and response taken on the basis of sound advice.