COVID-19 – crunch time for leasehold serviced apartment operators

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Scott Keown of JW Solicitors looks at some of the main issues operators and landlords are facing as the coronavirus outbreak makes property lease agreements extremely difficult to honour.

The UK serviced apartment sector has experienced strong growth in recent years, even despite the rise of Airbnb-style competitors, but the unfolding COVID-19 crisis has plunged virtually all operators into a nightmarish scenario of extreme uncertainty and in many cases even existential threat.

The sector is characterised by a diverse mix of business models ranging from PE-backed owner/operator models, high profile brands running property-light management or franchise agreement operating models, through to those operators on more traditional commercial lease agreements with third-party landlords. Regardless of the operating model, everyone is hurting right now – a sharp decline in new bookings and an onslaught of cancellations has seen overall demand plummet to unsustainable levels. While all operators are affected, in our experience it is those operating on traditional commercial lease agreements who are most exposed to the current COVID-19-induced crisis.

As the impact of COVID-19 on the UK economy becomes clear, operators and landlords alike are keen to understand what steps they can take, whether unilaterally or in cooperation with other stakeholders, to help them weather the unfolding storm. Each case must, of course, be considered on its own merits, and specific legal advice must be taken on a case-by-case basis, but we see the following key points arising repeatedly in the case of operators on traditional commercial lease agreements:

Frustration – many landlords and operators are asking about the doctrine of frustration. In the present context, this is where an operator-tenant would argue that the lease is “frustrated” by an event rendering it physically or commercially impossible to fulfil the terms of the lease or where the obligations have been made radically different by the frustrating event and radically different from that contemplated at the time of the lease. This doctrine has always been construed narrowly and the Supreme Court in the 2019 Canary Wharf v European Medicines Agency (“the EMA”) case held that neither the UK’s departure from the EU nor the EMA’s head office move were frustrating events. As the effect of frustration would be to end the lease entirely (and so end the operator’s own rights and obligations under it), even if the particular circumstances of the case meant that frustration could be successfully argued, it might not be an appropriate remedy for many operators. Many operators will simply have temporary cash flow difficulties, and will therefore be looking for a temporary relaxation of payment obligations, as opposed to a complete end to the lease. Operators looking for a temporary relaxation of payment obligations may be well advised to explore a company voluntary arrangement instead but this would of course impact on the landlord’s investment values and so would be resisted where possible.

Force majeure – the contractual principle of force majeure is being talked about a lot, which in the present context is where one or both parties might not have to perform the lease obligations due to the occurrence of certain events outside of the control of one or both parties. This might be argued to include the COVID-19 virus response. The party in question would not be liable for its failure to perform its obligations, such as payment of rent for example. The difficulty for an operator is that commercial leases rarely include such a provision and so this will not be available and in the absence of such provisions, an operator cannot argue for it.

Compliance with legislation – an operator is usually required by its lease to comply with all legislation passed which concerns the use and occupation of the premises. If the COVID-19 virus response was for a complete “shut down” of the premises and this was, as it would need to be enforceable, passed into law, then the operators would not be able to use the premises at all, but this would not of itself entitle the operator to stop complying with its payment obligations in the lease, although it might provide a basis for commercial negotiations with the landlord, who will need to consider carefully its response to what may be seen to be quite a unique situation.

Insurance – the landlord will usually have insured the premises for what are defined as “insured risks” and the landlord is given wide discretion in what to insure over and above the usual risks. A quick review of the policy coverage, whether acting for either party, will likely show that all risks covered entitling withholding of rent will be limited to those situations where the premises are rendered unusable as a result of physical damage or destruction. Further, apart from the ability of an operator to avoid paying rent under such a rent suspension clause, the general rent payment clause will prevent any withholding of rent for any reason, even if the operator had its own claim to make again the landlord for any reason. A check of the operator’s own business interruption insurance cover, if acting for them, should also be undertaken to see if there is anything in that policy which might be of help, depending on the particular circumstances in which its own insurer might pay rent.

Alienation provisions – in the EMA case the court noted that the EMA was able and had agreed to assign the unexpired remaining term in its lease to a third party as a way to avoid ongoing liability to its landlord. The alienation provisions of the lease should be carefully scrutinised in the context of the operator’s appetite or operational feasibility of giving up the whole or only part of the leased premises and whether, for example, it might wish to assign the lease or share occupation with a third party for a short period of time and thereby share its payment liabilities and whether a landlord would be able to let any part of the premises to a different operator entirely and on better terms.

Rent review provisions – if a rent review is pending or in ongoing negotiation, the operator could seek to agree a rent holiday or reduction for a certain period along with a corresponding agreement as to how and in what circumstances it might be terminated and perhaps with an agreement in relation to the future treatment of rent review provisions. For example, in exchange for a temporary relaxation of its leasehold payment obligations, an operator and a landlord may pre-agree a fixed uplift of rent on a future date, by which time the effects of COVID-19 may hopefully have passed.

Break clauses – if there is tenant break clause available then its terms should be scrutinised carefully. Often where an operator does not exercise a break clause it will be entitled to a corresponding reduced rent (or rent free) period in which case it may be possible to renegotiate the break date and/or the reduced rent period with a view to bringing forward the benefit of the reduced rent period so that it can be enjoyed now during the current crisis. Alternatively, a landlord may be persuaded to agree a temporary relaxation on lease costs in exchange for the operator agreeing to “drop” or reset a future break date, or to extend the remaining lease term if it is quite short. There are a number of ways in which an existing break clause could be restructured via negotiation between landlord and operator in ways that could be mutually beneficial in the longer term, particularly if doing so might improve the chances of there still being a solvent and rent-paying operator once the immediate COVID-19 crisis had passed.

Rent Deposits – in some cases operators will have paid a “rent deposit”, being funds paid by the operator and held by the landlord as security for performance by the operator of its obligations in the lease. The quantum of these rent deposits can often be in the region of six months’ rent plus VAT (and sometimes even more). We are working with some landlords and tenants who are together looking at ways to “unlock” these funds to help the parties through the immediate COVID-19 cash flow crisis. In unprecedented times like these, landlords and operators alike are willing to consider relatively extreme measures like these.

We are working with our clients and their other advisors such as accountants and surveyors to negotiate sensible solutions to the challenges posed by COVID-19. Ideally, negotiations are conducted without prejudice to the lease’s existing terms and, depending on the parties’ wishes, would either be formally concluded by a deed of variation to the lease or a less formal “side letter” setting out the temporary or permanent solution agreed. Landlords may prefer to deal with these solutions by way of side letter as those are often expressed to be personal to the parties and would not be subject to registration at the Land Registry, and could therefore be more easily kept confidential between the landlord and the particular operator involved. An operator should expect to be asked to provide financial information evidencing how the COVID-19 crisis is adversely affecting its business, including bookings and cancellations data, and its proposals to the landlord in terms of lease payment restructuring should be aimed at addressing those adverse effects. This could include the effect on its turnover, ability to run the business if staff and suppliers are not present or able to travel to work and whether, and to what extent, it would be able to make other savings across the business for example in relation to taking advantage of support/loans offered by central and local government (including relaxation of business rates) or reduction in staff numbers or management costs.

We encourage landlords and operators alike to engage early in focused and constructive dialogue exploring solutions designed to achieve the best possible outcomes for key stakeholders, not just for their own good but for the good of the serviced accommodation sector as a whole.

Scott Keown is a partner in the Real Estate Commercial team at JMW Solicitors, with more than 15 years’ experience transacting in the commercial property sector in the UK and Australia.  He delivers investment transactions for private and institutional participants alongside a range of asset management, development, funding, tenant representation and M&A deals.

 

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