Commercial landlords have emerged bruised and battered by COVID-19. The rent moratorium, CVAs, sudden and/or accelerated store closure plans and a shift from city centre to out-of-town retail have left the sector reeling. And whilst the green shoots of a post-pandemic recovery are emerging, it’s clear the landscape will remain fragile and uncertain for the foreseeable future. For property owners, managing cash will remain a key priority.
Variable rental income
Rental income is likely to become less certain following the pandemic. This has been exacerbated by the UK Government extending a rent moratorium on commercial leases until March 2022. Landlords therefore have less control over removing unwanted tenants and any arrears disagreements, which can’t be resolved through a voluntary agreement, may now have to be settled via a mandatory arbitration process.
A number of recently restructured leases have a range of clauses geared to support tenants, maintain occupancy levels and provide much-needed contributions to upkeep. These include conditional rent-free periods, whereby any future restrictions forcing tenants to close their business trigger the landlord to also take some pain.
We are also seeing turnover linked rental agreements being signed across the sector. This creates a much more variable income stream, and links the financial performance more directly to the business decisions of the tenant into which the landlord has no real influence.
Caps on a tenant’s service charge and capital contributions are also occurring more widely, restricting landlords’ ability to recover income in that way.
Turnover-linked rent agreements pose a number of queries:
- How do landlords mange cash flow income when tenants’ rent is based on unpredictable turnover, especially when many high street businesses were struggling pre-pandemic and where business models have been upended by changing consumer behaviour?
- Over what period should cash flows be modelled given the level of uncertainty?
- How best do landlords forecast over the short, medium, and long term?
- Should more attention be given to tenants’ covenant and performance forecasts?
- What is the mechanism by which turnover is calculated? For example, does it include goods sold via ‘Click & Collect’ or coffee purchased via online app? It can become complex to administer, especially if good faith is lost between the two parties.
Of course, turnover rent agreements work both ways, and if set up in a balanced way can allow landlords to benefit directly from the proceeds of growth.
It can be a balancing act, and if landlords are highly leveraged, understanding the headroom available under a range of economic scenarios will be critical.
Though estimated figures vary, it’s estimated that landlords were down between £5-7bn on rents during 2020. Whilst some of this has since been repaid, it’s likely that billions remain unpaid. With the moratorium extended into 2022, it’s likely that further arrears will continue to build.
In this environment, landlords may be considering the option of selling, either to generate immediate cash or as part of a longer-term strategic pivot.
The pandemic, however, still leaves an array of questions for prospective sellers unanswered:
- What impact has the pandemic had on values?
- How do valuers assess security of income?
Whilst the adoption of yields to reflect risk is reasonable, it is neither the most accurate nor most efficient way to proceed. This is especially true with the growth of restructured leases and turnover rent agreements, where yields become more unpredictable and tied closely to wider economic conditions.
By contrast, demonstrating a robust and suitably sensitised cash flow might show the ‘real’ financial performance of any given site more explicitly. In so doing, cash might prove a more reliable illustration of potential performance to prospective purchasers.
Sensitivity analysis is also important to establish pinch points in the event of unexpected consequences. Knowing the timing and quantum of potential cash shortages enables businesses to make good decisions ahead of time. If loan covenants are at risk of being breached, a prudent cash flow forecast may provide comfort to lenders that the business is across its key risk areas.
Even in the event where secured creditors need debt to be refinanced, any new lender will certainly want to see an accurate business plan with a detailed cash flow.
The real estate sector is entering a new era, where dependable fixed incomes become steadily replaced by innovative and more commercially-driven business strategies.
Landlord cash flows are likely to become more complex, more dynamic and more unpredictable than we’ve witnessed in recent history. In this environment, getting a really firm understanding of how cash impacts on landlord financial performance, liquidity and covenant requirements has never been more important.
If landlords know, with a reasonable degree of accuracy, the level of free cash, they can plan for the future and overcome challenges and pinch points before they occur.
Although the transition may be painful now, over the long-term really understanding the movement of cash through the business could have a hugely positive impact on landlords that can adapt effectively.
At Interpath we’re already supporting landlords adapt to the post-COVID landscape, through our market-leading cash and liquidity management service lines. If you’re interested in finding out more about how we can assist, please contact us.