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Debt: The £42 billion problem

publication date: Nov 8, 2009
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42According to the Financial Times (15 May 2009), loans of some £42 billion to the commercial property sector are due for repayment this year, which threatens default for property companies struggling to raise new money and puts further pressure on UK banks to support corporate borrowers. There is a risk of a multi-billion pound funding gap, given indications that many banks will continue to retreat from lending on commercial property in 2009, as the market continues to go through its worst slump on record.

The number of loans in default and breach of covenant has already grown fast, according to the Leicester Business School, De Montfort University survey of the commercial property lending market published at the end of May.


KEEPING YOUR LENDER HAPPY

First and foremost, foster and maintain a good working relationship with your existing bank. Many banks, rather than looking for new business, are looking to reduce their levels of debt and the likelihood is that re-financing with another bank will be difficult, expensive or impossible. Therefore, ensure that you are fully compliant with the terms of your loan/overdraft facilities, be it submitting accounts within the specified timescale, providing the required cashflow projections or maintaining the necessary loan to value ratio and minimum cash level. Also, inform the bank of any anticipated, material non-compliance. If appropriate, consider what (if any) additional security you or a third party can offer the bank. Do not commit to anything requiring additional bank finance without a written undertaking from the bank that the advance will be forthcoming and, if that undertaking is conditional, be sure that you can satisfy the conditions.

Although it is hard to see how banks are going to make up the shortfall (with over two thirds of outstanding debt being due for repayment by 2013), current indications are that we will not be seeing a return to the mass foreclosures seen in the early 1990s. Loan to value ratios of 80+ per cent for much of this decade and commercial property values having all but halved in recent years, many borrowers could be in negative equity. Simple supply and demand economics would appear to indicate that banks will be reluctant to compound the problem by flooding an already depressed commercial property market with more properties provided the interest continues to be paid. Accordingly, consider any need to ask your bank to roll over/extend your loan. But, supply and demand again, be prepared for the bank to seek to re-negotiate its fees, margins above base rate and loan to value ratios, or to demand a switch to margins over LIBOR.


PROPERTY INVESTORS


Be open to your tenants’ requests for relaxation of the strict terms of their leases. For example, a tenant might request a temporary rent reduction or, for cashflow purposes, payment of rent monthly rather than quarterly. Provided you can still service repayment of your loan, in bald terms, less rental income is better than none at all, bearing in mind that your refusal could result in the tenant’s insolvency and empty premises could be, to say the least, difficult to re-let on anything like similar terms. On the plus side, you could conceivably agree to accept payment monthly rather than quarterly in exchange for a modest increase in rent or agreement of an outstanding rent review. As for any new guarantees or rent deposits, although always being in definitive terms, guarantees are not usually affected by a tenant’s insolvency, bear in mind the possibility that a corporate guarantor will often be in the same group as the tenant and also become insolvent. However, any guarantor, corporate or personal, will remain liable for the remainder of the term, even after the lease is disclaimed by a liquidator or trustee-in-bankruptcy of the tenant. Make sure any new rent deposit deed provides for your drawdown of the rent deposit even if the tenant goes into receivership or liquidation. Also make sure it includes either an obligation on your part to repay the deposit at the end of the term or a provision that the deposit remains the tenant’s but is subject to a charge in your favour. That way, the deposit is likely to be a financial collateral arrangement and, as such, exempt from the statutory moratorium if the tenant goes into administration.

Under any leases granted by you before 1 January 1996, the original tenant will remain liable throughout the term, as will any assignees, provided they have covenanted with you to that effect in your licence to assign, so ensure that they do so. Under any leases granted by you on or after 1 January 1996, ensure that any assignor enters into an authorised guarantee agreement whereby it guarantees the assignee’s performance of the tenant covenants and agrees both that it is liable to you as primary obligor and to accept a new lease if the lease is disclaimed.


FORFEITURE

Any lease should provide for your re-entry of the premises and forfeiture of the lease in the event of the rent being in arrears for a certain number of days (whether or not it is formally demanded), the tenant’s breach of covenant or the tenant’s insolvency. Historically, that number of days is often 21. Nowadays, 14 is more common and seven, increasingly so. Ensure it is as low as possible but make sure it is more than the number of days after which interest (generally at four per cent over base rate) is payable on any arrears. Any lease should also provide for interest on arrears.

Ensure the rate is at least four per cent over base though and make sure the number of days after which it becomes payable is seven or less if the forfeiture clause states say 14 and zero if it states seven. However, before exercising a forfeiture clause, consider the marketability or otherwise of the empty premises, the need to repair or redecorate in readiness, any business rate or insurance obligations reverting to you and the cost of recovering and securing the premises. Also consider whether the lease includes a reasonably imminent, mutual break option, which you could take advantage of in order to negate the cost of any forfeiture proceedings.

If a tenant does become insolvent, you can also commence proceedings for any arrears, issue a statutory demand and petition for winding up or bankruptcy, exercise distraint on any goods on the premises, issue a warrant of execution/instruct bailiffs or apply for an attachment of earnings order on any employer. Consider the merits or otherwise of these options on a case-by-case basis. You can also serve rent diversion notices on any sub-tenants. There is some debate as to whether doing so when the tenant is in administration is in breach of the statutory moratorium but it is probably not.

There is also the possibility, where premises continue to be traded from or otherwise used, of persuading the liquidator or administrator to pay ongoing rent as an expense of the liquidation or administration in priority to all other debts. Do bear in mind that your remedies as landlord against an insolvent tenant may vary according to the insolvency procedure in question and so you should seek legal advice, as appropriate.


PROPERTY DEVELOPERS

Make sure that, on your contractor’s insolvency, the contract is determinable at your option rather than terminated automatically to afford you the opportunity to negotiate with the contractor or its insolvency practitioner with a view to completion of the works. Before entering into the contract, check the contractor’s financial position thoroughly. If the contractor is a subsidiary, seek a parent company guarantee. Consider also a performance bond, particularly if there are no other credible group guarantors. For future defects, if possible, obtain collateral warranties from sub-contractors and ensure that these include step-in rights to prevent a sub-contractor terminating for the contractor’s insolvency. However, also consider a latent defects insurance policy.

Also ensure that the contract provides relief from further payment to the contractor with effect from the date of its insolvency without the need for service of a withholding notice. You will be able to use such payment to complete the works. In the event of your contractor’s insolvency, consider retaining the sub-contractors and contracting with them direct with a view to minimising delay and maintaining continuity. It is quite conceivable that the sub-contractors are prepared to do a commercial deal. But ensure that there is an express right of subrogation in the contract or sub-contract enabling you to claim for a sub-contractor’s right to payment from the contractor and, if practicable, that the contractor’s liability to the sub-contractor is assigned to you.

Secure the development against removal of on-site materials by unpaid sub-contractors or other creditors of the contractor. Materials already affixed to the land are your property. As for off-site materials, provision for title to pass to you on payment being of little practical benefit, make sure the contract provides both that the contractor must supply you with reasonable proof of ownership and for their identification as to where they are stored, that they are held to your order and that they are destined for the development. And, ideally, get an off-site materials bond at the outset.


Andrew Hardcastle, Partner, Moorcrofts LLP www.moorcrofts.com