COVID-19 (Coronavirus) continues to have an impact on our daily lives and on businesses globally and locally - and it seems every day brings new challenges and highlights new issues.
In our first alert in this COVID-19 series we examined the consequences of COVID-19 on Australian borrowers generally.
In the second alert in this COVID-19 series we examined the consequences of COVID-19 on infrastructure and energy project financing.
In this third alert we turn our focus to Australian real estate and the impact COVID-19 is likely to have on property financing in Australia. Most (if not all) of the issues previously discussed are equally applicable to real estate financings. However, there are some specific issues that arise in these types of arrangements which borrowers and lenders should be especially aware of.
NEED TO KNOW
- The eviction moratoria will have ups and downs, with tenants seeing a cash-flow benefit, but at the cost of landlords and their financiers.
- Construction of new projects has seen some disturbance as a result of supply chain issues, which may impact timetables and budgets in construction facilities.
- Updates to valuations for purposes of existing debt covenant compliance is likely to be met with significant uncertainty - this might see a need for amendments/waivers of covenants.
- Additional liquidity might be difficult to generate for those outside the top of the credit spectrum, but more flexible private credit lenders and possibly also "in one line" sales of development stock to private investors remain clear options.
Some sectors of the property market have been affected by COVID-19 more than others - and lenders and borrowers dealing with assets in these particular sectors may suffer greater ramifications as a result. For example, property assets with an exposure to discretionary retail, tourism, hospitality and fitness business are likely to be impacted more than assets with an exposure to non-discretionary retail and medical assets. With an increase in the use of e-commerce, industrial assets with a focus on warehousing and logistics may also be sheltered from some of the impact of COVID-19 as online shopping continues to maintain demand.
More generally, business may look to decrease fixed costs - and with the majority of the workforce working remotely, reducing office space is a way to do this. This may lead to a short term reduction in demand for office space, and potentially on a more long term basis as business embrace the use of remote working on a more permanent basis.
Businesses are facing increasingly tough conditions as governments respond to the COVID-19 threat by imposing restrictions on the general population's movements. We have already seen various businesses close their shop fronts (voluntarily, or as a result of insolvency) and many are unable to pay rent. Borrowers who rely on tenants' rent to service their debt will face the loss of this income stream - and this will almost certainly have a flow on effect in their financing arrangements, for example breaching covenants in their loan documents which require a level of rental income and ultimately being unable to meet their scheduled interest and principal payments to their lenders.
Recent government announcements such as the proposal for a six month moratorium on tenant evictions may also have an effect on borrowers who will find themselves without an income stream, but are in a position where they cannot replace a tenant.
For more information on this, view our recent alert, where we have answered some frequently asked questions in relation to landlord and tenant rights, responsibilities and obligations in the current COVID-19 pandemic.
COVID-19 is having an impact on the various worldwide supply chains, and this will likely have a flow on effect on the construction industry as materials become harder to source or there are delays in delivery. COVID-19's impact on the construction workforce also cannot be ignored - as workers fall ill or otherwise self-isolate, or if government intervention makes working on construction sites impossible, there will be a smaller number of workers to do the work required. Factors such as these will have a flow on effect to time lines for completion of construction and will also result in increasing costs.
Construction financing arrangements often contain sunset dates by which construction is to be completed, and any delays in completion could lead to review events or events of default in the absence of consent from lenders. Financings also often require certification as to costs to complete, or contain obligations as to cost overruns (including requiring additional equity) - each of which will need to be considered as the effects of COVID-19 make their way through the economy and the construction industry in particular.
Builder insolvencies will also have an impact on construction financings as some borrowers may find themselves without a builder. A focus on the terms of builder tripartites will invariably follow.
Residential real estate financings often rely on pre-sales - either as a hurdle to drawdown or otherwise as an ongoing obligation. In the current climate, in addition to finalising new pre-sales becoming more difficult, we may see an increase in pre-sale contracts being rescinded or otherwise falling over due to the impact of COVID-19 on purchasers. Borrowers may face the situation where they are unable to draw on facilities as they are unable to evidence the relevant level of pre-sales or find themselves in breach of their undertakings.
Where low pre-sales levels make debt financing very difficult to secure, we also expect to see increased appetite from private equity investors to acquire "in one line" development stock from residential developers, providing them with much needed liquidity.
Another consideration for borrowers and lenders is the valuation of property assets being financed, especially as financial ratios are often tied to the relevant asset's value. There is an obvious concern as to the impact of COVID-19 on the value of all types of property. Lenders often have a right to ask for updated valuations in circumstances where they think the value of the property the subject of the financing may have fallen. Financing arrangements may also contain covenants tied to the value of the particular property. Should the value of the property in question have fallen, then this could result in the right of a financier to review a particular facility or a borrower may find itself in default of its loan-to-value ratio.
Practically, there may be difficulties in obtaining valuations as site inspections are more difficult to complete where restrictions have been placed on people's movements for non-essential matters and because the slowdown in transactions may make it difficult to assess comparable sales. In addition, the Australian Property Institute has also released a new valuation protocol to deal with significant valuation uncertainty (including clauses specifically dealing with uncertainty limitations in relation to COVID-19).
GENERAL FINANCE CONSIDERATIONS
Borrowers should be actively reviewing the terms of their existing financing arrangements as there will be a number of restrictions or other obligations which may be relevant in light of the effects of COVID-19. For example, a borrower may not able to enter into, terminate, vary or waive obligations under leases without the consent of their lender. These restrictions may also extend to sale contracts and construction contracts. If a tenant seeks a rent concessions, a builder asks for an extension of time or a purchaser request a variation to payment terms, the borrower may need to approach its lender in the first instance before agreeing to any of those requests.
A borrower may also be required under the terms of its facility agreement to exercise its rights against a counterparty in circumstances where it may not wish to, or may not be in its best interests to, do so. An open dialogue with its lender will be important in these circumstances.
Other provisions that borrowers should pay attention to include cessation of business and change of use provisions. As businesses pivot to meet COVID-19 challenges by (for example) repurposing hotels as hospitals or quarantine centres, care should be taken that such provisions are not triggered by their actions. Borrowers will need to renew their focus on monitoring ongoing compliance, especially as representations repeat on a regular basis and many of the above issues could have an impact on ongoing drawdowns.
Lenders will obviously need to be aware of all of the above issues when reviewing their portfolio of property financings. Given the likelihood of the breadth of the impact of COVID-19, a pragmatic approach will need to be taken when considering defaults, review events and other implications (such as pricing reviews and market disruption).
We expect that bank-led financing will continue to be selectively available from the Banks to tier one Australian REITS and other real estate borrowers at the top end of the credit spectrum. Others are likely to face a tighter lending environment for a significant period.
For borrowers who are unable to access bank-led financing, the Private Credit markets, and in particular the private debt funds, remain open and many have plenty of committed capital to deploy. Private Credit may provide a short/medium term solution for real estate borrower in Australia and can be repaid or refinanced when markets and economic activity reverts to the mean. While Private Credit is typically not cheap, it is better than running out of cash - provided that you do not commit to "non-call" periods or other tough restrictions on early repayment, Private Credit money is a flexible solution that can be replaced promptly once the crisis has abated.