Time for a Property Portfolio Health Check?
Introduction
The COVID-19 pandemic has had a devastating impact on global, national and local economies as well as a significant impact on the health of our communities.
Certain economists are forecasting an economic crisis that rivals the Great Depression. Everyone hopes that these forecasts are proved to be incorrect and the recent rebound of stock markets around the world have been encouraging. However, without doubt, the next couple of years are going to be incredibly challenging and the risk profiles for property investments are likely to be more complex which will affect property prices, market rent, yields, capital gains and losses.
Prudent property investors will be reviewing their current property portfolio to assess their commercial, economic and legal risks, in particular, the extent to which these risks have been, or could be, mitigated.
Issues to be Considered
Property investments should be subjected to a full "health check" to determine, amongst other things, the following:
- What is the investor's likely recourse in the event that a tenant defaults under its lease? For example, what is the financial substance of the tenant and what is the scope and strength of any third-party guarantee? For example, a bank guarantee is likely to be more effective security than a personal guarantee from an individual with no unsecured assets.
- What is the potential liability of the investor under its financing arrangements and/or commercial agreements (e.g. building contract)? Can the investor fulfil its obligations in the event that a tenant defaults under an agreement to lease or deed of lease?
- Does the investor's insurance policy cover loss of rent? Generally, losses that result from pandemics are carved out from landlord insurance policies, however, certain policies (e.g. insurance provided by Crombie Lockwood underwritten by Lloyds) do compensate landlords for loss of rent due to COVID-19.
- Have unencumbered properties owned directly or indirectly by the investor been ring-fenced so that they are safe-guarded from potential claims by creditors?
- What is the scope of any personal guarantees provided by the investor and any cross guarantees provided by related parties?
- Have the property investments been structured in a tax efficient manner which minimises the potential tax payable by the investor and allows the investor to fully and effectively utilise any losses that the investor may suffer as a result of COVID-19?
- What potential relief (if any) is available through government initiatives (e.g. deferral of tax payment dates by Inland Revenue)?
- What is the ownership structure in respect of the property portfolio? Are the properties owned under a joint ownership structure and, if so, what are the respective rights and obligations of the co-investors with regard to funding obligations and exit options?
Once a property investor (or its adviser) has carried out such a health check on its portfolio, the investor will have greater clarity with regard to its options and leverage when negotiating with co‑investors, tenants, financiers, insurance companies, Inland Revenue and commercial partners
Lease Arrangements
Many landlords will have received claims by tenants that they are entitled to cease to pay a proportion of rent and outgoings under their lease due to not having access to their premises as a result of the government imposed COVID-19 lockdown. Whether the tenant has a contractual right to such relief (and the magnitude of such relief) depends on a number of factors and the individual circumstances of the landlord and tenant. However, in many cases, this has caused cash-flow issues for landlords.
Upon the end of COVID-19 Alert Level 4, many tenants will not have the cash flows to be able to pay the standard amount of rent and outgoings (due to the damage to their businesses caused by COVID-19).
Landlords should be requesting details of the current financial status of tenants and their guarantors so that they can assess the risk of default and the likelihood of the tenant's business recovering. The landlord should be prepared to take early action, if appropriate, to minimise its loss should a tenant become insolvent and/or be unable to pay rent when due.
Generally, under a deed of lease and section 245 of the Property Law Act 2007 (PLA), a lessor shall be entitled to cancel the relevant lease due to a tenant's continued failure to pay rent.
We would encourage a landlord to obtain legal advice before serving a cancellation notice under the PLA because, if the form of the notice and/or the service of the notice fails to comply with the Act, the notice is likely to be deemed to be invalid. If a landlord re-enters premises for non-compliance with an invalid PLA notice, the tenant could claim wrongful termination of the lease and the landlord may be liable for the tenant's losses that arise from a wrongful termination
It should also be noted that the government has recently announced its intention to extend the minimum notice period that a landlord must give a tenant to remedy a failure to pay rent (from 10 working days to 30 working days).
In the event that a tenant defaults, the landlord will obviously need to make a commercial decision with regard to the risk of cancelling the lease and being unable to re-let the premises compared to the risk of giving the tenant rent relief and the tenant failing to trade out of its adverse financial situation (which could result in a larger loss for the landlord).
Financial Arrangements
Many landlords will have their own cash flow issues to consider if tenants are entitled to rent relief and/or are not able to pay rent and outgoings.
It is worthwhile communicating early with banks to pre-empt potential defaults as banks generally do not react well to negative surprises and are more inclined to discuss mortgage holidays and the restructuring of loan arrangements if the situation is not terminal and there is a reasonable likelihood of the existing debt being serviced and repaid (albeit over an extended period).
The Reserve Bank is proposing to relax loan to value ratio restrictions on retail banks which, when implemented, will help banks to continue to lend and to support customers through mortgage payment deferrals
Ownership of Properties
There are a number of different entities through which New Zealanders own property and the most appropriate entity will depend on the relevant investor's specific circumstances.
There is a real risk that certain property investments may generate losses over the next couple of years due to COVID-19.
Different ownership structures will give different flexibility with regard to utilising these losses across investments and across related parties.
For example, a company's tax losses are generally held at the level of the company and cannot be passed to its individual shareholders unless all shareholders elect for the company to be a look through company (in which case profits are taxed at the owners' respective marginal tax rates and generally losses may be offset against other income of the shareholders (subject to a loss limitation rule)).
It is important for property investors to obtain advice from a tax specialist with regard to the most tax efficient ownership structure for the investor's specific circumstances.
Co-Ownership Structures
Where a property investor is a co-owner through a company, joint venture, partnership structure or syndication, an investor needs to be familiar with its rights and obligations under the ownership documents (e.g. joint venture agreement, partnership deed, shareholders agreement and investment agreement).
The most important provisions, in the current economic climate, will be the parties' ongoing funding obligations (in the event that the joint venture, partnership or company requires additional funds for capital expenditure or operating expenses), the parties' exit rights and the dispute resolution provision.
An investor should assess the relative liquidity of its property investment(s) (i.e. the ease of disposing of its interest). The constitutional documents of a company or partnership should set out the process through which an investor may sell its interests to a co-investor or third party.
Most constitutional documents will include standard pre-emption rights where existing co-investors will have the first option to buy the outgoing investor's interest before such interest can be offered to any other person or entity.
Certain shareholders agreements and partnership deeds may include put and/or call options under which a party may have the right to make another party buy or sell an interest in the company or partnership at a prescribed price or a price calculated in accordance with a specific formula. Other transfer provisions may apply in the event that a co-investor becomes insolvent or goes into liquidation.
Once an investor is fully aware of its rights and obligations in relation to its co-investments, it can devise an appropriate strategy for holding, disposing or increasing its investment in the relevant property (or property portfolio).
Property Investment Agreements
Certain investors may have executed sale and purchase agreements, subscription agreements or deeds of participation with regard to a property investment that has not settled due to COVID-19.
Now is the time to review the relevant documents to confirm the investor's rights.
The investor may have a right to avoid the transaction and/or an opportunity to renegotiate the terms of the deal. Potential rights to terminate an agreement may arise if, amongst other things:
- the conditions precedent have not been satisfied;
- the agreement includes a provision which allows a party to terminate if there is a force majeure event or a material adverse change in economy; and/or
- the warranties and representations in the agreement are not true and accurate.
Legal Assistance
The writer was working in Dubai at the time of the Global Financial Crisis when the market value of properties literally halved overnight and a number of property owners were jailed for failing to repay mortgages (under archaic security laws). He advised a number of property investors as well as financial institutions and the largest trading group in the United Arab Emirates on their ownership, governance, contractual and legal position as well as their options for navigating through a complex legal system and insolvency regime.
Please contact Barton Hoggard (bartonh@simpsonwestern.co.nz) or any one of our other property specialists if you would like to discuss how Simpson Western can assist you with carrying out due diligence in respect of your property arrangements and advising you on how to preserve your assets and mitigate your risks whilst navigating through the COVID-19 crisis.
