Slowly but surely, Covid-19 is changing the shape of the real estate sector across Europe. As transactions incorporate terms made necessary by the immediate crisis, we are on the cusp of seeing risks rebalanced for the longer term.
Underlying the shift are two fundamentals, both present to some degree or other in real estate transactions across Europe.
Force majeure
The first is the law on force majeure – the concept that an event outside a party’s reasonable control can be expected to affect (maybe even release) pre-agreed contractual arrangements. Many European jurisdictions have codified some version of this, creating contracting environments that understand the principle of release in extraordinary circumstances. Nonetheless, while they often provide a helpful backdrop, helping to bring counterparties to the table for (re)negotiation, force majeure events are generally strictly interpreted. Additionally, parties are often able to amend or contract out civil code provisions altogether. For example, the Austrian Civil Code provides for rent reduction in the event of an epidemic, but there is no confirmatory case law. In the Ukraine, the quarantine restrictions are defined by regulation as a force majeure event, but parties must justify each instance of default by respective certificate.
In Germany the term force majeure is not uniformly defined and therefore remains subject to interpretation by the courts. In the absence of statutory regulation, a force majeure event only results in concrete legal consequences when the relevant agreement contains an effective force majeure clause. Where it does, there are basically two scenarios: either the contract is automatically terminated or the obligations are suspended for a certain period of time and reinstated after the end of the event.
There is, meanwhile, no implied statutory concept of force majeure in England and Wales. Depending on industry convention and bargaining power, parties must draft expressly to include it in a contract, and in a real estate context this is extremely rare.
Our limited common law construct of frustration – which serves to terminate a contract at the point of a frustrating, faultless event – has little applicability in the real estate sphere; we’ve long known that it is virtually impossible to apply the doctrine to leases or land contracts. Even Brexit wasn’t sufficiently frustrating for the European Medicines Agency to extricate itself from its rental obligations to landlord Canary Wharf Group last year: Canary Wharf (BP4) T1 Ltd v European Medicines Agency [2019] EWHC 335 (Ch); [2019] EGLR 17.
The balance of risk
This leads to the second fundamental – the traditional balance of risk in commercial real estate. In a sale and purchase contract, risk generally passes on exchange, notwithstanding the difficulty a buyer often faces in walking away from a fundamentally changed deal. Standard commercial leases are meanwhile structured as tried-and-tested investment vehicles. Full repairing and insuring (FRI) leases are well-established in England and Wales, and equivalents exist across many other European jurisdictions. They seek to provide landlords with a clear income stream akin to equity returns, in the form of (usually) quarterly rental payments collected on top of the running costs involved in owning, managing and insuring the property itself.
A laissez-faire approach
When the pandemic hit, many European governments responded by calling for a controlled halt on lease enforcement. The British government enacted a moratorium on the use of forfeiture when rent was not paid and equivalent bans found their way into law across Europe. In Germany, a law enacted in March excluded the landlord‘s right to terminate a lease if a tenant failed to pay the rent for the period between April to June 2020 due to the pandemic. Here, the obligation to pay rent and service charges remained, but was deferred for a maximum of two years.
However, there is little agreement when it comes to how long this approach should last. The German legislator did not see the necessity to extend this protection against termination beyond June 2020. By contrast, the moratorium was recently extended in England and Wales to take in the next quarter, but even those tenants taking grateful advantage of the respite wondered what would happen next as the debts mounted.
The British and German governments’ approach to this conundrum is to preserve the sanctity of contract, asking, politely, that parties “work together to protect viable businesses”. The UK Treasury’s advice has now been bolstered with a new Code of Practice that stresses this, leaving landlords and tenants to pick up (a) the phone, and (b) the pieces in court, if they can’t find an amicable solution while rental liabilities stack up. Likewise, in Germany the leading associations of retailers and investors developed a code of conduct for rental issues caused by Covid-19. In a bid to bring about an appropriate distribution of risk, it suggests a rent reduction of 50% for the closure period and a lower value for the following three months. Currently, many legal commentators and lawyers rely on the concept of “loss of the business basis”, ie that the rent should be adjusted on the grounds that the basis of the lease had ceased to exist.
The seemingly laissez-faire approach from the authorities is not necessarily a bad one. Real estate is necessarily built on relationships, and these hold the key to survival in the symbiotic world of landlord and tenant, even buyer and seller. It is in everyone’s interests to prevent huge rental debts accumulating and keep businesses alive into the longer term. Moreover, this approach is leading, on a micro-scale at least, to some creative risk rebalancing that might just, if it takes off, see the sector flourish in the brave new post-pandemic world.
Covid clauses
At the start, with a lockdown followed fast by the industry-standard rental payment date (the March quarter date), landlords across Europe were minded to offer concessions to the way rent was paid or collected. Preferring the certainty such an agreement could offer, in England and Wales many quarterly bills became monthly liabilities to ease cashflows, or were postponed altogether, to be picked up later in the year on specific dates. In Germany, many landlords made significant concessions to their tenants during the second quarter of 2020 to help them survive the crisis; and it looks as if they are inclined to continue during the third quarter.
Now, despite being embroiled in the current crisis, the real estate sector is turning its attention to the threats of the future. Of course, many spotted early opportunities for quid pro quo arrangements. Lease term extensions have been negotiated in return for immediate payment concessions, for example. With the benefit of breathing space, the industry is becoming more alive to the concept of more impressive “Covid clauses”, and the impact on that traditional risk balance is huge. It might be too early still to identify market-standard drafting, but it does seem that the sharper edges of risk allocation are starting to blur.
Unsurprisingly, for contracts for the sale and purchase of property (as well as agreements for lease with development obligations), Covid clauses generally amount to variations on a theme of force majeure, as parties consider the triggers and extent by which a contract can be delayed or even set aside as a result of a pandemic affecting completion. These clauses adopt features common to other commercial force majeure clauses, such as notification and mitigation requirements, and/or evidential hurdles.
The picture is more complicated in a letting environment. Parties in vulnerable sectors such as retail are asking for extraordinary rental concessions to be repeated if, or when, the next pandemic crisis emerges. These Covid clauses might be time-limited, or require insurance options or government support packages to be exhausted, but it doesn’t necessarily matter where that crisis is, when business continuity depends on global supply chains.
Across Europe, the risk-sharing principle is gaining traction, particularly in sectors where businesses depend on footfall and are particularly vulnerable to lockdown. In England, Wales and Germany, turnover rents seem to be making a cautionary comeback. Calculating whole turnover in a bricks-and-mortar environment can be problematic now online sales have taken hold, but it is beholden on the retail and F&B/leisure sectors to get creative. Similarly, tenants are looking for increasing flexibility on sharing space.
Of course, not all sectors have been affected to the same degree, but landlords with large investment portfolios might well spot opportunities to trade Covid clause concessions for amendments to existing letting arrangements that support their seemingly unconnected property management ambitions.
With growing industry concern about environmental, social and corporate governance, for example, landlords might bolster their sustainability benchmarking by inserting new leasing reservations, or future-proofing existing alterations covenants to deal with changing requirements on energy efficiency standards.
The Covid clauses incorporated today look set to have a massive impact across Europe on real estate in the long term, in particular on the world of leases. The timing could be right, as the sector looks to drift towards new models of letting, with shorter terms and increased services provision by landlords. Indeed, landlords and tenants increasingly adopt a lexicon of collaboration when it comes to building occupancy and, at the heart of these new partnerships, is an understanding how risks could be managed together, to enable longevity for all. One way or another, it looks like the effects of Covid-19 are here to stay.
Dr Alexander Peinze and Lauren Fendick are partners in Taylor Wessing, based in Germany and the UK respectively
