As the pandemic continues, certain sectors of commercial real estate have been impacted, particularly the office, hospitality and retail sectors.
Pressure is being felt especially by Canada’s brick and mortar retail and hospitality industries as some businesses are struggling to maintain healthy balance sheets, and all indicators suggest that the commercial real estate market will face more challenges in 2021. As market pressures mount, dealmaking opportunities are emerging. In this article, we explore important considerations that landlords and lenders, owners/occupiers and purchasers should keep in mind as they engage in distressed and other opportunistic commercial real estate transactions in the coming months.
To date, the Canadian commercial real estate market has not witnessed a wave of bankruptcies or insolvencies as a result of the COVID-19 pandemic, although some warning signs are emerging that we will continue to monitor. In the United States, there has been a host of bankruptcies by large retailers, such as Neiman Marcus, Brooks Brothers and Muji, among others, leaving empty lease spaces that landlords must repurpose for other uses. It remains to be seen whether these types of large-scale insolvencies will impact the Canadian real estate market.
Insolvency proceedings present several opportunities. A company whose real estate is overleveraged cannot sell a property, at least without the consent of the lender.
For those tenants who are surviving, landlords are working with them to offer concessions, such as rent abatement or reduced rent payments determined as a percentage of sales, if any. Other major issues faced by landlords include lease terminations on grounds of force majeure and renegotiations of co-tenancy agreements. In addition, tenants have had access to government rent-support programs which have provided some relief.
In contrast, in the residential real estate market, major Canadian cities have broadly fared well, though smaller markets are equally beginning to witness mounting pressures, especially with regard to maximum loan-to-value (LTV) analyses which lenders are undertaking as property owners seek to finance new, or re-finance existing, properties.
The short and long-term prospects for office properties remains unknown at this time and will only play out as the length of the pandemic becomes determined, office workers feel safe (or are mandated) to return to work and the extent to which the “work from home” trend continues following the crisis.
Seeking relief from mounting market pressures
The commencement of insolvency proceedings may present an opportunity for commercial real estate players to seek relief from mounting financial challenges, although landlords, lenders and prospective purchasers will need to weigh different considerations as they engage in these processes.
Insolvency proceedings present several opportunities. A company whose real estate is overleveraged cannot sell a property, at least without the consent of the lender. Insolvency proceedings allow a party to apply to the court for a vesting order—a powerful remedy giving the court broad discretion to deal with property which is subject to multiple creditor claims and needs to be sold or conveyed.
In the context of an insolvency proceeding, a court may remove from title all encumbrances, transfer title, and hold back funds for claims. Another benefit of an insolvency proceeding is the ability to market the assets in an expedited manner. Finally, if the relevant property is a development of pre-sales or pre-leases, those contracts may no longer reflect market value; the court has discretion to terminate these contracts and transfer title to the purchaser without it being bound by those contractual terms.
Many industries are surviving through government funding, and this will not last forever—there will likely be a wave of opportunities in the commercial real estate market in 2021 and beyond.
From a landlord perspective, if a tenant is going through a creditor protection or bankruptcy process, the landlord may be prohibited from exercising certain rights that it would otherwise have in normal circumstances, such as the right to terminate a lease, the right to distrain, and so on. Landlords will need to exercise caution when evaluating enforcement options in this context.
For lenders, they will need to determine if they want to go through foreclosure or power of sale proceedings when dealing with distressed assets and should understand timelines of both processes.
Finally, in terms of vesting orders, care must be taken when evaluating the language of the order. From the purchaser’s perspective, there may be limited avenues to perform satisfactory due diligence, including issues around tenant estoppels, or lack of representations and warranties.
Distressed opportunities on the horizon
While many market players are looking to acquire distressed commercial real estate assets, dealmaking opportunities have yet to fully materialize as the level of insolvency in the Canadian commercial real estate market remains relatively low. However, many industries are surviving with the benefit of government funding, and this will not last forever—there will likely be a wave of opportunities in the commercial real estate market in 2021 and beyond, with the long-term impact of the pandemic to play out in the commercial real estate market in a 3-5-year time horizon.