Working example to demonstrate proportionality agreement for rental reduction

OPINION: A WORKING example of how a valuer/mediator might deal with rental reductions between Lessor and Lessee.

An outline of the proposed National Cabinet Mandatory Code of Conduct was released for public discussion over the Easter break April 10 – 13 2020.

The main points of the proposed Code follow below, concluded with a hypothetical working example to demonstrate how the parties to a lease agreement might agree rental relief for a distressed tenant.

The purpose of this Code of Conduct (“the Code”) is to impose a set of good faith leasing principles for application to commercial tenancies (including retail, office and industrial) between owners/operators/other landlords and tenants, where the tenant is an eligible business for the purpose of the Commonwealth Government’s JobKeeper programme.

The objective of the Code is to share, in a proportionate, measured manner, the financial risk and cashflow impact during the COVID-19 period, whilst seeking to appropriately balance the interests of tenants and landlords. Such arrangements will be proportionate and appropriate based on the impact of the COVID-19 pandemic plus a reasonable recovery period.

All premises are different, as are their commercial arrangements; it is therefore not possible to form a collective industry position.

All leases must be dealt with on a case-by-case basis, considering factors such as whether the tenant has suffered financial hardship due to the COVID-19 pandemic; whether the tenant’s lease has expired or is soon to expire; and whether the tenant is in administration or receivership.

Leases have different structures, different periods of tenure, and different mechanisms for determining rent. Tenants may already be in arrears for instance.

Leases may already have expired and be in “hold-over.” These factors should also be taken into account in formulating any temporary arrangements in line with this Code.

LEASING PRINCIPLES CONCERNING RENTAL RELIEF

In negotiating and enacting appropriate temporary arrangements under this Code, the following leasing principles should be applied as soon as practicable on a case-by-case basis.

Landlords must offer tenants proportionate reductions in rent payable in the form of waivers and deferrals of up to 100% of the amount ordinarily payable, on a case-by-case basis, based on the reduction in the tenant’s trade during the COVID-19 pandemic period and a subsequent reasonable recovery period.

Rental waivers must constitute no less than 50% of the total reduction in rent payable over the COVID-19 pandemic period and should constitute a greater proportion of the total reduction in rent payable in cases where failure to do so would compromise the tenant’s capacity to fulfil their ongoing obligations under the lease agreement. Regard must also be had to the Landlord’s financial ability to provide such additional waivers. Tenants may waive the requirement for a 50% minimum waiver by agreement. Any amount of reduction provided by a waiver may not be recouped by the Landlord over the term of the lease.

Payment of rental deferrals by the tenant must be amortised over the balance of the lease term and for a period of no less than 24 months, whichever is the greater, unless otherwise agreed by the parties.

If negotiated arrangements under this Code necessitate repayment, this should occur over an extended period in order to avoid placing an undue financial burden on the tenant.

No repayment should commence until the earlier of the COVID-19 pandemic ending (as defined by the Australian Government) or the existing lease expiring, and taking into account a reasonable subsequent recovery period.

No fees, interest or other charges should be applied with respect to rent waived and no fees, charges nor punitive interest may be charged on deferrals.

The tenant should be provided with an opportunity to extend its lease for an equivalent period of the rent waiver and/or deferral period. This is intended to provide the tenant additional time to trade, on existing lease terms, during the recovery period after the COVID-19 pandemic concludes.

The following example is hypothetical, noting that the circumstance of each landlord, SME tenant and lease are different, and are subject to negotiation and agreement in good faith.

Qualifying tenants would be provided with cash flow relief in proportion to the loss of turnover they have experienced from the COVID-19 crisis (60% loss in turnover would result in a guaranteed 60% reduction in rent).

At a minimum, 50% is provided as rent free/rent waiver for the proportion of which the qualifying tenant’s revenue has fallen.

The balance of the reduction is to be provided through a deferral of rent, with this to be recouped over at least 24 months in a manner that is negotiated by the parties.

This means if the tenant’s revenue has fallen by 100%, then at least 50% of total cash flow relief is rent free/rent waiver and the remainder is a rent deferral.

If the qualifying tenant’s revenue has fallen by 30%, then at least 15% of total cash flow relief is rent free/rent waiver and the remainder is rent deferral.

Care should be taken to ensure that any repayment of the deferred rent does not compromise the ability of the affected SME tenant to recover from the crisis.

At all times, the parties are free to make an alternative commercial arrangement to suit their specific needs if that is their wish.

WORKING EXAMPLE with application to the leasing principles given within the Code.

Tenant has a retail shop Lease within a larger shopping centre and under the Lease is committed to an annual net rental of $100,000 per annum. The Lease has two years to run. Supported by BAS Statements a genuine trading loss of 60% is evident and accepted by the Lessor.

What is the discounted monthly rental that the tenant should pay after receiving a 50% rental waiver of $30,000pa and providing for the amortisation of the second $30,000pa rental to be deferred 24 months?

Assumptions:

The Parties agree to a rental reduction of $60,000 which leaves the tenant with a yearly rental of $40,000 which is to remain payable by the tenant in accordance with the Lease.

As per the proposed Mandatory Code, the relief of $60,000 per annum is to be apportioned between a waiver of 50% of the relief amount, with the balance 50% to be deferred and amortised over the balance of the lease, or for no less than 24 months, whichever be the greater, unless otherwise agreed by the parties.

In this hypothetical example, a dual rate of interest appears necessary to enable the parties to be put in the equivalent position they would have been in but for the coronavirus.

A yield or capitalisation rate of 5.5% appears appropriate to adopt in this instance for this particular Shopping Centre, and a safe investment rate of say 2.5% is reasonable to adopt as a Sinking Fund account, to allow the Lessor to receive a return on capital and recover the deferred rental of $30,000 per annum over the 24 month period. These interest charges are not punitive in any way.

As the annual rental is payable monthly the interest rates adopted need to be converted to monthly rests for the calculations.

STEP 1. Calculate the amortisation rate for the replacement of the $30,000 deferred rental over the period of 24 months at 2.5% per annum.

Convert 2.5%pa to equivalent monthly amortisation rate to apply for 24 months: –
(1.025)^.0833333 = 1.002059836

Amount of $1 per month for 24 months @ 2.5% p.a.

Reciprocal for Sinking Fund = .0406881239 ( 4.07%)

STEP 2 Add the remuneration Rate of 5.5% converted to monthly rests

Present Value of $1 per month for 24 months @ 5.5% p.a.

Reciprocal for Sinking Fund = .0440355026 ( 4.4%)

STEP 3 Add Remunerative and Sinking Fund Rates for Sinking Fund

STEP 4 Calculate the NPV for the deferred rental flow over 24 months

STEP 5 Calculate the total monthly rental to be paid by the tenant after relief:-

STEP 6 Proof

The deferred rental of $30,000 pa is to be replaced in 24 months

NPV of monthly rental for 24 months at 5.5% and 2.5% is $29,507.71

Monthly rental for $29,507.71 fixed for 24 months = $1,229.49 pcm, viz

$29,507.71 pa divided by 24 months = $1,229.40 pcm

Remuneration monthly return on $1,229.49 is $5.50pcm, viz

$1,229.49 pcm X .0044716989 = $5.497899320 pcm, and

Monthly rental to replace $30,000pa in 24 months is $1,223.99 pcm, viz

$1,229.40 pcm less $5.497899320 pcm = $1,223.99 pcm

This monthly rental will replace $30,000pa over 24 months at 2.5% pa, viz

Small closing error of $82 due to roundings in calculations

SUMMARY

Under the Lease the tenant has a reserved net rental of $100,000 per year. The tenant receives an agreed rental reduction of $60,000 per year made up by a 50% waiver of $30,000 per year and in addition is able to defer the other 50% payment of $30,000 per year for a period of 24 months.

With the deferred rental the Lessor is entitled to retain or maintain a return on capital as well as receiving a rental that will replace the deferred rental of $30,000 in 24 months.

A capitalisation rate of 5.5% is considered reasonably appropriate for the value of the Shopping Centre, while a safe investment rate of 2.5% is considered achievable for the Sinking Fund rate This dual rate of capitalisation and amortisation indicates a Monthly Purchase of 11.803083046 months for the recovery of the deferred $30,000pa rent.

Overall, including the waived $30,000 per annum rent, the tenant will enjoy a 45.25% discount in rental paid, viz

The discounted monthly rental that the tenant should pay after receiving a rental waiver of $30,000pa and providing for the amortisation of the further $30,000pa rental deferred 24 months is therefore $4,562.33 pcm or $54,747.96 per annum.

By Kingsley “Jock” Vincent FAPI, Licensed Valuer, Certified Practising Valuer.

Jock Vincent is a Fellow of the Australian Property Institute and was awarded the SF Whittington medal in 2001 from the WA Division of the API. He is a Grade II Arbitrator Institute of Arbitrators and Mediators Australia: Resolution Institute and Approved Mediator Institute of Arbitrators and Mediators Australia: Resolution Institute.

He is retired but since 2014 he has undertaken Property, Rental and Business Mediations for the Small Business Development Corporation in accordance with the Australian National Mediator Practice Standards (2007) and more recently been involved with mediations under the Farm Debt Mediation Scheme, also conducted by the SBDC Perth.