The fallout from COVID-19 on commercial property

By Martin Fowler - June 4, 2020

With its “ground zero” in the Chinese city of Wuhan, the coronavirus health issue quickly escalated to become a pandemic as it spread across the globe. Australia was found to not be immune from both the disease itself (though it fared better than the majority of nations in this regard) as well as the economic fallout resulting from the prolonged period of lockdown and the shuttering of many businesses.

The crisis has forever changed the way Australians work, as well as how they engage in leisure activities.

A market which has and will not escape unscathed from the COVID-19 fallout is the property market. Australia has long had a love of (direct) property ownership, though its continued attractiveness will be sorely tested over coming years due to the pandemic and its flow-on effects. The specific focus of this article is the commercial property sector, as opposed to residential property. Commercial property refers to all non-residential real estate, namely retail, office and industrial properties. Owners of commercial property face uncertain times as they come to terms with the fallout from COVID-19 and the Government’s expectations that they too share the pain of the crisis. Higher vacancy rates and lower rents are two of the most likely long-term outcomes of COVID-19, with the tenant mix changing substantially as many current businesses are forced to shut permanently.

In order to mitigate the fallout of COVID-19 on businesses, the National Cabinet developed a binding code of conduct in regard to commercial tenancies that will affect the way in which many commercial property owners deal with their tenants. The code sets out principles that are a mandatory starting point for good faith negotiations for commercial leases. The code of conduct refers to businesses with annual turnover of less than $50 million, and where turnover for such businesses has reduced by more than 30% (making such businesses eligible for the JobKeeper scheme) due to the effects of COVID-19.

In such instances the:

  • Business lease cannot be terminated for non-payment of rent
  • Rent can be partly waived or deferred in proportion to their lost turnover but not increased
  • Tenant cannot be penalised for reducing trading hours or not opening
  • Security bond or personal advance guarantee cannot be used for non-payment of rent
  • Lease must be extended if it is up for renewal
  • Landlord must proportionally pass on any benefits they receive (e.g. land tax or bank interest reductions).

The tenant, on their part, is also obliged to continue to meet all the other conditions of the lease in order to be protected by the binding code of conduct.

Retail

Whilst some retail businesses are thriving (namely supermarkets, retailers of electrical goods, fast-food and fuel outlets), the majority are struggling. Leisure and hospitality businesses such as gyms, restaurants, cafes, bars and pubs and businesses related to the tourism sector were effectively shut-down for many weeks and have only just emerged from hibernation. These businesses have further been saddled with strict conditions on the numbers of people allowed into such premises, to respect social-distancing measures. This will obviously lead to significantly lower revenues, notably in establishments where capacity far exceeds the numbers allowed under the current stage of lockdown measures. The path back to the “new normal” will be laboured and many retail businesses will not survive, but those that do should be able to negotiate rent and associated conditions on more favourable terms.

The “new normal” environment post-COVID will involve many businesses moving online and a generally lower presence of bricks and mortar retail. This will generally imply downward pressure on rents over the short to medium term as businesses deal with declining numbers of foot traffic. Retail malls will take some time to experience patronage levels anywhere near pre-COVID levels as people remain cautious of lingering health risks. Furthermore, many individuals have lost their jobs (though not permanently for some) and tourists are not able to enter the country for the foreseeable future, which presents headwinds to retail spending and dissuades business owners from having physical operations and investors from investing in retail property. The process of structural change in consumer shopping habits, which was in train before the current crisis, is likely to gather pace, which will lower demand for retail premises over time.

Office

The office sector is another that is likely to look vastly different in the post-pandemic world. Offices for medical and allied health professionals and other client facing professionals are likely to be in solid demand. Generally, however, the sector is expected to undergo structural changes in the way businesses, namely corporates and professional services, operate. The “new normal” will involve an acceleration of flexible working environments where many employers will endeavour to incorporate remote working practices into their organisational strategy, in addition to the rapid rollout of evolving technology within the business. The cost-benefit to companies would be significant and many workers would have flexible arrangements where on-site time would be limited, though not eliminated, as some workers prefer a centralised workplace (for many, weeks of isolation has led to a deeper appreciation of the workplace). The ease in which many companies have embraced a decentralised working environment has vindicated some and surprised (in a positive sense) others.

The rental profile of tenants in office buildings is likely to change once current leases expire. Where the tenant is a Government department or a well-capitalised multinational, the tenancy is likely to be renewed on more-or-less the same terms as the current lease. Where current tenants are other private companies, there will generally be less need for similar footprints going forward (unless the company has intentions or expectations of growing over the short to medium term), as workforces could be managed more dynamically and working off-site has been both accepted and encouraged to meet social distancing guidelines. Demand for office properties will weaken as a result and rents will face downward pressure.

Industrial

The thematic of industrial and logistics-orientated properties will be somewhat brighter. Social distancing measures are increasing the already solid demand for online retail, this e-commerce demand in turn fuelling demand for properties which can not only warehouse these goods, but in many instances also manufacture them. Industrial premises likely to benefit the most are those on the outskirts of the city in areas close to infrastructure. This “last-mile” demand is expected to gather pace as a result of COVID-19 and this structural shift will boost demand for industrial premises. With infrastructure spending being a key focus of all tiers of Government, industrial properties are likely to benefit.

Conclusion

Australia’s love of property ownership is unrivalled around of the globe. It has long been regarded as a set and forget strategy, delivering a stable income stream with low risk. The COVID-19 pandemic has turned this assumption on its head and Australia, like most other nations, is teetering on recession as economic growth takes a significant hit. Commercial property is likely to see a slowdown, especially where these tenancies rely upon the consumer (notably retail). Office property is also likely to come under pressure as businesses adapt to having less workers on-site due to social distancing measures and the popularity of working remotely. Industrial property is likely to be more resilient as it caters for the increasingly fast paced switch to e-commerce. The Government decree that property owners must negotiate in good faith where a tenant’s revenues have been impacted by COVID-19 will lead to many landlords finding themselves in breach of their loan covenants and many more questioning whether owing property remains “the great Aussie dream”.

The information provided is not personal advice. It does not take into account the investment objectives, financial situations or needs of any particular investor and should not be relied upon as advice. While the information is provided in good faith and believed to be accurate and reliable at the date of preparation, we will not be held liable for any losses arising from reliance thereon. We recommend investors consult their personal financial adviser to discuss suitability and application to their individual circumstances. You should also obtain a copy of and consider the Product Disclosure Statement for any financial product mentioned before making any decisions. Past performance is not a reliable indicator of future performance.

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