2020: Brexit and Covid-19 - a real estate review

Until the beginning of 2020 most (if not all) commentators considered the uncertainty brought about by Brexit to be the most important risk facing the real estate market.  But by 16 March, as lockdown measures were imposed across the UK, Brexit was starting to take a back seat as the impact of Covid-19 began to be felt.  Response to the pandemic has heralded the most significant changes to everyday life the UK has experienced since the Second World War and the impact quickly rippled through the UK economy.  Parts of the real estate industry have been hard hit, with the retail and leisure sectors experiencing almost total interruption of operations and, consequently, landlords reporting record low rent collection.  In many cases Covid-19 is the latest challenge in an already difficult environment.  Government support has, at least in the short term, prevented insolvencies on a mass scale - although few would suggest that the challenges facing the real estate sector as a result of Covid-19 are anywhere near their conclusion.

So it is understandable that Brexit contingency planning has fallen down the agenda.  But the risks presented by a "no-deal" Brexit, and the uncertainty and upheaval brought about by Brexit per se, are still very much present.  At the time of writing, some observers placed the chance of a no-deal Brexit at over 75%, with the UK Government insisting the implementation period will not be extended.  While the UK real estate industry is somewhat insulated from Brexit related legislative change – principally because (unlike other areas) much of the legal framework for real estate does not derive from European law but is national in origin – the risks of Brexit (and of a no-deal Brexit in particular) go much deeper than legal change.  With only months to go until the end of the year, real estate professionals should consider their businesses in light of the dual risks (and opportunities) of a no-deal Brexit and the fallout of Covid-19.  This piece considers some of the areas where a no-deal Brexit may impact the real estate sector, an impact which in many cases has been accelerated by the response to Covid-19.

Real estate investment

Our previous updates on the impact of Brexit on UK real estate (here) highlighted risks that remain relevant today.  Towards the beginning of 2020 however, observers were pleased to see transaction activity levels increasing, particularly in commercial real estate.  Investors who had paused the deployment of new capital while Brexit took shape clearly felt the election of a single party government with a strong majority (among other factors) helped to provide a certain foundation on which to recommence acquisitions.  That activity level was quickly dampened by the onset of lockdown, with transaction activity generally reduced since, with the exception of certain sectors which remained steady or saw a boost in demand – namely data centres, logistics and distribution and industrial sites.

We think the following may be features of the market over the next few months:

• The end of the Office? – recent industry-wide conferences, including those hosted by the Loan Markets Association, CREFC Europe and the British Property Foundation have devoted significant amounts of time to discussions around the future of physical office space.  Many agree that the period of mass working-from-home will produce some structural change in the habits of the working population in the UK, but that offices certainly remain a relevant part of the property ecosystem.  Relocation plans devised and implemented by many major banking institutions as a response to Brexit were delayed by the impact of Covid-19 , but many are expected to reach a conclusion in the coming months.  Although transaction volumes are generally lower than seen in previous years, anecdotal evidence suggests that there remains significant appetite for office investments, particularly core assets.  The uncertainty may afford opportunities for many.
• The return of Brexit clauses? – the run up to the 2016 Brexit referendum saw the use, in some transactions, of "Brexit clauses" allowing a purchaser to walk away from a transaction (or the opportunity to renegotiate terms) in the event of a vote to leave the European Union.  As the end of the year approaches, purchasers may wish to avail themselves of such clauses once more, this time to insulate against the risk of a no-deal Brexit.  Their appropriateness will depend on demand for the asset in question as sellers will not welcome the lack of certainty such a clause presents, but with limited transaction volumes some buyers may find they have the upper hand in negotiations. 
• Retail funds – the uncertainty brought about by Brexit and Covid-19 has affected the fortunes of many open-ended property funds, particularly those with exposure to the most significantly affected sectors.  Many retail funds were suspended to stem the outflow of capital following the referendum (see our 2016 briefing here) and the upheaval brought about by Covid-19 has prompted a similar response.  Funds have also found valuations challenging, with a significant reduction in transaction volumes making it hard to reliably value assets, given the dearth of recent comparable transaction data.  The liquidity issues faced by these funds have prompted the FCA to open a consultation on proposals to require investors to give up to 180 days' notice of their intention to redeem their interest in an open-ended property fund .  If implemented, it is likely to significantly alter demand for property funds among retail investors and could prompt some funds to close altogether - thus forcing a return of their assets to market.

Real estate development

Construction activity in the UK suffered considerably during the early part of Q2 but returned on a gradual basis, from May 2020.  Many market commentators expect a significant reduction in commercial development activity in the coming years, dampened by both Brexit and Covid-19, but with a historic under-supply of housing and the continuation of Government support schemes such as Help to Buy (together with specific provision made for residential developers in the Government's Coronavirus loan schemes), housebuilders in particular are expected to continue to be cautiously active.  But the commercial landscape has undoubtedly changed for many businesses and market participants will need to consider some of the risks presented by the current environment:

• Labour – it is without doubt that the viability of projects will need to be stress-tested to consider the impact of a no-deal Brexit on the availability of labour.  A significant number of UK construction workers, particularly in London and the South East, hail from EU countries .  Businesses which previously had frictionless access to a large pool of skilled migrant labour from EU countries may face the prospect of time consuming and expensive visa processes, assuming that such workers are indeed eligible.  More information on post-Brexit immigration matters can be found here.
• Materials and supply chain - the same is true for materials.  The UK construction industry has long enjoyed tariff-free access to an ecosystem of European suppliers, with four of the top five UK import markets for construction materials being EU Member States .  Developers (and their investors and financiers) will need to refresh plans for a no-deal Brexit in light of the additional strain introduced by Covid-19.  Any future tariff arrangements and border checks could impact both availability and timing of supply, particularly in a no-deal Brexit scenario, where the result would likely be a default to WTO terms.  Materials may very well become more expensive, both as a result of any tariffs levied and the devaluation of Sterling that many believe is a likely consequence of a no-deal Brexit.  The disruption caused to global supply chains by Covid-19 already will only exacerbate these issues.  More information on, among other things, supply chain issues in a no-deal environment can be found here.
• Contractual allocation of risk – the market began to respond to the risks posed by a no-deal Brexit shortly after the referendum result.  With Covid-19 now also affecting developers and contractors, parties may wish to audit their existing contractual arrangements to understand existing risk and take care over new contracts (to ensure they represent an appropriate allocation of risk) in terms of both cost and possible schedule delay to any construction project.  Covid-19 has caused many parties to look closely at contractual terms, particularly those designed to respond to unforeseen risk (more information can be found here).  As the impact of Covid-19 is likely to be felt across the construction supply chain for some time, parties should take care to understand and quantify their likely exposure should a no-deal Brexit occur alongside existing disruption.

Real estate financing

The response to the Covid-19 pandemic has placed banks at its centre.  In addition to the government-backed Coronavirus business interruption loan schemes (see our briefings here), many observers point to the crucial role banks will play in the recovery in the years to come.  That role will be amplified should Brexit negotiations fail to deliver a deal.  The availability of debt financing is crucial to the proper functioning of a thriving real estate market, something that has been proven in the months following lockdown in the UK.

• Waivers… and more waivers – the response to Covid-19 has resulted in large numbers of borrowers requiring waivers in respect of financial covenants – both in respect of income (due to tenant arrears, reduced rent collection and anticipated failure to pay) and LTV (due to concern around instability in valuations or, particularly during the height of lockdown, an inability to carry out valuations involving physical inspection).  As much of the UK Government's legislative intervention has concentrated on tenants, much of the strain has been pushed upwards through the "system", coming to rest (for now) with lenders.  Should a no-deal Brexit occur at the end of the year, borrowers who suffer further as a result may find it more difficult to obtain forbearance from their lenders without also injecting further capital to support their assets.  
• Debt funding gap? – the immediate impact of Covid-19 saw lenders focus on existing customers, with new lending falling considerably.  In many sectors this continues to be the case.  This, coupled with dampened sentiment towards UK property from some foreign banks as a result of Brexit may mean that, for some borrowers, refinancing existing indebtedness may become more challenging and/or more expensive.  This will be particularly true for asset classes already subject to systemic change (such as retail) or which may suffer disproportionately from a no-deal Brexit (such as development projects or, in cities with a high existing proportion of EU students, some student accommodation).  Borrowers looking to finance or refinance debt on core assets will find a more varied and liquid market than those holding non-core/value add properties, where opportunities will be more scarce and, as a result, pricing will be higher.

About Ashurst

At Ashurst, our market-leading expertise, seamless multi-disciplinary approach and commercial focus allows us to carry out the most complex and often pioneering transactions in the real estate market.  Our experience means we are ideally positioned to assist clients with navigating a changing legal and regulatory environment while maximising the potential of opportunities that arise from Brexit and Covid-19.

Our team advises on all aspects of real estate activity including high-profile acquisitions and divestments, asset management, large-scale development schemes, real estate finance, funds, joint ventures, construction, planning, environment and tax advice.  We also advise on major urban regeneration projects, the real estate aspects of energy, resources and infrastructure projects, property financing transactions, public private partnerships and private finance initiatives.

i. Bank of England, Q2 2020 Agents’ Summary of Business Conditions, published 18 June 2020.

ii. Financial Times, "London bankers balk at EU relocation over virus travel worries", 27 September 2020. 

iii. Financial Conduct Authority, Liquidity mismatch in authorised open-ended property funds (Consultation Paper CP 20/15**, August 2020).

iv. The precise figures vary depending on source. A summary of recent data is available here: http://speri.dept.shef.ac.uk/2020/02/19/restrictions-to-immigration-and-work-in-the-uk-construction-industry/.

v. Department for Business, Energy and Industrial Strategy, Monthly Statistics of Building Materials and Components, Commentary, August 2020.