Impact of the COVID 19 pandemic on real estate loans

The impact of the COVID 19 pandemic on lease agreements is clearly visible. As a consequence, the repayment of loans will also cause increasing difficulties for many landlords. The same applies to companies with debt-financing or leased real estate. Emergency measures by the German legislator do not provide for a suspension of payments under financing agreements (other than consumer loans).

Not only payment defaults, but also breaches of financial covenants or default events under “MAC clauses” may trigger unpleasant consequences. To avoid these and to allocate risks as appropriately as possible, property owners and financiers should seek to consult soon.

In doing so, borrowers should not only look at the loan agreements. In many cases, lenders should also be involved in the coordination with tenants, ideally at an early stage. It should also be examined whether and how any financing gaps can be closed with government assistance.

Law to mitigate the consequences of the COVID 19 pandemic
The Act on Mitigation of the Consequences of the COVID 19 pandemic in Civil, Insolvency and Criminal Proceedings Law was promulgated in the Federal Law Gazette on 27 March 2020 (hereinafter, the “Corona Act”). The amendments to the German Civil Code applicable to loan agreements and lease agreements will come into force on 1 April 2020.

The impact of the measures against the spread of the COVID 19 pandemic, and in particular the Corona Act, on financing agreements of real estate companies will be discussed below.

Effects of the crisis on cash flow for portfolio holders
Rental income is a major source of income and an essential component of the cash flow of a real estate company.

On the expenditure side, this is usually balanced by corresponding capital services. If rental income falls away, interest and capital services can quickly no longer be serviced and loan agreements may become non-performing.

Under the new law, tenants can factually suspend rent payments until at least June due to the crisis without running the risk of the landlord terminating the lease. A lot of tenants, particularly in the retail sector, will not be able to make full rental payments as a result of official closure orders and corresponding loss of sales.

Besides, the legal situation is unclear with regard to the possibility of reducing rental payments. It cannot be ruled out that courts may in the future qualify an official closure as a defect of the leased property or accord the affected tenants the right to a temporary rent adjustment due to a serious disruption in the basis of their business.

The new legal provisions
This legal privilege of tenants is not matched by any comparable regulation for loan agreements. Unlike the initial drafts, the Corona Act currently provides for deferral of repayment, interest and redemption claims due between 1 April and 30 June 2020 only for consumer loans (although even this may become a problem for real estate financiers in individual cases). The regulation can be extended by decree, especially to micro-enterprises (max. 9 employees, max. EUR 2 million turnover/balance sheet total per year). Further extensions, for example to small and medium-sized enterprises, seem rather unlikely at present, as the statue text does not expressly provide for this.

Loan agreements that are not consumer loan agreements are therefore not covered by the emergency regulations. The treatment of possible defaults on real estate loans must therefore be resolved on the basis of the general rules.

Legal rights of the lender
If the tenant can withhold rent payments, the ability of the landlord to service the outstanding loan instalments may quickly be under threat. The lender’s rights depend primarily on the terms of the loan agreement, however, also statutory provisions apply.

Most relevant, the borrower usually will be in default with the payment, resulting in increased interest and possibly damage claims of the lenders. In addition, the lender may be entitled to terminate the contract without notice (s. 490 (1) German Civil Code), if the financial circumstances of the borrower or the value of collateral deteriorate, or threaten to deteriorate significantly. Such material deterioration is a change in the financial situation of the Borrower that is detrimental to the prospects of satisfaction of the lender, in particular a deterioration in the earnings prospects of the borrower or an increase or the maturity of liabilities. The occurrence of such a situation is by no means unlikely in view of the dramatic losses in connection with the COVID-19-pandemic, at least if the shut down lasts more than two to three weeks.

However, the termination right is initially restricted by the fact that the termination may not be made in an abusive manner. In particular, if the borrower could trust that the lender would not terminate the loan agreement in the current crisis situation, termination may be qualified as abusive. If the lender – towards the borrower or publicly – has made corresponding statements, this might well be the case.

Furthermore, termination must not be declared in an untimely manner (cf. s. 627 (2), 671 (2), 675 (1) German Civil Code). Furthermore, termination must be preceded by a warning and the tenant has to be given possibility to provide remedy. However, this is essentially just a grace period for repayment, because termination is still effective and also justified after warning and the setting of the grace period.

Usual contractual rights of the lender
Larger loan agreements in particular usually provide for a more differentiated system to allow the lender to react in good time, even though payment defaults will entitle the lender to terminate the agreement very quickly.

Many loan agreements provide for financial covenants to measure the borrower’s assets or income. Relevant covenants for real estate loans include certain debt ratios (loan to value), interest cover and/or debt service coverage ratios. For property owners, rental income is of major importance, particularly for the interest and capital cover ratios.

If the ratios are not met, the lender may usually take remedial action in various degrees. Termination, calling due the loan and the realization of collaterals are normally an ultima ratio in which lenders often have no interest. Legal consequences are therefore frequent:

• Cash sweep to use revenues and free liquidity primarily to service and repay financing liabilities;
• Request of further collateral (eg shareholder guarantees, disclosure of assignments);
• Extended information and reporting obligations;
• Rights of the lender to influence on rental agreements, in particular to assert rights of termination.

In some cases, such remedies kick in automatically, if financial covenants are in breach.

This applies even more to actual payment defaults, where the borrower not only violates covenants, but defaults on its main obligation, i.e. interest and principal payments.

At the same time, the possibilities to cure covenant breaches by injecting equity (“cure rights”) are often limited.

Further consequences

In addition to the lender rights in the event of payment defaults due to a pandemic, further consequences may arise. In particular, agreements with tenants on deferrals or other measures will often require approval of the financing banks due to a security assignment of the receivables to the financing bank.

Negotiations with tenants should therefore always be coordinated in light of the financing and, if applicable, agreed with the banks to avoid inadvertent consequences. Often, it is not only the legal impacts of a breach of contract, but also the loss of confidence on the part of the banks that thwarts a medium and long-term solution and, in the worst case, can lead to insolvency.

Many loan agreements also contain “MAC clauses”, provisions that are triggered by a material adverse change in the borrower’s situation. These clauses often provide for adjustment and termination rights for the lender.

If the loss of rent (or other loss of income) impairs the ability to pay, insolvency issues must of course also be taken into account. The borrower’s insolvency is usually a reason for termination under the loan agreements.

However, the legal assessment now depends on the wording: If the loan agreement refers to the opening of, or the filing for, insolvency proceedings, it should be noted that the debtor’s obligation to file for insolvency is suspended until 30 September 2020 under the Corona Act, and that creditor applications are usually excluded, too. If, however, the clause defers to insolvency as such, termination may not be excluded.

Our recommendation: Contact the lender at an early stage and agree on contract adjustments
In the current situation, borrowers should seek consultations with their lenders at an early stage to reach an agreement before financial covenants are breached or event of defaults arise. In addition, it should be examined whether agreements with the tenants should be coordinated with the finance parties.

The following topics and objectives are particularly relevant:

• Coordination of negotiations of lease and financing agreements;
• Suspension or deferment of repayment of principal and, possibly, interest, for the time that rental income cannot be retrieved due to the Corona Act;
• No automatic increase of obligations under financing agreements due to breach of financial covenants for a certain period of time (e.g. until the end of September);
• Waiver of termination rights for a certain period of time (e.g. until the end of September);
• Granting of additional cure rights to the shareholders, if necessary;
• Waiver of termination for insolvency as long as obligation to file for insolvency is suspended.

In any event, it should be checked and clarified with the lending parties whether and which bridge funds are available, such as KfW loans to cover expenses or federal or state guarantees. In this context, attention should not only be paid to maintaining solvency in the short term, but also to the medium and long-term perspective to avoid a situation of over-indebtedness.

Our experts in rental law and finance law are available to provide you with comprehensive advice at short notice and support you in coordinating and implementing the necessary steps with the relevant parties.

Please do not hesitate to contact us!