Adaptation of UK commercial real estate in a post-pandemic world

Overview.

Since the outset of the COVID-19 pandemic, various aspects of our lives have, for better or for worse, changed. Some of these changes had already been occurring at a slower pace pre-pandemic, but are now rapidly accelerating and becoming the norm in a post-pandemic world. These changes to lifestyle and work habits affect not only the work force, but also the utilization of commercial properties across all sectors. Some sectors – notably hospitality, office and retail – are among those hit hardest by these forced changes. The question now becomes: how do developers, landlords, managers, lenders, tenants and consumers maximize existing and future real estate projects in a post-pandemic world?

Market Trends.

In many respects, the COVID-19 pandemic expedited existing trends relating to online retail and telecommuting. Pre-pandemic, online retailers such as Amazon were already experiencing rapid growth. Unsurprisingly, with many in-person retail outfits forced to close during the first months of the pandemic, online retail services exploded further in 2020, expediting the closures of many in-person retail stores. With respect to office leasing, many companies already permitted limited work from home options. However, the widespread pandemic “shelter in place” rules adopted by many states and municipalities forced a significant change whereby nearly all companies were required to permit remote working. Consequently, members of the workforce who once believed that consistently working from home led to inefficiencies and an inability to unplug from business related needs were forced to adapt for the better part of 2020. In many cases, companies even found that workers could be as (or almost as) productive as they were when physically working in the office. These forced adaptations led many executives and leaders, particularly in white collar industries, to rethink their current space footprint and question the long term viability of physical offices. If even a portion of their employees could be as productive working remotely as in the office, why not take the opportunity to reduce mortgage, rent and/or operating expenses, which often constitute some of the biggest line items in a company’s budget? As a result of this shift, office availability in New York City hit 16.1 percent in the first quarter of 2021, the highest number on record, according to Colliers International’s latest quarterly report. With this backdrop in mind, we are now left to ponder how best to utilize spaces that will likely be subject to a limited percentage of workers being permitted to work in-person at one time and flex scheduling.

Similar to the office and retail sectors, the hotel and restaurant industries took a beating as a result of the pandemic. In fact, no industry was hit harder during the pandemic than the hospitality sector. New York City, for example, saw more than 42,000 hotel rooms (representing about one third of the hotel rooms available in the city) wiped out, with nearly 200 hotels closing permanently, to say nothing of the many restaurants that were forced to close up shop. While trends regarding online retail and telecommuting have been on developer radars for quite some time, the shock to the hospitality sector brought about by the pandemic was unexpected. Most in the industry suspect that it will take several years (even into 2024) for the hospitality sector to fully recover. In order to ride out the expected long recovery, many hotels are now seeking short and long term options to maximize revenue.

Third Space and Suburban Revitalization.

These industry woes have forced tenants, landlords, property managers and lenders to pivot temporarily or even, in some cases, permanently from these ailing sectors. While traditional retail and office buildings may struggle to adapt, one area ripe for adaptation in the post-pandemic world is the concept of what is often called the “third space”. In its most general terms, the third space is space outside of the home and office where people can work but also collaborate and socialize with others. The third space concept is not new. In fact, many hotel operators had, prior to the pandemic, invested money, time and design into flexible spaces in their buildings to maximize utilization of their common areas. That said, the flexibility that employers are now willing to give to their employees makes this third space concept even more attractive for hotel operators and guests alike. With telecommuting becoming more of the norm rather than the exception, workers may be able to parlay working from home into longer vacation stays at hotels in desirable locations. Workers who were once hesitant to take longer vacations can now work remotely part time utilizing hotel facilities, while also being able to enjoy time away with their families.

On a similar note, as members of the work force spend less time in office buildings and more time working from home, suburban areas and related businesses appear poised to benefit. Suburban restaurants, bars and hotels may very well serve as a replacement for people looking to scratch that social itch. A key factor to this suburban revitalization is the explosion of the residential real estate market in suburban areas since the onset of the pandemic. Workers are fleeing tighter quarters in more expensive, densely populated areas and seeking larger homes with home offices and other amenities (e.g., pools) in the suburbs. To that end, we suspect that suburban areas located outside of, but still relatively close to, major city hubs will be the subject of increased investment and development.

Practical and Legal Challenges.

From a practical perspective, it is clear that in a post-pandemic world, preserving the flexibility for other permitted uses of office buildings is critical. It should be noted, however, that there are a myriad legal issues that landowners, developers, tenants and lenders must navigate to achieve such flexibility. In the commercial leasing context it is important to first look at one’s lease. For tenants, negotiating commercial leases with broad permitted use provisions is important. Often, landlords attempt to narrow the tenant’s permitted use for a variety of reasons, whether it be for zoning purposes (more on that below) or, in the retail setting, preserving a good tenant mix and navigating exclusive use clauses granted to certain attractive tenants. A savvy tenant will try to expand permitted uses during lease negotiations. Similarly, landlords should understand that, in many respects post-pandemic, flexibility is beneficial from their perspective as well.

Another major hurdle to seeking flexibility for existing and future projects includes working within the constructs of existing zoning laws, which limit property utilization and adaptation. Throughout the United States and particularly in the northeast, local municipalities codified various restrictions as to size and use of certain parcels of land. These restrictions, while well intentioned, restrict existing landowners and future developers from quickly adjusting to market trends. While there is some reason to remain optimistic that zoning authorities acknowledge the issue at hand, rezoning has typically been a slow development process requiring, among other things, public hearings. For example, when seeking to modify existing uses or developing projects, one must confirm whether such modifications are permitted “as of right”. If not, a variance or special permit would likely be required, and approvals must be sought which may further require studies, public hearings and various other governmental signoffs. These zoning challenges not only impact construction budgets, but may also cause long term construction delays and threaten project milestone dates. It is consequently important for all parties involved to take serious note of the zoning landscape before taking any meaningful steps towards the repurposing of existing developments or the commencement of new development projects.

Parties may also run into issues from a financing perspective, whether they are operating with an existing lender or seeking new financing. Lenders often have various financial benchmarks and covenants regarding the operation of the subject property in order to ensure appropriate cash flows to adequately service the debt. Converting existing commercial property into a different use entirely (for example, converting office space into hospitality) can run afoul of these types of covenants. Seeking an existing lender’s cooperation in these types of projects is therefore vital to the success of the property. When seeking new financing, a prospective lender will typically want some level of certainty as to the future use of the property as well as an idea as to the proposed tenant mix. As a result, future flexibility regarding a commercial property’s use is likely to be limited unless the appropriate changes can be negotiated in the loan documentation. Accordingly, in either scenario it saves borrowers a lot of time and money if these issues are broached up front with a prospective lender.

From a non-legal perspective, assuming all other hurdles have been cleared (or at least taken into account), parties should also consider whether undertaking such drastic overhauls to existing properties makes financial sense. These concerns include potentially costly and time intensive construction and renovation to existing structures to keep up with market trends. While new developments in underdeveloped portions of the U.S. will likely seek (and be granted) as much flexibility when it comes to building use and composition, existing properties in heavily restricted areas (e.g., New York City, San Francisco) will have a tougher and more expensive situation to address.

Conclusion

As mentioned, the key to maximizing existing and current real estate projects is increased flexibility as to the use and services provided by each respective property and, most notably, to take advantage of this emerging demand for so-called third space. Failure by local and state governments to quickly adapt to and revise applicable zoning laws will cause significant and perhaps permanent damage to these properties (and, by extension, the municipality and state governments themselves, which rely on real estate as a tax revenue generator). Similarly, lenders will also need to provide some degree of flexibility to existing and new borrowers to give their borrowers a chance at maximizing revenues. When navigating these challenges it is imperative for all stakeholders to have knowledgeable and experienced counsel.
Withers Bergman LLP is an international law firm with substantial experience with diverse leasing from anchor tenancies in shopping centers to large office leases, luxury brand single city retail leases and multiple city retail rollout programs, residential portfolios as well as diverse lending and development matters. For additional guidance on these matters and other COVID-19 related items, please reach out to our New York Commercial Real Estate Team to develop a legal strategy to plan for near- and long-term solutions tailored to achieve your specific goals.

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