The year 2020 has not got off to the ideal start for Hong Kong's retail sector. During the last year, Hong Kong retailers have suffered two folds: from the socio-political unrest of 2019 to the current COVID-19 coronavirus outbreak. COVID-19 could not have come at a more damaging time for retailers in Hong Kong who were looking forward to a big Chinese New Year spending rush. COVID-19 halted the Hong Kong economy to a standstill for the second time in a year.
To avoid the highly contagious virus, Hong Kong residents are staying home and keeping their distance from crowded places. Tourism numbers have also taken a further dive as a result of the Hong Kong government's imposition of border controls and mandatory quarantine rules. It is estimated that retail sales in Hong Kong could take a hit in the double-digit range, to as much as 50% (1). To cope with the dwindling foot traffic and lack of sales, retailers across Hong Kong have resorted to shortening business hours and suspending their businesses all together. Furthermore, many shop tenants are actively negotiating with their landlords to reduce their rent.
In this article, we will address rent reduction negotiations, re-structuring rental payment provisions, and formulating leases with an aim to balance the interests between landlords and tenants to withstand the economic turmoil as well as to explore other viable solutions for retailers.
Rent reduction – is this sustainable?
Negotiations for an abatement of rent has become a common phenomenon amongst shop tenants and landlords in Hong Kong. In fact, some major developers have offered temporary reductions in February rent for their commercial tenants. For example, Sun Hung Kai Properties reduced its February's base rent for most of its tenants by 30 to 50% to stabilize the economy and protect employment (2). Henderson Land adopted similar measures, cutting its February rent by 20 to 60% for small-to-medium sized tenants in the retail, food and beverage and education sector (3). Many other Hong Kong landlords have announced similar measures, such as Wharf Real Estate Investment Co.(4), New World Development, MTR Corp (5), Swire Properties Ltd and Hang Lung Properties.
Nevertheless, rent reduction by such a substantial extent may be less acceptable for smaller landlords in Hong Kong. On one hand, it might well be important to retain tenants and maintain cash flow. On the other hand, in view of the unprecedented scale and prolonged nature of the pandemic, it would be unfair to the landlords for commercial tenants, who have contracted to pay an agreed rent, to now turn around and ask for rent reduction for an indefinite amount of time. It would be sensible for landlords and tenants to work out ways to restructure the rent with a view to alleviate the financial burden of the tenants without undermining the interest of landlords when negotiating the terms of a lease in the event of an economic downturn.
Rent restructuring as a solution?
Rent is one of the major operating costs for retailers in Hong Kong. At the same time, for many landlords, rent is their major source of income. Instead of a straight up reduction in rent, landlords may consider the following options to alleviate the burdens of rent to tenants. In fact, first-movers have already begun to do so. In early February, Link Real Estate Investment Trust set up a HK$80 million relief scheme for its community malls, including rent payment by instalments, waiving off late payment interest and service charges, granting rent-free periods and reducing rents (6).
Another option is to vary the timing of rental payment. Landlords may offer to tenants a deferral of rental payment currently payable, or a portion thereof, for certain months, followed by payment of the deferred rent in a lump sum or installments after the deferred period. Landlords may also re-negotiate with the tenants for postponement of any rental increase as agreed under the leases or spreading such permitted increase over a longer lease term. This will allow more buffer time for retail tenants to meet its costs with revenue during the pandemic while landlords can still collect the exact same amount of rent.
As an incentive for tenants to drop the "rental down" negotiation, landlords can make commitments to use a portion of the rent received to support their tenants' retail business. For example, landlords could consider initiatives such as hosting more promotional or marketing events; buying their tenants gift coupons to give out to customers of their shopping malls or lowering the minimum spending amount for free parking in shopping malls to stimulate sales revenue and increase customers foot traffic. Landlords can also take more proactive steps to safeguard the health of customers and ease their anxiety, such as temperature checks, providing surgical masks and hand sanitizers and stepping up their cleaning schedule of facilities and common areas.
Furthermore, instead of succumbing to once-and-for-all cuts in rent for retail shop tenants, landlords could adopt a more flexible solution to rental reduction by holding regular rent review meetings with shorter intervals. As such, landlords and tenants are entitled to enter into discussion on the tenants' financial standing on a frequent basis and to assess the need for upward or downward rental adjustment.
If, however, landlords still have to make a compromise in rent to avoid a close down of operation by the retail tenants, careful negotiation should take place to ensure that the bargain for rent abatement be perceived as a balancing exercise with the landlords' interest safeguarded. This may increase the landlords’ bargaining chips regarding adjusting other aspects of the lease concurrently with the rent reduction. For example, introducing a break clause exercisable by landlords, locking the tenants for a longer lease term to secure long term rental income, temporary removal of turnover rent conditioned on a subsequent revival of the same with an increase of turnover rent percentage and imposing an obligation on tenants to keep their shops open, amongst others.
What safeguards do landlords and tenants have in formulating the leases?
The experience of SARS in 2003 and the current COVID-19 outbreak have reminded us of the importance of being proactive and flexible in the negotiation of leases. It would be prudent and more preferable for landlords and tenants to incorporate provisions in advance to protect their interests, than to seek the parties' mutual acceptance in amending the terms of the lease only when the adverse impacts of such epidemics/pandemics come to the surface.
Some considerations of protections for landlords to introduce in the lease include:-
- an express exclusion from liability for business disruption or loss of business, profit or other economic loss and damages arising from any outbreak of epidemics, pandemics or diseases;
- an express waiver of the tenants' right to request for any rental adjustment or reduction by reason of economic downturn, whether or not this is caused by unforeseeable epidemic, pandemic or disease;
- strict prohibition against any alteration of pipe designs in the premises during the tenants' fitting out – since it is said that the problematic design in pipes and connections linking to the sewage system can potentially lead to a faster spread of viruses; and
- positive obligations on tenants to take precautions in the maintenance of pipes and other service media to prevent the spread and diffusion of viruses and bacteria.
Tenants, on the other hand, may consider:-
- the inclusion of an epidemic/pandemic outbreak as one of the force majeure events which allows for a suspension or abatement of rent, with a specific description of how the epidemic/pandemic outbreak can qualify as a force majeure – for example, a declaration by the World Health Organization (WHO) on 30 January 2020 of the coronavirus outbreak being a Public Health Emergency of International Concern (7) – for the purpose of invoking the clause;
- an exclusion of liability for losses and damages in respect of the premises due to the landlords' defective installation of sewage connections, vent pipes and drainage system and indemnification of the same by landlords; and
- incorporation of a warranty clause in the lease to ensure that the installation in pipes and sewage connection is of good quality and hygienic condition at the time of handover.
E-Commerce as the way forward?
While the retail sector has experienced a negative slump in its overall business, e-commerce retailers appear to be unaffected by the coronavirus outbreak. A case in point is HKTV Mall, a local e-commerce platform, that has experienced a surge in its daily orders and daily gross merchandise volume in January 2020 respectively by 64.7% and 49.3% as compared with the same time last year (8). According to a report published on 7 February 2020, JLL opined that the current economic climate may actually be beneficial to e-commerce as shoppers gravitate toward buying from the safety of their homes to minimize the risk of infection by shopping outdoors, and this would be an opportunity for investment in modern logistics and warehousing in the long term (9).
The spike in demand of online retail transactions will also provide inspiration for conventional retailers to re-position part of their business operation via online transactional platforms, backed by a strong data tracking and management system with a modern logistic warehousing network. In this case, it is expected that these emerging retail businesses looking to expand online may search for additional warehouse space in the physical shops’ locations and the sharing or subletting of their shops with other e-commerce retailers as pick-up points, which will bring new perspective in the drafting of the leases as well.
The above discussion on rent restructuring and formulation of lease terms is by no means exhaustive. Parties should remain vigilant, well-prepared and proactive in drafting and negotiating the terms of the leases, or a variation thereof, in light of the coronavirus outbreak. Both parties should aim to achieve a fair and reasonable balance between their particular interests.