Simon Keen plays “what if?” and imagines the effect on real estate if the UK base rate were to drop below zero
Many jurisdictions around the world now have central bank base rates below 0%. In simple terms, this means that banks will deduct interest on deposits they hold, rather than pay it.
Japan has had a negative base rate for a long time, but Switzerland and other parts of Europe have now joined that club, as have some Southern and Central American countries. In combination these countries account for about 25% of global GDP. While the governor of the Bank of England has ruled out, for now, replicating that approach in the UK, what if that changes?
The effect on leases and contracts
If UK base rates became negative, how would interest provisions in commercial leases and other real estate contracts fare? At the moment, these documents do not generally anticipate negative interest rates. For instance, a tenant must usually pay interest at base rate on any “back-rent” after a rent review has been settled. If the interest rate is negative then might the landlord have to pay the interest to the tenant? That could be the outcome if the drafting required the back-rent to be paid “together with base rate interest”. This might mean, in effect, reducing the back-rent payment to the landlord.
Does the drafting in leases that prevents tenants from making deductions or setting off monies from payments help here? Probably not. Strictly speaking, this is not the tenant making a deduction or exercising any set-off, it is a direct result of the lease drafting, and so the tenant is simply doing the maths and making the payment due under the lease.
Unless negative interest rates plummet, penal rates for late completion of a purchase, or a late rent payment, would probably be unaffected as they are usually two, three or four percentage points above base. But if the negative base rate is low enough, it might mean the landlord paying the tenant for late payment of rent, or the seller paying the buyer for late completion – which would be surreal.
To fix or not to fix?
What would happen to interest on rent and purchase deposits? Can a deposit-taker comply with an obligation to place it in an interest-bearing account if the interest rate is negative?
There is an easy drafting solution for this. Going forward, it could be provided that, if the base rate is negative, a zero rate applies. Alternatively, a fixed rate could be agreed, as long as the fixed interest rate chosen is not out of line with the market and seen as a penalty.
But would investors actually want a solution at all? If negative interest rates reflect a topsy turvy economic paradigm where it is desirable to minimise cash receipts (for a while at least), might they prefer late payments or lower amounts (as long as their fixed costs are covered)?
Would there be any difference at rent review between a lease containing a provision collaring base rate interest at 0% and another lease without it? Would a rent review surveyor treat differently a lease that is out of keeping with the rest of the market in this way? Normal commercial leases have not typically contained this sort of provision – why would they? And would landlords want a drafting solution if it might unintentionally be seen as having a negative impact on rent review?
A drafting fix will not help with existing leases anyway, as it is not practical to try to vary them all. They will therefore need to be reinterpreted in the context of negative interest rates. That would require legislation (which is unlikely), guidance from the courts (which might, possibly, be forthcoming in time), or just a commercial approach recognised by the market (the most likely solution).
If asked to consider a lease in this context, a judge might decide that the draftsman did not have negative interest rates in mind when preparing a lease, and rule that a tenant who pays late should not benefit from his breach by being entitled to deduct late payment (negative) interest from, and so reduce, his payment to the landlord. On the other hand, the judge might decide to uphold the strict wording of the lease.
Plenty to ponder
Might commercial real estate investors just live with the outcomes? At first glance they seem unattractive, but businesses would evolve their approach in an environment with negative interest rates. If it will cost money to have cash in the bank, because the bank is charging (not paying) interest, businesses will reassess their cash flow and investment needs and could refocus their investments to capital appreciation and low/no yielding assets. They might decide to pay for things in advance (if they can find someone to accept the early payment). Conversely, they might want to receive payments as late as possible and be unwilling to accept pre-payments.
There are many questions to which, as yet, there are few answers. But if the UK does follow other parts of the world and negative UK base rates become a reality, the industry will need (quickly) to ask and answer these questions.
Simon Keen is a counsel in the London real estate team at Hogan Lovells International LLP
