‘This is serious’: Are distressed assets Germany's new normal in the coronavirus era?

COVID-19 and real estate: Germany’s economic situation and the legal framework from a real estate and restructuring perspective.

“This is serious. Since German reunification, no, since the Second World War, there has not been a challenge for our country in which action in a spirit of solidarity on our part was so important… Things are already very difficult for the economy, for major companies, and also for small businesses, for shops, restaurants and freelancers. Things will get even more difficult... the Federal Government is doing everything that it can to cushion the economic impact and, above all, to safeguard jobs.”

In her speech in March 2020, Chancellor Angela Merkel labelled the COVID-19 crisis as one of the biggest challenges in recent German history. While statements and forecasts at that time were based on estimates, the consequences of the pandemic have since become part of everyday life. The extent of its impact on the global economy is becoming far clearer.

The current economic situation

Largely due to its total shutdown in March and April, the German economy – the world’s fourth largest economy according to GDP 2018 – finds itself in a recession deeper than any other in recent German history but not as dramatic and drastic as other countries. German GDP declined by 2.2% in the first quarter of 2020. Notwithstanding previous forecasts, the German Council of Economic Experts (Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung) estimates a decline in economic output of 6-7%. Estimates from the Kiel Institute for the World Economy (IfW¹) indicate the economy will lose approximately EUR390 billion due to the COVID-19 crisis. Rising unemployment to a rate of 6.2% as of July 1, 2020 provides evidence for these presumptions.

Of course, the prevailing economic situation also affects global real estate markets.

At the time of writing (July 2020), COVID-19 had not caused a significant decrease in the German market as current price indices² display a delayed market situation. However, the impacts are still significant and complex. For example, Germany is seeing numerous collapses of significant market players, particularly on the user and operator side. The challenging situation facing a large number of market participants is leading to major challenges for the commercial renting sector. At the same time, today’s new market reality results not only from the fact that a growing number of companies have become subject to insolvency proceedings in recent months but also from temporary legislative amendments.

The legal framework

In response to the COVID-19 pandemic and its economic impacts, the German government implemented a range of temporary amendments, particularly to German civil and insolvency law. Legal adaptions were made in a fast and pragmatic manner to rapidly cushion the consequences of the emergency.

In the wake of amendments to tenancy law, the government abandoned the landlord’s right of termination in case of payment defaults by the tenant for a period of three months, between April and June 2020. Whilst pursuant to Sec. 543 Par. 1, 2 sentence 1 no. 3 German Civil Code BGB, the landlord may make use of its right of extraordinary termination if a tenant is in default of payment for a period exceeding two rents: the so-called “Corona laws” provide otherwise. According to the temporary amendments, there is no termination right for landlords in case of a payment default between April and June that was due to the effects of COVID-19. Notwithstanding the suspended cancellation right, any payment obligations under rental agreements remain due.

While tenants usually benefit from noticeable reliefs of expenditure, a large number of commercial landlords are facing the problem of not being capable of acting quickly in the event of a default. The fact that any payments remain due and accumulate, whereas collaterals under rental agreements usually don’t fully cover the accumulated payment obligations, leads to an enormous default risk for commercial landlords arising from the temporary legislative changes.

In addition, the “Corona laws” provided for a number of temporary changes and adjustments to German insolvency law. The most significant is the suspension of insolvency filing obligations (Sec. 15a InsO) between March and September 2020.

In normal circumstances, this provides for the duty to file an application for insolvency if grounds for the commencement of insolvency proceedings exist. Such grounds may either be an imminent or already occurring insolvency (bestehende oder drohende Zahlungsunfähigkeit) or over-indebtedness (Überschuldung). That duty is suspended until September 30, 2020. However, the suspension does not apply if the insolvency is not based on the effects of the coronavirus emergency or if there is no prospect to eliminate an existing insolvency (Zahlungsunfähigkeit).

While a large number of companies are currently benefiting from these regulations, it is important to consider the temporary limited applicability of those legal provisions. This means that current problems arising from COVID-19 may be prolonged to a certain extent, and will still need to be fundamentally solved at some point in the future. This could be one reason why a notable number of German companies including Galeria Karstadt Kaufhof and ESPRIT have filed for insolvency regardless of the suspended filing duty.

New risks, new opportunities

According to a survey by the Munich-based Ifo Institute for Economic Research, 27% of German service providers and 18% of companies in the retail sector currently fear for their existence³. If those organizations cannot pay back outstanding loans, this may put a heavy burden on German banks and so threaten their existence in the long term. Reint Gropp, president of the Halle Institute for Economic Research (IWH), has indicated that “a new banking crisis is likely to arise”⁴.

Considering the economic situation and German markets, however, positive business trends are also noticeable in most areas⁵. According to the Federal Ministry for Economic Affairs (BMWi), industry is recording a growing number of incoming orders, 10.4% in May compared to April. The ministry also said that our economy has already pulled through the worst of the crisis. However, it should be noted that these positive trends are largely based on orders from other European countries and the global situation remains difficult.

It is clear the economic situation remains tense, with markets facing multiple uncertainties. A lasting change in the market may result from the re-establishment of the duty to file for insolvency from October 1, 2020. At the same time, the crisis is leading to numerous opportunities. For example, in company business strategy and future development. Many enterprises are now putting topics such as digitalization and digital transformation at the top of their agenda due to deficits revealed by the coronavirus pandemic⁶.

We can also expect a high degree of dynamics in investment markets in the near future, particularly with the reinstatement of the filing for insolvency obligation. The expected collapse of some market players enhances opportunities for investors. The latter may take the opportunity to invest in certain distressed assets and acquire targets at a far lower price compared to previously.

Indeed, these uncertainties and market developments could mean increasing options for sellers as well as buyers. Many companies may need to deal with over-indebtedness as grounds for insolvency. Massive loans taken up during the COVID-19 crisis will have negative impact on a company’s balance sheet and may therefore prevent the company from proving a positive prognosis of its continued existence (positive Fortführungsprognose). The duty to file for insolvency could lead to an acquisition by a third party, offering new potential for the insolvent company.