BPM’s Mark Leverette Article in National Real Estate Investor
This article originally published on November 4, 2020 in National Real Estate Investor.
All around the country, commercial real estate landlords are being confronted with a fundamental problem: tenants cannot pay their rents. Again, this is a problem not only for the tenants but for the landlords too, who typically rely upon income from rents to pay their own business expenses.
Government has thus far not been much help in this regard. Other than the convoluted Paycheck Protection Program, or PPP, there has been little action on the federal level to help landlords or tenants. State and local support has been basically piecemeal. While a few cities like Pittsburgh have come up with small amounts of relief, and others like New York are considering a proposal for long-term tax breaks for landlords who agree to renegotiate lease terms with tenants, the vast majority of commercial landlords have not seen even a modicum of relief from public sources.
In short, landlords have to navigate the issue of tenants seeking rent relief for COVID-19 on their own, without expecting any government incentives to help prop them up. That does not mean they are helpless, though. There are strategies that landlords can bring to negotiations with tenants over terms for rent relief that can help recoup their losses. To that end, we invite you to read on for our explanation of some key principles that landlords can follow to help achieve the most favorable outcome for them.
Understand and identify the ‘phases’ of tenant requests
To respond with the appropriate leniency and urgency, it is important to understand the financial position that is compelling the tenant’s request for rent relief. This is a function of knowing the actual and projected balance sheet, revenue and operating costs of your tenant, as well as knowing the specific market for your space. The type of space you are leasing factors into this heavily. For instance, when a retail business is forced to close its doors, that typically leads to an immediate cash flow problem—and in turn, a revenue problem for the landlord. The typical office-based corporation, by comparison, can continue on with revenue-generating activities largely as usual by leveraging a remote workforce approach.
Tenant requests can be understood as being in one of three ‘phases,’ so to speak:
— Reaction to immediate impact. This kind of request results from businesses hit hard by shelter-in-place or social distancing orders. Retail property owners have probably already seen tenants with immediate cash-flow concerns approach them to negotiate rents.
— Delayed reaction to COVID-19 impact. The Paycheck Protection Program, or PPP, was a lifeline for many businesses, allowing them to continue to pay rent even with major reductions in normal revenues. However, with PPP now over, and other forms of stimulus lacking, tenants are reassessing where to spend their available resources. Some businesses that kept paying their rent in full for a period of time may start to rethink that decision.
— Reaction to bankruptcy or other turnaround management. With funds drying up and rent moratoriums lapsing, and creditors rigorously pursuing collections, the full economic effects of COVID-19 are now bearing down on businesses. For many, the only respite will be bankruptcy. Requests for relief from tenants in bankruptcy proceedings present additional challenges for the landlord, because the tenant business may have creditors and investors to answer to before it can be legally compelled to pay any rents due. Bankruptcy proceedings also create an “automatic stay,” which makes it that much more difficult for landlords to evict said tenant and replace them with a paying tenant.
Leverage the full range of solutions available to landlords
Once you understand what phase the tenant’s request falls under, the next step is to evaluate your relative bargaining power. For instance, if it is unlikely you will be able to fill the space left by an evicted tenant, it may be worth it to you to earn some revenue rather than none from the space—even if it is only a fraction of the rate specified in the contract.
Unfortunately, in most bargaining situations, there is no one thing you can do to tip the balance of power your way. However, understanding the range of solutions that you can deploy to appease tenants seeking relief other than straight up rent reduction may result in a more favorable outcome. Here are some of the various levers landlords can pull to retain tenants:
— Rent deferral. “Rent deferral” just means that the landlord postpones the due date of all or a portion of the tenant's rent to some future date(s). Landlords can work out with the tenant whether the deferred rent will be due in a lump sum or through increasing subsequent payments. This is a nice starting point from a landlord that wants to show sympathy, while securing a valuable contract that settles the original lease value.
— Rent reduction. The landlord agrees to reduce the rent for either a portion or all of the term left on the lease. The usual forms of rent reduction are to reduce the base rent, operating expenses or both. However, under retail leases, it may be possible to convert base rent—a set monthly amount—to a higher percentage rent, where the tenant need only pay a percentage of their income when it resumes. This may be an attractive option to tenants, although it nevertheless represents a gamble for both parties.
— Rent abatement. If a tenant is already significantly past due on rent payments, a landlord may agree to forgive a certain amount of the past due rent under the condition that the tenant remains current thereafter. While not ideal, not evicting tenants is a prudent and safe choice in markets where vacancies are high and new tenants are far and few between.
— Loan conversion. Rather than abating past due rent, a landlord may agree to convert the past due rent into a loan payable over time. A loan conversion is similar in principle to rent deferral, except it is a backwards-looking agreement with tenants that have already failed to pay their rent. Under this kind of agreement, the tenant is still responsible for paying current rents, while the loan is then evidenced by a promissory note that is cross-defaulted with the lease.
— Application of deposit. If the landlord holds a deposit from the tenant, they may propose to have the deposit credited against any current obligations. If bankruptcy is looming, you need to be very cautious with this approach as courts could reverse this transaction.
— Subletting. The landlord could encourage or help the tenant find a new tenant to lease part or all of the rented space. Although it is unlikely that in a soft commercial real estate market tenants will have any better luck than landlords in finding a replacement tenant, the option of a shared space might make the space more attractive by offering the possibility for synergistic uses.
Keep negotiations confidential
Do not negotiate against yourself by making this agreement public. Once it gets out that a landlord is offering concessions to tenants, you are suddenly dealing not with the power of one tenant, but the combined negative impact of multiple tenants. That is why it is so important that before negotiating anything you get tenants to sign a non-disclosure agreement. To encourage tenants to sign the agreements, landlords may consider making an NDA a precondition to any discussion about rent.
Build your COVID-19 real estate dream team
NDAs are a complex and subtle area of law. Ensuring you have an enforceable and favorable NDA with tenants is just another reason why it is essential that you keep a lawyer on retainer during this team. Not only can they help you with creating NDAs and understanding lease contracts, but a good real estate lawyer can act as a strategic and legal advisor at a time when commercial real estate is likely to be an increasingly litigious business.
And while you are at it, if you do not already, you owe it to yourself to get a good broker and an experienced real estate accountant. It is only with the combined professional insight of this team that you will really know where you stand with regard to a tenant, and it is with them that you should be formulating a game plans for negotiations with tenants in order to have the best chance at success.
Mark Leverette is a partner in the assurance and advisory practices at BPM and is co-leader of the firm’s real estate industry group. BPM’s John Hayashi, Edward Webb and Terry Hill contributed to this article.
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