By Roger Huggins
Being a commercial landlord can be difficult even in the best of times. The current COVID-19 pandemic magnifies those difficulties. To understand the issues, it is first important to understand the relationships and interdependencies that exist in the typical commercial real estate investment.
In most situations, the landlord serves at least two masters: the landlord’s tenants and the landlord’s lender. A third could be the landlord’s equity investors but for purposes of this article, the equity investors and landlord will be treated as one. The tenants, of course, serve as the economic driver of the real estate project. The rents they pay provide the single source of revenue from which all others in the project are compensated and operating expenses, taxes and insurance are paid. The income from the property provides the funds to pay the lender. The amount and strength of the income stream provides the basis for valuing a commercial property and the underwriting of the project by the lender. Indeed, without a strong income stream generated by tenants, there would be no mortgage loan and, in the vast majority of cases, no viable commercial property. Of course, the strength of the income stream is a direct function of the strength of the tenant’s business.
From the lender’s perspective, commercial loan documentation typically includes a number of representations and warranties about the property and the leases. Lenders conduct considerable due diligence into the financial stability of the tenants, the leases, and the lease terms. Financial models evaluate the performance of the property and are critical to the decision to lend. In order to protect themselves, lenders include a number of covenants in their loan documents with which landlords must comply in order to maintain their loans in good standing and to avoid default. These covenants typically include debt service coverage requirements, lender consent requirements for new leases or modification of existing leases, and loan-to-value thresholds. Landlord net worth and liquidity covenants may also appear as well as protective provisions for the lender in the event of adverse changes in the financial condition of the landlord or loss of value of the property.
When the income stream is threatened, the relationship between the parties can be affected in many ways. The onset of the COVID-19 pandemic, and more particularly, the precautions instituted to address the pandemic, have struck at the heart of commercial real estate with a sudden, sharp drop in economic activity. The businesses of many tenants have been severely curtailed, leaving a number of them unable to pay their rent. The result is a shock wave up the line to the landlord and the lender.
What can a landlord do?
Examine the Relevant Documentation
First, the landlord should thoroughly examine the relevant documentation to evaluate the rights and obligations of the respective parties. This begins with an examination of the lease. An understanding of the lease provisions and the duties and obligations of the landlord and tenant under the circumstances is critical. Are there any provisions that provide defenses to the tenant’s obligation to pay rent? Many leases contain “force majeure” clauses intended to excuse performance under certain circumstances. Often, these clauses include examples of the types of events that are covered. Generally speaking, these provisions are interpreted strictly; thus, unless a lease includes terms such as “pandemic”, “virus”, “state of emergency”, “disease” or the like, the “force majeure” provision is not likely to apply. Also, leases typically exclude rent payments from the scope of the clause. There are generally very few lease provisions that permit the abatement of rent or termination of the lease by the tenant. It is, however, imperative to know what, if any, such clauses do exist and to recognize what notices must be given, and when, in order to preserve and not risk waiving any rights.
In addition to the lease, landlords also need to fully review their loan document and in particular, financial covenants, to determine the latitude they have in dealing with the tenant and the lease. More likely than not, an amendment to the lease, especially one modifying the rent, will require lender consent. Care must be taken to ensure that any rent modification will not result in the landlord violating the financial covenants in the loan documents. Landlords must consider possible ripple effects as well. For example, will a rent reduction now result in a loss of value such that a loan-to-value covenant will be violated or will the lender in the future determine that there has been a material adverse change in the landlord’s financial condition?
The type of loan will have considerable bearing on flexibility. If the mortgage loan is a portfolio loan from a local lender, landlords will have more flexibility than they if the loan is a capital markets or other syndicated loan. In the latter situation, loan servicers are considerably more constrained and covenant breaches or lease modifications could easily result in the landlord losing control of the income stream from the property or the implementation of some other servicing action, any of which will also result in additional fees to the landlord/borrower. Also, even local portfolio lenders may sell loan participations to other lenders and the participation agreement may require the involvement of the participants.
Other relevant documents, to the extent they exist, also must be examined. For example, is the property the subject of an agreement of sale? If so, at a minimum, the prospective buyer is likely to have the right to approve any lease modifications, not to mention the potential impact on the sale terms and a possible termination of the agreement of sale. Property managers are typically compensated in the form of a percentage of revenues. Management contracts should be reviewed to determine whether any rights or duties are affected. Similarly, real estate brokers are compensated in the form of a percentage of rent. How are commissions affected by a lease modification reducing the rent? Are they addressed in the listing agreement?
Other Defenses to Payment
As things progress over the next weeks and months, tenants can be expected to assert a variety of legal theories to excuse performance under leases. These include impossibility of performance, impracticability of performance, and commercial frustration. Generally, such theories have been narrowly construed making it difficult to prevail. For the most part, circumstances that involve inconvenience or increased cost are not enough. However, one has to ask whether a non-life sustaining business that is all but shut down by the response to COVID-19 has a valid claim. In the end, these will be time-consuming claims that, even if successful, are not likely to save a struggling business.
Last, but certainly not least, landlords must consider the effects of a tenant bankruptcy. While not pleasant to contemplate, the fact is that it is quite possible that a number of tenants will seek bankruptcy protection. Filings will invoke bankruptcy provisions that establish time lines for assuming or rejecting leases, uncertainty as to the treatment of existing rent arrearages and deposits, and possible unexpected consequences such as a lease assignment notwithstanding a lease prohibition. At a very minimum, a tenant bankruptcy filing will stop things in their tracks due to the automatic stay that becomes effective at the time of filing, whether the landlord is aware of the filing or not.
Terms of Negotiations
Before entering negotiations, it is advisable for a landlord to enter into a pre-negotiation agreement with the tenant. It should be made clear that the landlord will not be bound by any statements or discussions unless and until they are reduced to a signed writing. Confidentiality should also be addressed. Because negotiations do not always result in a deal, it should be clear that the negotiations are being made in the context of a settlement and are inadmissible in any subsequent litigation. The landlord should be free to break off negotiations at any time.
Many possible alternative sources of financial relief that do not require lease modifications also must be explored. One of the most recent is the recently enacted SBA 7a Paycheck Protection Program that may well be available to a tenant. Loans under this program have extremely favorable terms, carry payment deferrals, and if the funds are properly used, the loans may be forgiven. Despite its name, the payment of rent is a permitted use of Paycheck Protection Program funds and any business with fewer than 500 employees may qualify. While the demand for these loans has been overwhelming, there are other possible sources of relief under the federal CARES Act as well as the SBA Economic Injury Disaster Loan Program or the PA COVID-19 Working Capital Access Program. Landlords typically carry rent loss insurance and tenants typically carry business interruption insurance, either of which may be a possible source of relief. Although at first blush, these policies appear to exclude coverage for COVID-19, some states such as New Jersey have introduced legislation striking the exclusion and a number of lawsuits have been commenced in various jurisdictions seeking coverage. Claims should be considered.
Discuss and Document
This is a time for all parties to be reasonable and creative. Although technically adverse legally, all parties have some common goals. Tenants do not want their businesses to fail, landlords want to maintain tenant relationships and not have to deal with avoidable vacancies, and lenders want performing loans. Regulatory authorities are signaling to lending institutions that a degree of flexibility is preferred and federal, state and local governments are working to provide sources of liquidity and relief. Thus, while they should be fully informed and have a clear understanding of the rights, duties and obligations of all involved, landlords should be open to meaningful discussions with tenants and not be reluctant to discuss alternatives with their lenders. Importantly, discussions should be clearly documented to keep everyone on the same page as we all negotiate this very uncertain time.
If you are a landlord or business owner who needs assistance, Lamb McErlane PC can help. Contact us at 610-430-8000. www.lambmcerlane.com
Roger Huggins is a partner at Lamb McErlane PC. He practices in the areas of Commercial and Real Estate Transactions, Real Estate and Equipment Leasing, Business Law, Finance, Banking and Contracts. His clients include individuals and businesses, ranging from small local businesses to publicly traded corporations, lending institutions and public and private non-profit institutions, including public and private schools and school districts. email@example.com. 610-701-3276.