Consider Short-Term Lease Workouts For Commercial Tenants
The COVID-19 pandemic is adversely affecting commercial real estate as it continues to wreak havoc in industries throughout the economy. For many years, the primary declining CRE sector has been brick and mortar retail stores. However, the retail sector is no longer suffering alone, as the COVID-19 outbreak is hurting most other CRE sectors: office, hospitality, multifamily, restaurant, personal services, entertainment and construction.
Federal, state and local governments have ordered business shutdowns and social and travel restrictions limiting most social and commercial activities. As a result, commercial tenants throughout the country are going out of business, temporarily closing, curtailing operations, laying off employees and suffering sharply declining revenues.
Short-Term Leasing Workouts of Tenant Defaults
Thousands of tenants are partially operating or temporarily closed and lack sufficient cash flow or access to additional working capital to pay some or all of their rent. How should a landlord address a distressed tenant's default and request for rent relief, taking into account the landlord's own responsibilities to pay maintenance costs, real estate taxes and debt service on the property?
With certain exceptions, leasing parties should exercise patience, restraint and consider practical short-term workouts only. Holding workout discussions will require both sides to assess a variety of circumstances, many of which are in a state of flux due to the uncertainty regarding the timing and extent of the lifting of the stay-at-home orders throughout the country.
Consequently, the most practical approach is for landlords and tenants to focus on addressing key issues over the short-term through a lease amendment or forbearance agreement, referred to as short-term workouts, such as:
- Rent relief: Deferral, reduction or abatement of base rent only or all rent including tenant's share of pass-through obligations for operating expenses and real estate taxes.
- Rent repayment: Repayment schedule for deferred rent including appropriate acceleration triggers for earlier repayment due to future lease defaults or adverse events such as a tenant's permanent closure of its business.
- Tenant assurances and reporting: Arrangements addressing tenant's obligations to mitigate business interruptions and resume full operations; tenant reporting to landlord of ongoing financial condition, operating status and public and private financial assistance.
- Collateral: Landlords may prefer to apply security deposits against unpaid rent or require third party guarantees or additional collateral to secure payment of deferred rent.
- Modification of operating clauses, etc: Temporary suspension or modification of operating covenants, co-tenancy, kick-out clauses and other lease terms.
- Third-party consents: Landlord and tenant obtaining required consents to lease modifications and rent relief from lenders and other third parties.
Key Legal, Practical and Financial Issues Affecting Short-Term Workouts
The ability of leasing parties to enter into short-term workouts will depend on their evaluation of a number of critical legal, practical and financial issues:
Critical Lease Terms
There are many lease provisions that should be reviewed which may affect the parties' negotiations and the terms of any short-term workouts: tenant operating covenants; co-tenancy; kick-out and recapture rights; force majeure; renewal options; defaults and remedies; and security deposits and other collateral.
Status of Tenants' Business
The parties must review COVID-19's impact on a tenant's business operationally and financially to assess a tenant's current and future ability to pay rent and comply with other lease obligations. Tenants need to consider their business options including closing underperforming locations, consolidating operations, limiting expenses, keeping key employees and maintaining operating funds and reserves.
Landlords should request a range of information regarding a tenant's financial condition and status: profit and loss statements; financial statements and tax returns; and the status of tenant's business with its lenders and critical suppliers and customers.
Tenants' Short-Term Outlook
Does the tenant intend to permanently close in the short-term or continue to operate and at what capacity? Tenants will need to discuss with landlords their plans and projections, however uncertain, to stay in business, capabilities to operate remotely, wind down certain parts of their business and/or resume operations as governmental restrictions begin to lift.
Access to Government Funding
Landlords and tenants should determine if they are eligible for loans and grants for working capital, rent, payroll and mortgage payments under recently approved legislation such as The Coronavirus Aid, Relief and Economic Security Act and the Small Business Administration's Paycheck Protection Program.
Landlord Ability to Recover Leased Space
Landlords will also need to assess their own ability to find a suitable replacement tenant if they opt to repossess leased spaces. Evictions and reletting CRE will most likely be very difficult in the short-term. Many states and courts have issued moratoriums suspending residential and commercial evictions and foreclosures.
Landlord Ability to Prepare Premises for Reletting
After securing possession, landlords will need additional time to make repairs and market space for reletting, and to negotiate new leases. State and local governments across the country have imposed restrictions on nonessential construction activities. Until lifted, these restrictions may significantly delay restoration work and tenant improvements under new leases, and push back related rent commencement dates.
Generally, commercial landlords and tenants should only consider short-term workouts due to the continuing uncertainty of when most businesses will be allowed to resume full operations and begin to rehire, reopen and rebound. Unlike the rapid closure of businesses in March, the recovery of surviving businesses will be gradual and long-term.