Landlords and Tenants Restructure Rent Obligations in Response to COVID-19
Client Alerts | April 22, 2020 | Leasing
Stay-home requirements in response to COVID-19 have left most commercial tenants unable to use their spaces, which more often than not has resulted in significantly reduced (or eliminated) income. Similarly, many landlords are facing reduced rent rolls with vacant space that cannot be filled, while certain operating expenses, taxes and debt service obligations still must be covered. This is a drastic departure from the immediate past, where leasing transactions were being entered into and many landlords and tenants were in the midst of tenant improvements, relocations and performing under leases, all of which activities have been interrupted. The accompanying economic downturn has also forced landlords and tenants to revisit operating budgets, capital improvement plans and other expenditures for the near future.
As tenants seek relief from lease obligations and landlords have to assess competing tenant requests while they try to preserve their assets, the following strategies may be useful for either party in considering their options.
Be Thoughtful. Take a long-term approach to the current situation and do not rush into action. While the immediate outlook may not be promising, lease parties are best served by taking the view that some level of business activity will eventually resume. This will require existing business relationships to be reestablished, including those between landlords and tenants (in most cases). Acting precipitously will make it more difficult to rebuild businesses after the pandemic and take advantage of new opportunities at that time.
Be Informed. The starting point for any analysis is a review of your lease, loan or other relevant documents. Special consideration will need to be made if you are in the midst of tenant improvements, nearing the end of the lease term or in a holdover rent period. Most leases tend to be landlord-friendly, but landlords will have certain obligations, such as the need to provide continuous operation of the building, 24-hour access to the premises or amenities for tenants, all of which may be affected by force majeure occurrences and emergencies, as specified in each lease, and some of which may still need to be provided, notwithstanding government mandated shutdowns of business activity. Tenants’ rent obligations, while usually absolute and non-discountable, may similarly be affected by such externalities. At the same time, you will need to understand how the exercise of lease rights (including sending and accepting default notices and accessing cash or letter of credit security deposits) may require engagement with lenders, including sending copies of notices and obtaining consents, which may inform future action. Further, your loan may have cash reserves and undrawn credit lines which may be accessed by your lender at this time, or impose obligations on you to conduct improvements or repairs, which your lender may continue to require, notwithstanding any difficulty you may have in accessing labor markets. Finally, a landlord amending its lease terms or waiving rights against a tenant may require consent from its lender, joint venture partner or ground lessor to the extent where such parties exist.
Be Updated. Familiarize yourself with existing and proposed legislation that affect your lease and your rights as landlord or tenant. For instance, some states have enacted legislation that limit tenant evictions for a period of time. While this may not prevent the landlord from noticing defaults against tenants, it may provide some breathing room for the parties to evaluate options and solutions. Similarly, you may be entitled to loans and other monetary relief from federal and state programs intended to address the economic impact of the pandemic.
Communicate, but Protect Yourself. In most situations, you will be seeking a consensual resolution between landlord and tenant. Once you understand your rights and obligations under the lease and loan documents, consider approaching the lease counterparty with a suggestion that given national and global situation, there should be a discussion about potentially modifying lease obligations to allow both parties to weather the current economic storm. Landlords may require tenants to enter into a pre-negotiation agreement to firmly establish that all discussions between parties are non-binding and shall not be deemed to amend or modify existing agreements unless and until a written amendment is entered into. (Lenders likely will demand the same from borrowers seeking loan relief). A pre-negotiation agreement could benefit the tenant as well, in the sense that it will promote more open discussion.
Be Candid. If you are a tenant, you may be asked to disclose information about your business and finances (after signing the pre-negotiation agreement, which should also provide for maintaining the confidentiality of such information), in order to better allow the landlord to evaluate the gravity of the situation and the potential solutions. Note that other tenants in the building may also seek concessions from the landlord, and so in a manner of speaking, you are competing for a limited amount of concessions. Similarly, if you are a landlord, you may choose to share some information about building operating costs and expenses. Both sides should not, as reasonably possible, look to obscure any information provided, as this may give rise to suspicions of bad faith in the course of negotiations. Also be aware that, depending on the nature of the proposed concessions, on the one hand the tenant may be establishing the severity of its short term cash flow shortage, while on the other hand convincing the landlord that tenant remains a good long-term investment.
Evaluate Your Options. Crafting a solution that works for both a landlord and tenant is limited only by the parties’ willingness to compromise and their creativity. At Kleinberg Kaplan, we have worked and are currently working with both landlords and tenants to develop mutually satisfactory outcomes for similarly affected clients.
We suggest considering the following possible solutions:
- Defer Rent Temporarily. While generally we are not seeing landlords simply forgive rent, landlords may consider deferring all or a portion of the fixed rent portion of leases temporarily, but probably not with respect to additional rent (e.g., operating expenses (which may, by circumstance, be reduced anyway) and real estate taxes). The agreement between landlord and tenant may provide that the net amount of rent reduction be recovered as a lump sum at the end of the deferral period, be spread out over a particular period of time at a certain rate of interest or be divided in some other manner.
- Extend Lease Term in Exchange for Free Rent. Regardless of how close a lease may be to its expiration date, the parties may find it mutually advantageous to extend the term of the lease in exchange for a certain period of free rent that would be granted immediately to help the tenant get through the current crisis rather than upon the commencement of the extended term. The rental rate would be set at a rate that enables the landlord to ultimately earn a rental stream that justifies the free rent.
- Applying Cash Security Deposits. Landlords and tenants may consider the option of allowing the landlord the option of applying cash security deposits against rent obligations (or part of rent obligations), with a possible further agreement that the tenant would restore the applied amount at a future date. However, landlords need to evaluate the risk that the deposit will not ultimately be restored, which will leave them exposed if the tenants go out of business.
- Reduce Leased Space. Lease parties may consider surrendering separately demised space in the building that is already occupied by a tenant in exchange for some other consideration, such as extension of lease term or increased rent in the remaining space. Alternatively, if a tenant has expansion rights in a building, and the landlord is aware that there are other tenants that potentially desire the same expansion space, the landlord and tenant could agree for the tenant to surrender the expansion rights in exchange for some rent concessions or other consideration.
- Consider Adjusting Time for Performance. In order to account for the realities of governmental confinement and social distancing requirements and the issues with a remote workforce, lease parties may want to consider extending some of the time periods and deadlines within leases in order to allow the parties adequate time to respond. For instance, if the time for performance is stated as “five business days,” the parties may agree to extend this by two additional business days in order to avoid any potential for default, perceived delays, requirement for formal waivers and the charging of interest or late fees. More significant obligations, such as performing construction, may require extended deadlines to the extent not already covered by force majeure clauses.
- Increasing Collateral. Some of the actions described above may have the effect of increasing landlord (and even lender) underwriting risks, and landlords may need to consider additional credit support, such as additional guaranties or increased amounts for letters of credit provided as security (presumably, at this point, increasing cash security deposits would be challenging).
- Remember Your Insurance Policies. While not strictly a leasing issue, you should also have your insurance consultant and/or attorney review your insurance policies to determine if a claim may be made. For instance, there is considerable discussion whether the pandemic and the ensuing governmental orders may give rise to claims under business interruption policies or even for property damage.