Rent Negotiations During the Coronavirus Crisis
Commercial property owners have been holding their collective breath: what would April 1st, 2020 bring? Who would be paying rent and who wouldn’t?
The Coronavirus crisis had seemingly come out of nowhere. Even the most prepared investors couldn’t have predicted an absolute shutdown in economic activity the way we’ve seen today. Almost overnight, tenants with otherwise impeccable records have found themselves unable to pay their rent on time.
April 1st gave us some early insight into this dire situation: In some areas up to 30% of commercial tenants failed to pay rent on time with numbers higher or lower depending on the industry. The retail and hospitality industries, for example, have been particularly hard hit. Some of these tenants knew it was going to be ugly and didn’t bother waiting until April 1st to tell their landlords that the rent wouldn’t be coming in. Other property types have fared better, particularly multifamily and industrial, as these product types remain in high demand.
Across all property types, though, landlords have been forced into complicated rent negotiations as a result of the COVID-19 crisis. In this article, we look at some of the prevailing rent negotiation tactics that are being employed today.
Rent Negotiation Tactics during the COVID Crisis
The COVID crisis hasn’t impacted all tenants equally. Some businesses are still operating in full swing, even beyond capacity. This is certainly true at pharmacies and grocery stores, but it’s also true for many office-based businesses whose employees are able to seamlessly work from home. Other tenants are operating partially, while some have shut their doors entirely.
Depending on the tenant’s situation, they may have asked their landlord for relief. Relief can come in many forms. We’re seeing the following rent negotiation tactics being employed today:
Some tenants have simply asked landlords if they can pay a reduced rent for a portion or all of the term left on the lease. This ensures the landlord collects some revenue, even if it’s short of what the landlord would otherwise be owed. Sometimes this is structured as a reduction in base rent. Other times, tenants ask for reduced operating expenses. Sometimes they ask for both. In retail, we’re seeing many tenants request to convert base rent into percentage rent until restaurant restrictions are lifted and business is back to normal.
There’s an important distinction to be made between rent deferral versus rent abatement. Rent abatement, i.e. rent forgiveness, is when the landlord agrees to forgo rent collection entirely – without penalty or expectation for future repayment. Some of the more well-capitalized landlords are providing tenants with rent forgiveness. We’ve seen this primarily in the retail and restaurant sector, where these ground-floor uses are already a loss-leader for the owner. In many cases, these businesses are already so heavily subsidized (think: the restaurant in the ground floor of a lab building), that rent forgiveness costs the landlord little in practice.
Forbearance is when a landlord provides temporary payment relief to assist tenants who cannot afford to pay given unusual hardship scenarios—in this case, COVID-19. Depending on the structure, forbearance can result in either penalties or interest being added on to the rent owed though during Coronavirus many landlords are waiving these additional fees and penalties either voluntarily or by local municipality mandate. That rent, plus any associated fees, is expected to be paid back over a period of time (e.g., three month rent forbearance that is then repaid over the following 12-months).
Owners can also seek loan forbearance from their lenders if a sudden cash crunch results in delayed mortgage payments. Fannie Mae and Freddie Mac have already implemented a program by which they provide a 90-day deferral to their customers under certain conditions. GSA-backed multifamily loan borrowers can request forbearance until December 31, 2020 or until the end of the coronavirus emergency, whichever is sooner. It is important to note, however, that residential landlords cannot evict tenants during this period.
Modification of Operating Clauses
Some tenants have asked their landlords for a temporary suspension or modification of operating covenants, such as co-tenancy, kick-out clauses, go dark provisions and/or minimum operating hours, etc. These conversations are particularly common in the retail, restaurant and hospitality sectors.
FOR REAL ESTATE DEVELOPERS
THE WHITE BOARD WORKSHOP
Learn the exact system best of class sponsors use to raise money online.
Invoking Unusual Lease Terms
Both residential and commercial leases will often contain “boilerplate” language that few people truly understand. This language is usually drafted by an attorney to protect their client’s interests, but most often, these clauses never need to be invoked. The COVID crisis now has landlords brushing off their lease agreements and loan documents to understand what recourse may be available given the uniqueness of this situation (i.e., a global pandemic).
Here are some lease terms that are suddenly being invoked for the first time:
Force majeure, which is French for “superior force,” is a clause used in contracts to allocate risk between parties by relieving obligations under exceptional and/or unforeseeable circumstances beyond the control of the individual parties. Historically, force majeure clauses are rarely invoked. They are usually only used in situations where there’s been extreme damage, such as terrorism, floods and hurricanes. Now, many businesses, contractors, buyers, etc. are trying to invoke force majeure clauses to get out of their contracts, such as leases or purchase and sale agreements.
However, depending on how the clause is written, a pandemic might not be considered one of the triggering events to allow for force majeure. Businesses must review their contracts closely to see what is covered in the force majeure clause. Some contracts include specific language regarding notice and dispute resolution procedures; owners must comply with these requirements if invoking a force majeure clause.
Common Law Doctrine of Impracticability and/or Impossibility of Performance
These terms are used interchangeably and typically in contracts where force majeure is not spelled out or otherwise applicable. Impracticability and impossibility clauses generally cover “acts of God,” or acts of third parties that are both unforeseeable and beyond the control of the affected party. For example, retail tenants are invoking these clauses by making the argument that the government shutdown of their businesses has made it impractical or impossible to fulfill their lease obligations. Impracticality and impossibility may each constitute grounds for termination without liability of the affected party, depending on the contract language and individual circumstances.
Frustration of Purpose
The frustration of purpose doctrine applies to both the sale of goods and performance of services and may excuse performance where the party seeking to be excused no longer has the motivation to perform. Like the clauses discussed above, frustration of purpose typically requires the frustrated party to have become so through no fault of his or her own. If the frustration is merely temporary, obligations may be suspended but not considered fully terminated.
The theory of “constructive taking” is well established in case law and could potentially be applied to certain leases if courts accept the argument that the current shutdown is an act of government that amounts to a partial (or more importantly, temporary) taking.
Material Adverse Changes
Material adverse change (MAC) clauses were readily invoked during the 2008-09 recession, mostly on behalf of lenders. MAC clauses can also be used in transaction documents to give buyers (or tenants) the ability to walk away from a deal to the extent they can demonstrate that a MAC has occurred. Legal experts are still opining on whether the current COVID-19 outbreak constitutes a MAC, but this has not stopped some buyers/tenants from pursuing this strategy when seeking relief from certain contract obligations.
Landlords and tenants, along with their respective lawyers and accountants, are pouring over their lease agreements and contracts to understand how these clauses may be invoked. Most are doing so in search of relief: tenants from their rent obligations, landlords from their mortgage obligations. Those who successfully invoke these clauses may be able to back out of deals, extend escrow periods, secure price reductions and more.
Ranking Asset Classes: From Worst to First
Not all asset classes are being impacted by the COVID crisis to the same degree. Below is a quick snapshot of what we’re seeing, by asset class, in terms of rent re-negotiation:
Retail and hospitality have been hit equally as hard. Some retailers have gone from paying full rent to zero rent in the matter of days. Retailers deemed “non-essential” have been forced to close in most markets and are in dire need of rent relief right now. Retail landlords have been advised to think long-term: a few months of no rent is far better than a few years of no rent. The way the landlord reacts in this moment of crisis will be remembered by tenants. When retailers and restaurants are back on their feet, tenants will make certain real estate decisions based on the way landlords handled this crisis.
The travel and tourism industry has been virtually shut down, and as a result, hospitality properties are taking a beating. Hospitality may feel the lingering effects of COVID much longer than other asset classes. Conventions, conferences, business meetings, and other large events that drive demand for hospitality may be slow to start up again even as government restrictions are eased.
Commercial office is a bit of a mixed bag right now. Some office tenants, particularly white-collar professions, seem to be weathering the storm well right now as many of employees can work remotely. Startup companies, particularly nascent tech companies, have furloughed or laid off substantial portions of their workforce. This may create less demand for office real estate moving forward, particularly if businesses decide to put growth plans on hold. Unlike retail landlords which have been more proactive in working with tenants, office landlords have been more silent to date—opting to take a “wait and see” approach (i.e., who pays rent) before taking any action.
One side effect of the COVID crisis that we may see in the office market is a restructuring of leases to allow for subletting if this was previously not allowed. Larger office tenants might also opt for short-term leases (or subleases) in lieu of signing longer-term leases until they have more certainty of how the economic picture looks moving forward.
A final thought on office: we’ve seen a few cases of office tenants using coronavirus as an opportunistic play to try to secure a rent concession from their landlord. In one example, a midsized, national, fully healthy accounting firm approached the owner at a top office property in New York demanding rent concessions because of the shutdown. The broker conferred with the owner and agreed that their intent was likely an opportunistic play to benefit from this versus a small business or retailer that’s legitimately hurting. Office landlords should be on the lookout for this type of behavior in the months to come.
Early predictions were that roughly 25-30% of multifamily tenants would fail to pay April 1st rent on time, and so far, actual nonpayment rents reflect this prediction with about 30% of multifamily rents reportedly late this month. A deeper look at the actual numbers shows that Class A multifamily buildings are only around 5% off their usual delinquencies, Class B at around 10% and the most pronounced problem in Class C apartments where the working class tends to live and who are disproportionately impacted by job layoffs and financial hardship.
It will be interesting to see what happens moving forward: on the one hand, federal (and increasingly, state and local) regulations have been put in place preventing evictions due to COVID-19. On the other hand, landlords also have an obligation to their lenders. Something has to give.
Moreover, rent negotiations tend to be more difficult at multifamily properties where more people have month-to-month leases or are approaching the end of their lease term. In situations like these, deferring rent payment today and expecting payment in the future may not be realistic.
Industrial property, including self-storage, continues to perform well. There’s been huge demand for distribution facilities and warehouses, particularly “last mile” facilities, as more people turn to online shopping in lieu of leaving their home. Self-storage is also resilient, at least in the short-term. Self-storage rents tend not to be high and are paid using autopay, so rents are still coming in as of now.
The Case for Business Interruption Insurance
Many landlords assume that businesses should be able to claim reimbursement under business interruption and rent loss insurance for coronavirus losses. In reality, there are substantial barriers to overcome that may preclude insurance coverage for COVID-19 related losses (namely, that most business interruption insurance is triggered by “direct damage to property;” a lack of physical damage on premises will preclude most claims). Nevertheless, landlords and tenants are being urged to file claims with their insurers for several reasons:
- The insurance company has the burden to prove that there is no coverage under the policy and is obligated to investigate all relevant facts and circumstances surrounding a claim.
- There may be governmental intervention or court decisions that compel insurers to pay losses as a result of COVID-19, in which case it will be important that owners have already filed a claim. There are ongoing legislative discussions in multiple states on this topic (including in Massachusetts, New Jersey and Louisiana).
- The state or federal government may offer a subsidy program at some point that would reimburse companies for additional expenses and lost revenues due to COVID-19. It is important to keep detailed records to support a claim. Any government assistance program may require evidence than an insurance claim has been submitted and denied.
Conclusion: Reasons to Remain Optimistic
Despite the ongoing turmoil in which rent negotiations will become more commonplace, there’s reason for investors to be optimistic. Indeed, most investors are confident about the long-term prospects of commercial real estate. They view this as a blip on the radar. Instead of doing deals on a five-year time horizon, they’re tacking on a few months and viewing deals through a lens that assume a five-year, six-month horizon.
This isn’t unfounded optimism. Already, we’ve seen commercial real estate hold its value relative to the stock market. While yes, it is harder to get deals done right now, commercial real estate investors aren’t panicking. We haven’t seen any significant price adjustments yet, and if we do, industry experts anticipate a drop of potentially 10% -- certainly not the 30-50% pricing adjustment experienced during the last downturn. Those with dry powder are sitting tight for now: they’ve hit the pause button but are preparing to jump in the next three to six months as the economic engines roar up again.
A Guide for Commercial Real Estate Professionals
Copyright 2019 - ADAM GOWER PH.D. - All Rights Reserved