September 22, 2010
By Yvonne A. Jones, CCIM, CPM
The ongoing recession has had a profound impact on commercial real estate throughout the United States: More and more landlords and tenants are struggling to survive. As a result, most property managers have noticed a significant uptick in the number of tenant negotiations they are working on at the properties they manage. While these tenants seek to reduce their costs, landlords must find ways to preserve their cash flow and maintain occupancy to ensure long-term financial stability.
Landlords can employ a variety of strategies to provide tenants with relief. The most common are discussed below.
Rent Reduction. The landlord can reduce the tenant’s rent for 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. In regard to retail, it is common to convert base rent to percentage rent.
Rent Deferral. In this case, the landlord can defer a portion of the tenant’s rent but would require them to repay the rent deferred at a later time, either in a lump sum or by increasing subsequent payments. A variation of rent deferral could be to cap or set a base year to operating expenses for a short or extended period of time.
Rent Abatement. If a tenant is significantly past due on rent payments, a landlord may agree to forgive a certain amount of the past due rent if the tenant remains current thereafter.
Loan Conversion. Rather than abating past due rent, a landlord may agree to convert the past due rent into a loan payable over time. The tenant would, however, continue to pay the current rent. The loan is then evidenced by a promissory note that is cross-defaulted with the lease.
It is important to note that many strategies for restructuring leases have the potential of creating significant tax consequences and, therefore, both the landlord and tenant should consult with their tax advisers.
Due Diligence
When considering a tenant’s request for rent relief, it is important to perform due diligence. The first step is to request and review the tenant’s current and prior years’ financial statements, and for retail tenants, their gross sales receipts. To the extent possible, the information received from the tenant should be certified as being complete and accurate. The next step is to conduct an evaluation of current asking rents, common area expenses, and real estate taxes at comparable properties. Finally, a thorough review of the existing lease terms should be reviewed and scrutinized to see what opportunities there are to tighten up language for the benefit of the landlord.
As a general rule, tenants in default should not be entitled to rent relief. However, the reality is that you are likely negotiating a rent reduction with a tenant because they already are, or will soon be, in default. Regardless of the tenant’s current default status, any document granting a rent modification should be expressly conditioned on the tenant not being in default. Furthermore, the same document should stipulate that the rent reduction automatically will terminate and revert back to the original rent schedule if the tenant does not pay the future payments on time. Reinstatement of the contract rent and acceleration of unpaid, but accrued, rent at the contract rate is important because it provides the landlord with an initial remedy to enforce against a tenant before the landlord has to resort to the remedies allowed by a tenant default in the original lease.
Rent relief also should be viewed as a temporary concession over a short period of time -– typically 24 months or less. The economic downturn will end, and by establishing a relatively short period for rent relief, landlords can protect the long-term value of their asset. Any document should, therefore, also include a provision that at the end of the reduced term, the rental rates either revert back to the rental stream identified in the original lease agreement, or will be renegotiated by the landlord and tenant based on the fair market rents at that time.
As further consideration, the landlord should view the tenant’s request for rent relief as an opportunity to “tighten up” certain nonfinancial terms of the lease agreement. For example, in the case of a retailer, the landlord may request the elimination or modification of the exclusive use, co-tenancy, and/or sales reporting clauses. Looser language concerning any of these clauses will allow the landlord more flexibility in leasing current and future vacancies and/or give them better insight into the operating performance of the retailer.
Other key clauses to consider negotiating include the following.
1. Guarantees –- If there is currently no personal or corporate guaranty in the existing lease, the landlord could ask for a guaranty to further secure the future rental stream.
2. Estoppels –- The landlord could include estoppel and release language in rent relief documents that would release a landlord from any claims up to the date the rent relief document is executed.
3. Assignment/Subletting –- The tenant should not be allowed to have the rent relief assumed by a tenant they may assign or sublet their space to, even if it is a subsidiary or affiliate. The rental stream should revert back to what it was in the original lease agreement.
4. Right to Recapture -– The landlord could include a right to recapture the space from the tenant for any reason during the rent relief period.
5. Confidentiality Provision –- The landlord may want to include a provision in the rent relief document prohibiting the tenant from discussing with other tenants at the property or in the market area the terms of their agreement with the landlord. While this is difficult to enforce and/or prove breach, it is worth asking for and trying to enforce.
6. Agreed Order of Possession –- Landlords may be able to shorten the judicial process to recover possession or monetary damages for breach of the lease by obtaining an “Agreed Order of Possession.” While this will not prevent the need for an unlawful detainer action, it may shorten the time between filing and enforcement.
7. Lease Termination –- Sometimes the best course of action for the landlord is to let the tenant out of its lease. If the tenant is in trouble and it has no assets for the landlord to go after, pursuing the tenant in court may be throwing good money after bad. In such cases, it makes sense to arrange for an organized exit where, for example, the landlord has the right to terminate the lease upon a limited period of prior notice, for example, 30 days. Such agreements should be carefully worded and explain that the selection of a replacement tenant is at the sole discretion of the landlord. Additionally, the landlord should be under no obligation to actually find a replacement tenant.
High unemployment, lack of significant job growth, and limited capital are all working together to recalibrate the real estate market. A skilled and knowledgeable property manager who can work with landlords, tenants, and even lenders will be extremely valuable during this time.
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