The coronavirus crisis and resulting state and local orders requiring businesses to close or materially reduce operations have had far-reaching impacts throughout our economy. They have disproportionately affected the retail and service sectors, but so many other businesses are also feeling the financial impacts of the crisis and are seeking rent relief.
How should landlords and tenants approach these challenges? First off, we suggest that both parties be in communication with each other early and often with the objective of understanding the business realities of the other side, which will inform the negotiation process. It also is important that they assess their legal risks and take steps to preserve their rights. Reaching out to legal counsel to review critical contracts and evaluate the specific circumstances in play also is an important first step. We suggest that Landlords and Tenants think about the following in maneuvering through these difficult times:
What is the financial condition of the tenant in the short and long term? Will the tenant be able to survive the crisis if concessions are given? Just as in the original underwriting of a tenant, landlords should consider the financial backing of their tenant, sales levels before and after the shutdown, the tenant’s available cash, and whether the tenant has historically been current on rent.
Is the tenant experiencing losses? We are seeing tenants ask for the rental relief that have not actually experienced losses. So tenants need to demonstrate that they have, in fact, been impacted by the crisis. Before requesting a rent concession, a tenant should be prepared to demonstrate its loss and actual need for a concession.
Is the tenant judgment-proof? Both parties need to think about how the tenant is organized as a legal entity. If it is a limited liability entity (such as a limited liability company, limited partnership or corporation), with little to no assets, filing an unlawful detainer action with a claim for damages might get the space back, but little else. If the tenant signed a personal guaranty, failure of the entity is less of a concern. But a personal guaranty is not a slam-dunk solution where the guarantor has multiple creditors, such as, for example a franchisor with guarantees in favor of the franchisor and multiple landlords, and insufficient assets to satisfy all of them. A bankruptcy filing may be the only way out if a workout cannot be achieved. If a bankruptcy trustee rejects a lease, the most a landlord may recover in damages (under Section 502(b)(6) of the Bankruptcy Code) is the greater of (i) 12 months rent or (ii) 15% of rent for the remainder of the term, not to exceed 3 years. Except for the security deposit held by the landlord, rent is an unsecured claim, which means that the landlord must get in line with all other unsecured creditors, who are paid only after secured creditors and only to the extent assets are then available.
PPP loans and other disaster assistance. Up to 25% of the proceeds of a PPP (Payroll Protection Plan) loan may be used to pay rent and utilities. Tenants should maximize the use of these funds to pay rent if they are not otherwise used to pay payroll expenses. The SBA has made available other disaster assistance loans, such as the Economic Injury Disaster Loan (EIDL), and some local jurisdictions also have offered assistance funding.
What is the value of the lease? The landlord and tenant need to consider the remaining term of the lease and the current and near-term market conditions to evaluate whether the lease is worth preserving. If the lease is at or above market, concessions might be appropriate because, between delays in finding a replacement tenant, tenant improvement and brokerage costs, and market adjustments, it could very well be more costly to the landlord to re-tenant the space than abate or defer rent. And from the tenant’s perspective, if the lease is below or at market and there is a significant amount of term remaining, it might be worth negotiating with the landlord rather than walking away. We expect to see the rental real estate market decline through this next cycle, which should create favorable leverage for tenants.
Lender Issues. Depending on the size of the lease in relationship to the overall project, making rent concessions could require lender approval. Typical loan provisions that come into play in these situations include: requirements that the lender’s consent be obtained to material lease amendments; notice to lenders in the event of a tenant default; and financial covenants including debt service ratios and minimum level of cash flow. Personal guarantees for “bad boy carveouts” also may be triggered if a borrower does not bring the lender to the table when required. So we recommend bringing the lender in early. Landlords may even find that the lender is amenable to structuring the debt.
Make a claim on your insurance policies. If your property policy contains business interruption coverage (rental loss for a tenant), there is no downside to making a claim through your broker. The insurer will invariably decline the coverage, however, if you do not timely file in accordance with the notice requirements, you may lose your rights to do so in the future. If the insurer declines, you do not need to immediately file a lawsuit. Several lawsuits have already been filed by plaintiffs with deep pockets which, if resolved in favor of the insured, will create significant leverage in dealing with the insurance companies who previously declined coverage.
Consider eviction moratoria. Many municipalities have enacted or are subject to eviction moratoria that apply to both residential and some commercial tenants, which are typically limited to small businesses and non-profits. They typically ban evictions for the non-payment of rent if the tenant can show that its inability to pay rent is due to “financial impacts related to COVID-19”and provide for the potential deferral of rent for up to 180 days. Also, the California Judicial Council has essentially banned all California courts from carrying out any residential or commercial eviction proceeding until 90 days after the California state of emergency is lifted. These restrictions will affect landlord/tenant dynamics, at least in the short term.
Lease Workout Strategies
In light of the uncertainties going forward, landlords and tenants may find that a negotiated workout is in the interest of both parties. The following are possible ways to approach a lease renegotiation.
- The landlord could apply the security deposit to outstanding rent (if permitted by the lease), which likely would not violate the local eviction moratorium ordinance, if any.
- Abatement or deferral of rent for a period of time, with the deferred portion amortized over the remaining term or a shorter period of time. A restaurant client of the firm negotiated a deferred rent package based on the tenant’s pro rata share of the landlord’s debt service payment. Alternatively, the deferred rent could be added to the end of the term.
- A landlord could agree to collect CAM charges but defer all or a portion of base rent.
- For retail tenants, converting a base rent deal to percentage rent or a combination of base rent and percentage rent is an option.
- A landlord should consider whether it can get anything in return for lease concessions, such as a personal guaranty.
- Termination of the tenancy for an upfront payment by the tenant also may be an option.