The manner in which we live and conduct our day to day business has been drastically altered by the COVID-19 pandemic. The economic repercussions we face as we social distance to prioritize everyone’s health and safety will be profound. Particularly with the state-mandated shutdown of non-essential businesses. A recent Chamber of Commerce survey concluded that more than 40% of the country’s 30 million small businesses could permanently close in the next six months due to the pandemic. Which begs the question – what about commercial landlords? Nobody’s talking about them as they’re faced with the tenants currently unable to pay their monthly rent or lease and lost recurring rental streams. We thought it would be good to provide some tips to help commercial landlords stay solvent through this unprecedented and tumultuous time.
There’s been much talk in commercial real estate circles about the “force majeure” clause. This provision excuses delays in the performance of certain obligations due to circumstances beyond that party’s control. This can be anything from natural disasters to acts of terror, war, labor strikes, and most relevant to what’s going on today, government-set orders and prohibitions. Pandemics may also be specifically referenced in the verbiage of some lease agreements.
A force majeure clause of proper scope may allow for the delay of a party’s deadlines to carry out specific lease obligations by however many days a force majeure event makes the party unable to meet those obligations. However, this doesn’t necessarily mean a tenant’s rent obligation is excused or delayed through COVID-19. Even with a “force majeure” in the lease, most tenants are still contractually liable to pay monthly rent.
This is a great time to assess the contents of your agreement’s force majeure clause. Here are a few recommendations as to what to do from there.
EVALUATE MONETARY & NON-MONETARY OBLIGATIONS
Lease or loan agreements always outline some core obligations. Take note of monetary obligations – things that either need to be paid out or will require money coming in to carry out. For instance, promised tenant improvements or property taxes and insurance premiums. Look for opportunities to either reduce these costs or defer them if an agreement renegotiation is possible.
Additionally, assess non-monetary obligations you may have. For example, your loan may have an occupancy or debt to income ratio requirements. Or there may be co-tenancy requirements. Something written into a bank loan or tenant contract stating that a mall, shopping center, or office park/building must maintain a certain tenant occupancy or “anchor tenant” or the agreement can be voided.
TALK TO YOUR TENANTS
Once you’ve identified your monetary and non-monetary obligations, it’s time to approach your tenant. Be tactful. Be empathetic. They weren’t expecting to be in this situation either. Some will be okay – perhaps still bringing in some degree of revenue through online or curbside offerings – and others might be in complete financial distress.
This is why establishing dialogue is so important. If you’ve done your due diligence when it comes to evaluating your obligations, you should come prepared to present some type of negotiated solution to them.
When talking to your tenant, make sure their lease profile is available to the both of you. Perhaps through a screen share if you’re having a Zoom or online conference with them. Present them with their present and future rent obligations and the terms of their current lease.
Every tenant will be different. A big tenant needs to be assessed differently than your smaller ones who, while important, don’t mean the same to your bottom line in meeting those monetary obligations you’ve already established. Ask yourself what this specific tenant means to your overall portfolio.
A tenant that’s a small business or mom and pop shop will be in a different situation than a large national franchise. If your tenant is a chain restaurant or retail store, where does this specific location and lease fit into their franchise’s portfolio? Perhaps this tenant might be eligible for some franchiser assistance?
While you’ll want to help all of your tenants, if one’s outlook for recovery and future success is bleak, this may be a chance to cut the cord and end their lease. You’ll need to ask them for financial statements and projections. Everything from the cash they currently have on hand and its projected disposition to an itemized list of non-cash assets with value estimates, a list of creditors with account balance details and payment schedules, and any type of explanation of their current financial issues and plan to recover.
Just keep this in mind. In times like these, it’s likely in a landlord’s best interest to not lose their tenant. We have no idea what else the next year will bring. We could be looking at another economic recession or depression. Filling a vacancy may come at a cost many landlords can’t afford – commission and legal fees and construction costs for tenant improvements.
So, what options does a landlord have for a tenant struggling to meet their rent obligations?
- Reduce Rent: As of now, this is the solution most landlords are considering. Rent can either be reduced for an agreed-upon period of time or on a month-to-month basis. Some landlords are even deferring rent payments to a later date or spreading repayment out over many dates.
Although you want to avoid placing added stress on your tenant at this moment of time, landlords should seek some type of return for any rent concessions. This can be anything from adding interest to the rent repayment, extending the term of the lease for a longer commitment, and even taking a share of the tenant’s business or a percentage of retail sales
- Lease Buyout: In this scenario, the existing lease can be terminated in exchange for a payment that should be enough to offset releasing costs like legal fees, commissions, tenant improvements, and the anticipated downtime from vacancy.
While a financially distressed mom-and-pop tenant may have difficulty coming up with a lump sum of money for a buyout, collateral like their personal residence or property could be used to secure a promissory note. Be sure to be mindful of the reduced rental rates we’ll likely see for at least the next 3 to 6 months in the wake of the economic volatility brought on by COVID-19.
- Subletting or Lease Assignment: If the agreement permits, the tenant could sublet part of their remaining lease years to a sub-lessee. This other party replaces them as the primary user of the premises. However the original tenant remains liable to the landlord.
This enables the landlord to maintain an income flow while the original tenant (now a sub-lessor) is still obligated to finish out the lease. The original tenant would probably prefer to either share or subdivide the space or charge the sub-lessee a higher rent.
Still, given the current climate and how this pandemic may or may not affect rental rates, even subletting to another party at a reduced rent will give the landlord continued incoming revenue. And the original tenant is still on the hook to pay the difference. Of course, the challenge now is a global pandemic is a horrible time to find a new occupant ready to takeover.
Both the landlord and tenant can also look into insurance and government assistance options possibly available to them. This is a trying time for all of us. Communication and empathy are key to getting through it.
HAVE A COMMERCIAL CONSTRUCTION OR TENANT IMPROVEMENT PROJECT IN THE LOS ANGELES AREA?
H.W. Holmes, Inc. provides commercial construction and tenant improvements throughout the Los Angeles area. If you’d like a quote on a project, contact us today to talk.