Landlords Concerns Relating to Upfront Costs Required by a Pre-COVID Commercial Lease
July 8, 2020
Scenario – On March 1, 2020, you, as the owner of an office building (or a shopping center or industrial park, etc.) enter into a commercial lease with a high credit tenant which involves the outlay of either extensive improvements to the premises prior to delivery or the payment of a sizeable allowance to the tenant in return for a generous rent payment over ten years by the tenant in whose ability to pay you had great faith. Then life as we know it gets turned upside down, and the credit of your tenant is substantially downgraded. It is now time for you to pay the broker and build out the premises or allow the tenant to start its work, thereby obligating you to pay the allowance. What are your options? Suddenly, this is not the lease you thought you were entering.
With respect to the impact of COVID-19 on commercial leases, much of the focus has been on established leases and the tenant’s ability to meet the economic challenges of their lease commitments in light of their changed financial circumstances. However, many leases were executed, lease terms renewed, or premises expanded just prior to the outbreak, leaving you, the landlord, on the hook for commitments for sometimes very large outlays of resources, whether in the form of broker commissions, tenant construction allowances, or tenant build-outs. The problem you are now facing is that these commitments, which you previously made, now benefit a tenant who is no longer as creditworthy as they were when the lease was executed. What to do?
As the landlord, you should take the following steps before investing resources into the tenant’s premises or paying commissions or allowances with respect to a new lease.
- The first step should be to obtain a current credit report for the tenant and request updated financials and/cash flow projections from the tenant to determine the effect of the last several months on the tenant. The lease may or may not require the tenant to deliver financial statements, which may be problematic.
- The broker agreement must be reviewed carefully, and it must be determined when the commissions became, or will become, due and payable. Some agreements state that the commission is earned upon full execution and delivery of the lease, others are not payable until contingencies are met, or rent milestones are met. Rarely do these agreements contain force majeure type provisions, but a thorough review should be done, and any loopholes considered.
- Review the lease carefully, in particular, those provisions that focus on include: (i) the terms of any allowance, (ii) force majeure, (iii) tenant default, (iv) landlord default, if any, (v) landlord’s improvement work/delivery conditions, (vi) representations by the tenant, including as to financial strength, and (vii) the requirement of delivering financial statements.
- Discuss your concerns with your lender to further determine what your options are. The lender’s consent will certainly be required if, pursuant to the alternatives below, any financial changes are to be made to the lease.
The risks of moving forward with the lease should be evaluated.
- If a commission is payable upon execution of the lease according to the broker agreement, it should be determined whether that obligation is impacted if no rent is ever paid by the tenant. In this scenario, Brokers will undoubtedly argue that their obligation was met when the tenant was successfully procured. Still, in light of the drastic change in circumstances, it is possible that the courts/arbitrators, as applicable in accordance with the terms of the agreement, may feel that the obligation is not as clear cut. You want to avoid liens being filed against the property by the broker, so you should be communicating with them when possible.
- Are there specific default remedies in the lease for your failure to uphold your obligations as a landlord? Often a lease will not clearly state what the tenant’s remedies are or will limit their remedies to an abatement or offset against rent, which is not as big of a risk in this instance.
- Was a security deposit paid by the tenant that can be used to enhance the tenant’s credit position?
- Can you use a force majeure provision in the lease to delay the timing of any required construction or payment of an allowance? Likewise, can the tenant invoke the same provision to its benefit?
- What damages might a court award for the breach of contract, and are these necessarily worse than paying all the upfront costs?
- Is there a chance that a court would look outside the broker agreement or lease due to substantial changes in circumstances resulting from the pandemic?
Alternatives to be considered.
- Terminating the Lease – The first decision to be made, and discussion to be had, is whether both parties want to move forward with the lease. The tenant may agree that moving forward is too risky or does not make financial sense, and, therefore, it may be mutually beneficial to discuss the termination of the lease. If this is agreed upon by the parties, and any lender, then it needs to be determined which of the parties should bear the burden of the broker’s commission, which may still be payable. Additionally, if the termination is more beneficial to the tenant than you, the payment of a termination fee by the tenant may be discussed.
- Credit enhancement/rent restructuring – If you want to move forward based on your review of all conditions and despite the compromised financial condition of the tenant, you may want to try to obtain a credit enhancement from the tenant in the form of a letter of credit or personal or corporate guaranty.
- Rent incentives in lieu of allowance – If both parties decide to move forward with the lease, you may want to discuss rent incentives or other structuring of the rent payments to avoid having to make any upfront cash outlay for an allowance.
- Renegotiating broker commission – A discussion should be had with any broker who believes that a payment is due to them even if the lease is terminated. If the terms of the lease end up being renegotiated, the new terms should be reflected in the commission payable to the broker.
- Renegotiating with the lender – It is imperative that whatever decision you make, and whatever deal may be struck with the tenant and/or the broker, that the lender is on board. Additionally, you can try to restructure any loan you have that may be impacted by the loss or restructuring of this lease.
- Litigation – A final option may be to file a declaratory judgment lawsuit, the purpose of which is to ask a court to rule on the rights and obligations of the parties before one party or the other takes an irrevocable position that causes a breach of contract. For example, if there’s a question about whether a broker commission is owed if the procured tenant almost immediately defaults and doesn’t pay rent, you can ask the court to weigh in on that question. This serves two purposes: 1) it keeps you you “out of breach” because you are asking the court to interpret the contract before having to decide; and 2) it buys you time to negotiate a resolution because the wheels of justice move very slowly.
Whatever option you choose, keep the lines of communication open, and document your discussions.