Real estate premise expense can consume as much as 20% of revenue for many businesses, making it one of the top operating costs. It is therefore no surprise that in these times of uncertainty, tenants are looking for short-term liquidity from their long-term lease commitments. State-mandated shutdowns have left many businesses without the ability to generate revenue. Business owners are asking for rent reductions, deferrals, abatement and potential restructurings. So far, landlords seem to be willing to discuss alternative rent arrangements – but is it entirely up to them? While we have yet to hear a collective voice, lenders may have the upper hand in lease renegotiations.
Market dynamics work best when marketplaces are in equilibrium and market actors, landlords and tenants share similar expectations. In the current changing market, “normal” expectations are changing day by day and only a real estate professional who is constantly active in the market knows best the pulse of the moment.
Several familiar options often come up when taking on lease renegotiations. Adjustments to rental rates due to market factors are typically the most common form of modification. For some businesses, however, that may not be enough to ensure continuity of operations, as rate changes may not materialize until lease expiry. Further, we are not yet in the post-COVID economy to be able to confirm what market rates should be. Tenants are looking to other avenues for short-term relief.
Do All Tenants Need a Rent Concession?
With evictions halted in many areas of the country, some tenants are declining to pay rent. While headlines are full of businesses postponing rental payments, very little has been made public about the terms of their agreements. Leases for large retailers and restaurants could be structured to be primarily a percentage of sales, so when sales are zero, rent payments drop. Cheesecake Factory (which remains open in many areas as a delivery/take-out food option) made headlines when it announced that it would withhold all rents for April. According to its 10K filing, however, the firm has leases with rent structures that “generally provide for the payment of both minimum base rent and a contingent (percentage) rent based on restaurant sales.”
Other tenants are large, financially solvent corporations, who may be leveraging the situation to maintain cash reserves. Adidas made waves with the German government with its decision to cease rental payments, but quickly changed its position. No doubt already feeling the impacts of online retailing, Staples, an “essential business” that remains open, has also announced that it will withhold rent. Additionally, other businesses, such as grocery stores and pharmacies are already realizing increases in sales. As such, landlords might not be receptive to work through near-term lease struggles if they feel negotiations may not be entirely in good faith.
To Pay or Not To Pay
Tenants may have no choice but pay rent, as many leases do not provide an out, barring default. Yet tenants need to remember that a lease is a contract and tenants may not take unilateral action. It is a best practice that all communication between landlord and tenant be in writing with the tenant citing specific reasons why rent deferment or forgiveness is requested. It is reasonable for the landlord to request both residential and commercial tenants for evidence that they do not have the resources to fulfill their rent obligation. In exchange for rent abatement a landlord may request that the tenant use a portion of government relief funds towards payment of rent. All parties should keep in mind that the communications must be professional and may be used as evidence in the event that there are subsequent legal proceedings.
Is Force Majeure the Silver Bullet?
Corporations are citing force majeure clauses, although these clauses typically do not release the tenant from their financial responsibilities under the terms of the lease. Force majeure typically only excuses closures in times of a catastrophic event, a moot point where the government has issued widespread business closures, rendering entire properties to be closed anyhow. Nonetheless, state and local governments may play a role by enacting rent moratoriums in addition to the aforementioned eviction delays. While not necessarily a force majeure maneuver, it may provide tenants with some relief.
The Road Less Controversial
More conventional occupancy strategies could include blend-and-extend scenarios, where in exchange for some sort of interim rate reduction or other concession, the tenant commits to a longer-term lease. Concessions could include a future tenant improvement allowance, the right to downsize at some point, or a right of first refusal for additional space. Rent deferrals or abatements, which are essentially interest-free loans from landlords, are also options, wherein all or a portion of the rent payment is deferred to a specific point in time. The deferred/abated rent could be spread over a certain period, involve a lump-sum payment, or some combination of the two.
Credit enhancements could also be employed, such as a corporate guarantee, as collateral for the rent abatement or deferral. Regardless of the method by which the business seeks relief, landlords and tenants should seriously deliberate on the term. If the deferral period is too short, renegotiations may come up again as some businesses may continue to struggle. If the term is too long, landlords may be faced with cash shortfalls in an otherwise rebounding economy.
Tenants with security deposits that are reduced annually over the initial lease term, could use that as a bargaining chip. Landlords may consider a faster burn-off or deposit elimination to provide tenants with much-needed cash. Landlords should be cautious to take the overall long-term financial health of the business into consideration prior to traversing this path. For financially secure tenants seeking to close locations, a lease buy-out might be an option, which could also assist cash-strapped landlords. Under this scenario the tenant offers a one-time payment in exchange for an early lease termination. This method is common even in stable times, as companies frequently examine and adjust their space needs.
“We are in this together” has become a conventional catch phrase, one that will be tested as tenants and landlords sit down at the virtual negotiating table. The pain is being felt from the consumer all the way up to the lender. Will this result in mutually beneficial lease and loan augmentation? The current business climate would indicate that now is the time, but in this constantly evolving environment, only time will tell. Best action? Connect with a real estate professional who has a finger on the pulse of the market every day.
Tom Hershey is the national director of Servicing & Growth at Coldwell Banker Commercial. Dan Spiegel is managing director and Jane Thorn Leeson is research and resources analyst at Coldwell Banker Commercial.