2020 is and will continue to be a particularly difficult year for commercial tenants and their landlords. The sudden economic downturn resulting from the COVID-19 pandemic has radically changed the nature of businesses and the ownership and operation commercial properties. These unforeseen circumstances are requiring tenants, landlords and their professional advisors to address not only the short-term economic ramifications of the pandemic, but also the long-term impact on the manner in which commercial real estate is owned and operated.
Putting aside the manner in which space will be used, the impact of flexible work arrangements on the demand for office space, and the permanent closing of a large number of local and national retailers, the most immediate consideration is the need for stabilization of the financial condition of both tenants and landlords. Struggling tenants’ inability to pay rent now that PPP loan proceeds have been exhausted will have a direct bearing on landlords’ continued ability to pay operating expenses and service their debt. This zero-sum game is forcing parties to come up with creative solutions to balance the needs of both parties. Over the past six months, we have drafted many commercial lease modifications to address the new financial realities. The following is a brief summary of some of the issues landlords and tenants must consider in addressing both immediate and long-term implications of a tenant’s continued occupancy of the premises.
Rent Abatement vs. Rent Deferral
Although conceptually similar, the “abatement” of rent and the “deferral” of rent are quite different. In the case of rent abatement, a tenant with delinquent rent payments is relieved of its obligations to pay those missed payments. While this will provide the tenant significant relief in the near term, it does little to alleviate the landlord’s financial pressure. In the case of a deferral, the delinquent rent payments remain due, but are simply postponed until a later date, and take the form of either additional lump sum payments or staggered installment payments spread over a specified period. Needless to say, struggling tenants may be reluctant to commit to future higher rent payments or additional rent payments at a time when they are concerned about recovery and survival. By contrast, landlords will advocate for recovering delinquent rent rather than absorbing a complete loss of unpaid lease payments.
Tax and Expense Reimbursements
In addition to base rent, commercial leases will often include additional rent provisions requiring tenants to reimburse the landlord for the tenants’ proportionate share of operating expenses and real estate taxes attributable to the property. In considering whether to provide a tenant with rent abatement or rent deferral, a landlord will need to consider its ability to pay basic operating expenses such as taxes and insurance, which continue to accrue regardless of the tenant’s ability to make rent payments. Accordingly, it is not uncommon for landlords and tenants to compromise on rent abatements and rent deferrals by limiting those provisions to the tenants’ base rent obligation, but not the obligation to pay its proportionate share of operating expenses and taxes. As with the decision to provide rent abatement or rent deferral, the treatment of operating expenses and tax obligations will need to be considered to address the landlord’s receipt of sufficient cash flow sufficient to continue to operate and maintain the property.
Extensions of Lease Term
While it may seem counterintuitive to extend a financially troubled tenant’s lease term, lease extensions are common as they provide time for the tenant to recover financially from the impact of the pandemic and the opportunity to spread deferred rent over a longer period of time. Extensions are often combined with a new rent schedule that reduces rent payments in the short run, but allows for the payment of escalated rent over the newly extended term. Moreover, lease term extensions are also desirable to the landlord as they allow the landlord to increase rental income over a longer period of time and to avoid the difficulties associated with procuring new tenants during an economic downturn. Although a lease term extension may provide some benefit in the short run by reducing the tenant’s short term rental obligations, the increased rental obligations over an extended period of time could cause economic stress to a tenant looking to downsize by closing certain locations or imposing a long-term financial obligation on the tenant’s lease guarantor.
Alternative Rent Provisions
As an alternative to the parties reducing base rent, retail landlords and tenants can get creative by basing rent payments on a percentage of total tenant revenue. Although “percentage rent” clauses are not uncommon with larger retail leases, they can provide a compromise to parties to smaller retail leases as well. So long as parties can easily determine revenues received from in-store sales, percentage rent clauses are feasible. However, percentage rent clauses can be quite detailed and present a multitude of complexities when defining the revenue attributable to the premises. For example, sales made at separate tenant locations or sales made via the internet would need to be excluded. Similarly, tenants will need to be able to reduce sales to account for returns and the portion of customer sales attributable to sales tax. Inevitably, these clauses impose accounting and financial reporting burdens on tenants. The failure of the parties to properly address these issues by hastily drafting percentage rent clause runs the risk of future disputes.
In the retail context, many leases will provide tenants a right to terminate or reduce their obligation to pay rent in the event that the retail property fails to include specified tenants or tenants of a certain type (e.g., a department store or grocery store). These lease provisions are included at a tenant’s request to assure the tenant that the retail property will attract a certain type and number of shoppers. Thus, the failure of retail chains and independent operators could have a substantial ripple effect on other leases in the retail property. In amending a lease, the parties should address the impact and continued relevancy of these types of provisions and the possibility of required rent modifications which account for the disappearance of other tenants of the property.
Release of Obligations
As discussed above, the parties need to address the extent of a tenant’s continued obligation to pay pre-COVID amendment liabilities. Careful consideration should be given to blanket releases of pre-amendment liabilities as those types of releases will often impact ongoing obligations that the landlord would want preserved. A tenant should not be absolved of its failure to perform non-rent obligations under the lease, such as repair and maintenance obligations. Moreover, consideration must be given to monetary obligations that first arise after the lease amendment but which relate to pre-amendment periods of time. For example, damage or liability claims that may be covered by tenant insurance should continue beyond the amendment. Additionally, the parties should determine whether a tenant remains liable for the results of the landlord’s annual reconciliation of operating expenses and taxes for prior fiscal periods, including the portion of any reconciliation payments attributable to pre-COVID periods of time.
Many articles have been written regarding the applicability of force majeure clauses during pandemics. Because typical force majeure language does not specifically address the impact of pandemics, tenants will often seek to modify these clauses to address the possibility of future waves of the pandemic. Landlords will need to give special consideration as to the limits of any force majeure clause expansions. For instance, does it relate to this particular pandemic or all pandemics? Is the trigger tied to government-imposed shutdowns rather than the pandemic itself? Once again, a hastily drafted clause can bring unintended future consequences and additional disputes.
The foregoing discussion is by no means intended to be an exhaustive list. The point is that commercial landlord/tenant relationships can be complex and multi-faceted, and there are a number of immediate and long-term issues arising from the impact of the pandemic that require careful consideration.
If you have any questions about commercial leases or commercial transactions, please reach out to Jeffrey Galkin (email@example.com) or any of Levin Ginsburg’s litigation attorneys at (312) 368-0100.