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Thoughts on Leasing in a Troubled Commercial Real Estate Market



The COVID-19 pandemic brought changes to all aspects of life, some of which will never revert. In the world of real estate, the most significant change stems from the race to remote work instigated by the pandemic. Many companies and office workers discovered that working remotely was just as efficient, if not more, than working in an office. Today some companies are requiring workers to return to the office, but many are either instituting hybrid policies or not requiring return at all. This has resulted in an extreme drop in demand for office space in certain markets, particularly central downtown areas. Some tenants are not renewing, while others are only taking a fraction of their former space. 

With rental income drastically declining as a result, landlords are finding it difficult to pay the mortgage loan on their buildings. Many are electing or have no choice but to turn the buildings over to the holder of the mortgage loan. Even well-heeled institutional landlords may take this route if the mortgage loan is non-recourse (i.e., the owner has no liability to pay the loan) and rents are not sufficient to pay the mortgage or the owner perceives no chance of the value of the building exceeding the amount of the loan when value is calculated on today’s rental rates even if it were somehow fully leased. A lender who takes back a building or a party who buys from the lender has no choice but to attempt to minimize its losses by leasing at the lower rates that the market demands.

Whether you are a landlord or a tenant and you find yourself in a troubled market, its implications should be considered when entering into an office lease. Here are just a few things to keep in mind.

1. Length of the term of the lease. Although no one can predict the future, with decreased demand for office space and foreclosures, it seems likely that rental rates will continue to fall in certain markets. It's more important than ever for a landlord to secure a long-term lease from a tenant so that today’s rates (with escalators) are locked in and so that the landlord can recoup its investment in tenant improvements. Vice versa, it's beneficial for a tenant to obtain a short-term lease if rates are falling, so that it can benefit from lower rental rates as they continue to fall.

2. Options to renew. A short-term lease with an option to renew is the best possible world for a tenant in a troubled market. A standard clause in most options to renew is that the rent for the renewal term will be set at fair market value but in no event less than the rent for the current term. In the past this floor on the rental rate was not controversial or negotiated, because it was assumed that rental rates would increase. But today a tenant should try to avoid such a clause so they can benefit from falling rates. Conversely, such a clause with a floor on rent is more important than ever to a landlord and should be included, if possible.

3. Disappearing landlords. To secure a long-term commitment from a tenant, landlords will often offer generous tenant improvement allowances. In today's market, a tenant must take precautions against the landlord turning the building over to the lender who holds the mortgage loan on the building before the tenant improvements are completed. This is particularly true if the tenant is funding part of the tenant improvements itself. The mortgage will be on record prior to the lease being executed, so the mortgage will have priority. This means that the lender will not be obligated to fund the tenant improvement allowance when it becomes the owner. A subordination, non-disturbance, and attornment agreement (commonly referred to as an “SNDA”) between the tenant and the lender that includes a clause that the lender will honor the tenant improvement allowance should it become the owner is a good vehicle for a tenant to use to protect itself against this risk. The SNDA should be signed concurrently with the signing of the lease or the lease should be made contingent on the landlord delivering the signed SNDA. Alternatively, the tenant could require that the landlord deposit the tenant improvement allowance in an escrow for the benefit of the tenant. At a minimum, a tenant needs strong language allowing it to terminate the lease if the premises are not built out and delivered within a specified time.

4. CAM Charges/Operating Expenses. Half-vacant buildings are becoming more common in certain markets. Office leases typically pass on to the tenants of a building the common area maintenance expenses and other operating expenses associated with the building. A well-drafted lease will include provisions that ensure that the expenses passed on to a tenant do not increase or decrease when occupancy in the building decreases; however, we’ve seen leases that do not adequately cover this issue. From a tenant’s perspective, it’s important that the tenant’s share of expenses is equal to its pro rata share of the rentable square feet of the building, not its pro rata share of the square feet in the building that is actually rented. Otherwise, as the building becomes more vacant the tenant’s share of expenses would increase. Fortunately, almost all leases adequately cover this issue. From the landlord’s perspective, it’s important to include a clause that “grosses up” the expenses that decrease when occupancy decreases to the level at which they would be at full occupancy; otherwise, the tenants are not paying their fair share. Unfortunately, many leases do not address this issue adequately. For example, if a tenant occupies 10% of a building and the cost of utilities (e.g. electricity, water, and natural gas) for building when fully occupied is $100,000, then that tenant will pay 10% of that amount or $10,000. But if that same building is only 50% occupied and as a result utilities decrease to—let's say--$60,000, then unless there is a gross-up clause, the tenant would only pay $6,000, instead of $10,000, even though its usage of the utilities has not changed. The tenant gets a windfall at the expense of the landlord.

If you’re a landlord or a tenant in a troubled commercial real estate market, it’s a new world when it comes to leasing. Many of the old assumptions, such as that rents will always increase, that the landlord will always be there, and that buildings will be substantially occupied, can no longer be counted on to be true. Advice from an attorney experienced in leasing is more valuable than ever.

This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.

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