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Publications
Protecting the Landlord in a Difficult Leasing Market
Real Estate Newsletter
The commercial leasing market has experienced a multitude of challenges since 2007. As tenants fail, more vacancies occur. Increasing vacancies create market opportunities for existing and prospective tenants. And, of course, increasing market opportunities create greater pressure on landlords to take steps necessary to retain tenants. As has become evident, tenants routinely ask landlords to lower rents. Because of covenants with its own lenders, however, a landlord might not have the ability to lower rent for its tenants. Indeed, few landlords can accommodate significant across-the-board rent decreases without suffering serious economic hardship themselves. But if a landlord does have the ability to accommodate a tenant's request for lower rent, there are a number of steps a landlord should take to protect itself.
The landlord's first response for lower rent should be to ask the tenant to prepare and submit a short- and long-term business plan and current financial statements. Before renegotiating an existing lease, the landlord must be satisfied that the tenant is in financial distress, that it has a viable business plan, and that it has (despite its distress) the financial wherewithal to implement its business plan successfully. If these factors are not in place, the landlord should think long and hard before renegotiating the lease. Assuming these factors are in place, the landlord has two primary goals: first, to retain the tenant; and second, to position itself to recover as much as possible if the tenant were to file a bankruptcy case.
If the landlord is satisfied that the tenant's business plan is viable, then the landlord should not agree to lower the rent. Instead, the landlord should offer to defer a portion of the rent for an agreed period of time. The deferred rent can be recaptured by the landlord in at least two ways: it can be repaid in a single lump-sum payment on a certain date; or more likely, it can be repaid to the landlord at the end of the deferral period in equal monthly installments over the remaining term of the lease. Whether the tenant must pay interest on the deferred rent is a matter for negotiation. In all events, the landlord should insist on adding to the lease a set of milestones that track projected business plan successes. Failure to reach a milestone should constitute an event of default under the lease that triggers repayment of the rent deferred to that date.
In exchange for concessions in the rent schedule, a landlord should attempt to obtain security for repayment of the deferred rent that will survive a bankruptcy filing, such as a personal guaranty or a letter of credit issued by a financial institution. In the case of a personal guaranty, the landlord should also require regular reporting of the guarantor's net worth. Securing repayment of the deferred rent with a personal guaranty or a letter of credit reduces the likelihood that the tenant's bankruptcy estate will be able to avoid its pre-petition obligation to repay the deferred rent.
The list of events giving rise to a default under the lease should also be expanded to include events specific to the landlord's agreement to defer rent. For example, if any of the following occur, the landlord should have the right to terminate the rent deferral and demand immediate payment of rent deferred to date in addition to the landlord's other rights and remedies in the lease (all of which should be cumulative): (a) a tenant takes actions that reasonably indicate to the landlord that the tenant is preparing to close its business (for example, the tenant makes substantial distributions, pays unusually high or unscheduled dividends, sells assets outside the ordinary course of business, or lays off staff); (b) the tenant fails to occupy the leased premises and to conduct business in the ordinary course for more than an agreed period of time; (c) a change of control occurs with respect to the tenant (for example, one or more key personnel cease working for the tenant, or 51 percent or more of the ownership interests in the tenant are transferred during any consecutive 12-month period; or (d) a material adverse change occurs with respect to the tenant, its business or its financial condition, as reasonably determined by the landlord.
The landlord should also amend the lease to make it easier for the landlord to exercise its remedies if a default should occur. Among other things, the landlord should delete any provision in the lease requiring that it deliver written notice to the tenant before the tenant will be deemed in breach or default under the lease.
Finally, the landlord should eliminate or severely restrict the tenant's right to sublease the premises or assign the lease, whether to an affiliate or a third party. The prohibition against subletting and assignment should also prohibit any collateral assignment for security, such as encumbering a tenant's interest in the lease with a mortgage or deed of trust. If it does not already contain such a provision, the lease should be amended to provide the landlord with the right to recapture the space for which the tenant has sought consent to sublease. In addition, the lease should be amended to prohibit the tenant from exercising any option to extend the term or expand into additional space until all of the deferred rent is paid in full.
In addition, if the landlord determines there is a significant possibility that the tenant will file for bankruptcy but nonetheless elects to work with the tenant, the landlord should consider consulting with bankruptcy counsel to determine if there are any lease provisions that should be inserted that could assist the landlord if bankruptcy were filed. For example, a landlord might consider converting the amount of deferred rent and unamortized tenant improvement expenses into a secured loan (with appropriate loan provisions and securitization documents), which would grant the landlord the status of a secured lender in bankruptcy with regard to those amounts. Although bankruptcy law generally trumps contrary provisions in a commercial lease, the landlord should not refrain from taking the steps noted above.
These points are not intended as an exhaustive list of issues to be addressed in lease negotiations with a tenant. Each lease and each tenant are unique and a workout requires due consideration of the special interests and circumstances confronting the landlord and the tenant. In these difficult times, a landlord should work closely with experienced legal counsel to protect, preserve and manage its assets.
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