Leveraging Uncertainty to Craft Leasing Strategies

April 21, 2021

Commercial landlords and tenants are no strangers to changing economic cycles. Adjusting lease agreements to different circumstances is one of the main factors in negotiating favorable terms for both parties. But the pandemic has thrown a wrench into the status quo, prompting industry players to realign their strategies and think up creative solutions.

“Prior to the pandemic, flexibility was key and now it’s even more exaggerated,” Lisa Davidson, vice chairman & chief diversity officer at Savills, told Commercial Property Executive. “Landlords are prepared to meet tenants’ needs for flexibility in terms of providing or granting termination options or having tenants use allowances however they’d like.”

Flexibility is the new buzzword, according to Bonnie Hochman Rothell, a partner at Morris, Manning & Martin, with both tenants and landlords looking to include the term into their lease agreements. Landlords need protection in case of further eviction moratoriums and tenants seek to avoid long-term commitments.

Hochman Rothell also noted that one of the most important lease terms being negotiated today—which was never even contemplated before the pandemic—is who is responsible for health and safety issues at the property. Parties are increasingly negotiating responsibility on that front.

EMPHASIS ON CONCESSIONS

On the other hand, some tenants are taking a different, more bullish approach, Native Realty CEO Jaime Sturgis explained, by using the current uncertainty to their advantage and negotiating longer-term leases and locking in more favorable rents. “Many tenants are seeking to minimize the term and scope of these agreements and are opting for reduced and often floating or burn-down guarantees on the lease in the event of default,” he told CPE.

When it comes to finding solutions to lease obligations, the challenges facing landlords and tenants are similar, but not quite the same. With many office employees working remotely, one of the main challenges for landlords is the current lack of demand, Davidson observed, which results in large concession packages for those willing to sign leases.

“On one hand, it’s a good time for tenants to take advantage of the market, but on the other hand, tenants have to be confident in their decision-making before they move to a new space or commit to a long-term lease,” she continued, highlighting that tenants with a predominantly remote workforce have leverage with time and aren’t as concerned about when their lease expires.

According to Davidson, some landlords are willing to allow tenants to move into a new space without beginning rent payments until the next year or the year after, depending on the lease term. However, landlords also want to ensure that leases are well-crafted and enforceable.

“Landlords want to know that the tenant is well-collateralized and personally guaranteeing the lease with an entity of substantial worth,” Sturgis said, adding that tenants are often intent on securing renewal terms and controlling expenses where they can. “We often see renewal options negotiated at the onset of the lease and a cap on controllable expenses within reason,” he further clarified.

WIN-WIN FOR BOTH PARTIES

When it comes to establishing a framework for the renegotiation process, lease relationships are best when viewed as a partnership and from a long-term approach, according to Hochman Rothell, who emphasized that a trust and partnership-based cooperation may be the most useful for the business relationship.

“Concessions may be necessary on all parties’ parts and creative approaches will be most effective. For example, we have seen leases extended and rental escalation clauses in exchange for forgiveness of some amounts that may have been deferred,” she explained.

A win-win scenario for both parties could be when the tenant provides the landlord an extension, and the tenant secures near-term abatement or can even return some unused space, according to Davidson.

“Right now, landlords are looking to get any new tenants into their space, even if it is in a spec suite or by offering a short-term lease. They also want their existing tenants to find replacement tenants to take over the space they are attempting to sublease. Landlords don’t want to have to compete with tenants who are also offering up their space. If they can bring in new tenants to the building, even if they take a sublet, it’s a positive outcome for the landlord,” she added.

As for rent that came due amid the height of the health crisis, many landlords are agreeing to defer these obligations, with tenants required to “repay such deferred rent over the course of six to 36 months,” Fernando Landa, a partner with Crosbie Gliner Schiffman Southard & Swanson, noted.

“For businesses especially impacted by the pandemic—such as gyms and movie theaters—landlords may be more inclined to forgive a portion of the rent due or otherwise restructure the rent entirely,” he said.

Landlords should also consider reviewing existing leases and reconsidering terms that were previously acceptable, Hochman Rothell recommended, as lease terms and the impact of closures or eviction moratoriums “are critical issues.”

MITIGATING RISK

As uncertainty still looms, one of the biggest challenges from a legal perspective is addressing the risk of potential future lockdowns. “Tenants want protections in the event they are unable to fully use their space because of such measures, while landlords want to protect the cash flow they expect from prospective leases as the risk of COVID-19 abates,” Landa remarked.

In order to mitigate such risks, force majeure clauses are of particular importance, as these may provide relief when natural and unavoidable catastrophes prevent parties to the contract from fulfilling their obligations.

“Landlords will have an advantage if the force majeure provision includes such a carveout, whereas tenants are in a very strong provision if the force majeure does not include such a carveout,” Landa said. He also noted that most well-drafted leases will not enable tenants to withhold rent in the event of pandemics or other similar events, providing landlords with leverage.

According to Sturgis, many changes have occurred in terms of business interruption clauses in leases and force majeure. “From the tenant’s perspective, the objective was to make sure tenants wouldn’t be paying rent if there were government or state-sanctioned lockdowns prohibiting them from operating their businesses. For the landlords, they continue to be responsible for their cost obligations, such as real estate taxes, insurance, maintenance, mortgages and debt service coverage ratios, etc. We typically found common ground with an understanding that if this situation were to occur, rent would be reduced or abated in some form. However, the triple-net expenses would continue to be due and payable,” he explained.

While prior to the health crisis most force majeure clauses weren’t specific enough to cover events such as a pandemic, post-COVID-19 force majeure clauses will likely become more detailed to cover a wider range of unexpected events, Hochman Rothell expects. She thinks it will be necessary for these provisions to clearly state that a force majeure event doesn’t relieve a tenant from its obligations to pay rent or other charges as they become due.

REIMAGINING THE OFFICE

The increased focus on flexibility is not the only shift generated by the pandemic. The COVID-19 era also changed how landlords provide turnkey spec spaces, a trend that predates the pandemic, but has only increased since. “Tenants do not want to spend a lot of money on renovating their office spaces and are searching for something move-in ready,” Davidson added.

Tenants have multiple options when it comes to reconsidering their office needs. “One is to ‘kick the can down the road,’ where tenants either renew for a year or will let their lease expire and continue to have their employees work fully remote until they have a better sense of their office-space needs,” Davidson explained. The ‘hub-and-spoke model’ is another option, where companies have the main office and keep smaller suburban offices or even bring in employees to coworking spaces.

Another solution is to make part of the workforce permanently remote. This way, companies will be able to take on less space. “Or if they are in a long-term lease, they can provide a lease extension to the landlord in exchange for taking back space early,” Savills vice chairman said.

According to Sturgis, while many tenants were able to renegotiate their leases to include more favorable terms during the peak of the health crisis, “that window of opportunity has closed now in many markets, especially South Florida.”

He noticed that COVID-19 provided a temporary break for landlords, allowing them to assess their portfolios. “Many used this time as an opportunity to get out of one asset class and into another or sell off underperforming assets in their portfolio. This restructuring and musical chairs created a lot of movement in the market as a result,” he added.

In addition, Sturgis highlighted a shift in landlords’ and tenants’ approach to technology as well, with both parties becoming more comfortable touring spaces remotely.

ONE STEP AT A TIME

When it comes to eviction moratoriums, while several are ending soon or have already ended, states and localities are still considering extensions. While circumstances are mostly subject to government and local authorities, many jurisdictions have implemented moratoriums on commercial evictions under certain conditions, keeping in mind the economic hardship businesses have undergone and are still subject to.

“We do not necessarily recommend that landlords jump into court when the moratoriums end and do not recommend that tenants bury their heads in the sand. The best course of action is to begin negotiating early to come up with creative ways for both the landlords and tenants to continue to operate successfully, which in many situations may justify renegotiating certain lease terms,” Hochman Rothell concluded.

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