"Cancel Rent" is Catchy, but Complicated
April 22, 2020
April 22, 2020
All economic landscapes are in flux right now; commercial real estate is no exception. Income properties face unique challenges as tenants are unable to make rent payments, threatening solvency and overall market stability.
In order to mitigate the problems, many landlords and tenants are revisiting leases and restructuring some of the terms to adjust to business closures and cash flow interruptions. What are some of the ways in which leases can be modified to accommodate both the needs of the tenants and the landlords?
Full or Partial Rent Abatement: This is a term we are seeing a lot in headlines and repeated when we talk to market participants. Scared of potential vacancies or simply concerned about their tenants’ businesses, many landlords are granting free rent for a few months or reduced rent for a temporary and short amount of time.
Rent Deferral: When rent payments are not forgiven, but instead delayed by a few months this is deferral, not abatement. For example, if a tenant’s rent is $1,000 per month the landlord may not collect rent in May or June, but have the tenant pay $2,000 per month in July and August. This makes sense with businesses that were strong and expected to be able to open fully functional fairly soon.
Blend and Extend: For a situation in which the timeline to re-open and get back to strong sales is important, a blend and extend adjustment might make sense. In this scenario, the landlord does not collect rent for a period of time, say six months, but adds that debt to the end of the lease term wherein the tenant may no longer be occupying the space, but is making up the lease payments deferred from the crisis.
Percentage Rent Increase: Many restaurants and some other retailers pay a percentage rent of sales on top of a base rent rate. To help devastated restaurant tenants, a landlord may abate rent during closure in exchange for an increased percent of sales once the store re-opens.
Early Termination: If a tenant is struggling and is near the end of the natural term of the lease, this may be the most merciful and least complicated way of restructuring their lease. This makes the most sense when the term is near and either the business has failed or the landlord/tenant relationship has soured and seems irreconcilable.
Of course, if a property is subject to a mortgage, in most cases the landlord will not be able to modify in-place leases without the consent of the lender. This means that these complex negotiations between parties may need to be between three parties and not just two. All parties would be wise to be open to restructuring solutions though, as all of them have a vested interest in the business remaining solvent and financially viable.
What does this mean for the property’s value?
Any disruption or changes to a property’s income will potentially affect the value. The effects and the impact will be individual to that property alone, so due diligence will be critical in the current landscape and moving forward. Anyone looking at valuation (appraisers, underwriters, analysts and investors) will need to look at each lease on a more granular level to determine the true cash flow and what the expected strength of the tenant is both through the crisis and coming out of it. Making assumptions from previously negotiated market comps will not be sufficient to truly analyze risk and value.
For properties that are under construction or proposed, adjustments to price changes and timelines will need to be considered. Some materials are proving hard to come by or experiencing significant delays, and the labor supply must be considered as well, especially if there are a high number of COVID-19 cases in that area. Changes to the supply mean changes to prices for materials and labor as well, so the most up-to-date budgets need to be analyzed. To a lesser extent, this also applies to newly leased space (even in existing buildings). Tenant improvements are also a type of construction so pricing and timelines need to be factored into pro-formas. Ground leases may not need building materials, but often need approvals by municipal authorities. As many offices are closed, delays in zoning, building plans, certificates of occupancy, etc. are being reported.
Some questions that will be important to consider in the coming days and weeks are:
How will the new PPP loans be disbursed? Will they be easier to access than the first iteration and cover enough businesses? Will there be voluntary or government-enforced reduction in space capacity that fatally affects gross sales potential of stores and restaurants? Will high-end retail experience a longer downturn than low or mid-tier retail due to not only widespread job loss but to pressure to reduce conspicuous consumption? The forthcoming answers will continue to give us new opportunities to do our due diligence.