Foreclosures, vacancies, defaults and bankruptcies are changing the face of credit risks on both sides of the lease negotiation table.
Both landlords and tenants are looking for ways to reduce the risks, or at least the consequences, of default by the other party. Landlords are looking for ways to offer incentives to tenants without devaluing the property, while tenants are concerned with protecting their occupancy rights and enforcing the landlord’s obligation if the landlord is foreclosed or goes into bankruptcy.
“The current economic climate has impacted the negotiation of a handful of key lease provisions,” says Shari Ben Moussa, Esq., an associate with Katz Barron Squitero Faust. “Landlords and tenants are using different negotiating tools to manage their credit risks. And, they are using each other’s creditworthiness as leverage to negotiate greater protection in favor of their own financial interests.”
Smart Business spoke with Shari Ben Moussa about lease negotiations in an evolving market.
How have credit and liquidity problems changed lease negotiations?
One major change is that tenants are evaluating the landlord’s credit before committing to a deal. The question of creditworthiness has long been a one-way street when it comes to lease negotiations — the landlord investigated the tenant’s capacity to meet its lease obligations, but the tenant often took for granted that the landlord would have the financial ability to perform.
Tenants who were planning to make significant investments in leasehold improvements might ask for a nondisturbance agreement from the landlord’s lender, but only key tenants would usually be successful in doing so. In a nondisturbance agreement, the landlord’s lender agrees not to terminate the lease through foreclosure, so long as the tenant is not in default under its lease.
In the current market cycle, tenants are coming to the realization that no matter the size and strength of the landlord, they are potentially vulnerable to the pressures of the credit markets (or lack thereof), paired with the impact of rising vacancies and falling rents. Tenants are now asking for the landlord’s financial statements and requiring ongoing access to financial information and audit rights. Also, tenants are often demanding, and getting, a viable nondisturbance agreement, even if they are not the key tenants for the asset. And some tenants are even evaluating the solvency of the landlord’s lender and the landlord’s refinance prospects if the existing loan is close to maturity.
Another change is that tenants are sometimes advancing the tenant improvement costs that the landlord agrees to ultimately contribute, and then recovering the cost on an amortized basis through rent reductions over an agreed period. This shifts the liquidity and financing burden from the landlord to the tenant. The cost of funds is likewise shifted to the tenant, but this can be accounted for in the overall pricing of the lease. The tenant is protected from the landlord’s default in failing to pay for tenant improvements because the payment is built into the rent structure. Likewise, the landlord is protected from the tenant’s default because it has not advanced the cost of tenant improvements.
What key lease provisions affect changes in the bottom line?
Landlords are offering incentives to new tenants to keep occupancy levels stabilized. These usually come in the form of longer free or reduced rent periods as opposed to lower base rents per square foot. Landlords are steering clear of permanent base rent reductions of any significant amount because of the effect on the property value. Temporary concessions and improvement allowances have less of an effect on the property value from a financing perspective and are therefore favored.
Landlords are also willing to give interim rent abatements or deferments to existing tenants under financial stress. Landlords and tenants have a mutual interest in the tenant staying open for business and the temporary relief may enable a tenant to shore up its operations and survive the cycle. This is particularly important in a multi-tenant property, such as a shopping center, where vacancies may trigger co-tenancy provisions that entitle other tenants to pay reduced rents, go dark or terminate their leases, all of which has a snowball effect on the landlord.
Landlords are also offering larger tenant improvement allowances, and the stronger tenants may be given a customized or upgraded space with added luxuries. If the tenant is willing to advance the improvement costs, as I mentioned before, it will be in a position to negotiate top dollar for the allowance.
Tenants are also looking for a greater array of termination rights. In addition to co-tenancy rights, which give tenants the right to terminate or pay a reduced rent amount if a key tenant closes, tenants are asking for the right to terminate if it becomes economically infeasible for them to continue to operate their business in the premises. This adds a considerable element of subjectivity and exposes the landlord to greater risk. However, this may still be workable if the termination right cannot be exercised or does not take effect before a certain date that allows the landlord to recover at least its improvement costs and leasing commissions.
What about subleasing?
Subleasing is a typical exit strategy for tenants who may need to untimely shrink or vacate their spaces. Subleasing rights are an important noncash lease concession a landlord can offer. However, they do have a value that will be taken into account in metering the overall cash-based concessions. Typically, the landlord will have a contractual right of reasonable consent to the sublease or assignment and can be expected to approach its credit review of the proposed subtenant the same way it would a new primary tenant.
Shari Ben Moussa, Esq., is an associate with Katz Barron Squitero Faust. Reach her at firstname.lastname@example.org.