5 Ways to Protect Against Defaulting Commercial Landlords

A few weeks ago, one of my clients had an issue where a landlord gave them a proposal to lease space and the client accepted the proposal.  The proposal was at an aggressive market rate with a significant, although not exceedingly unusual, improvement allowance.  The landlord group is a large institutional investor fund with millions of square feet of prime Class A and B office space.  The tenant is a large national firm with strong financial statements.  This particular building happens to be about 40% vacant.  “Send us a lease document for review”, we told the landlord agent.  We waited, and waited, and the document never showed up.

Finally this week, we called the managing partner for the landlord.  “Our partners won’t approve the deal”, said the managing partner.  Now this can only mean a few things: 1.  The partners are holding out in anticipation that a very large user will show up soon and fill the remaining 40% of the building (ridiculous), 2.  The agent and managing partner made the proposal outside of agreed upon return guidelines for the ownership group (unlikely), or 3. The bank that provides financing for tenant improvements and leasing costs refuses to advance additional monies on a property that is valued at less than the outstanding debt (highly probable).

In fact, although we were disappointed, we were not caught completely off guard.  In researching the property, we had discovered that the loan on the building was in “special servicing”.  This generally means that the loan is in technical default, although the bank or debt holder is attempting to “pretend and extend” by restructuring the terms to allow the landlord to remain in possession and avoid foreclosure.  When we originally questioned the landlord’s managing partner, he assured us that the special servicing classification by the bank was simply “posturing” as they attempted to negotiate revised terms.  Right.

At least we went in with our eyes open.  Why bother at all?  Well, the property was the most attractive to our client, the rate was a bargain, and with proper protection in place the client thought it was worth the offsetting risk.  In any case, it was probably better that the landlord’s situation was discovered before we entered into a lease although there are ways to navigate a lease through a loan default situation.

There will be many commercial loan defaults over the next few years, especially as Commercial Mortgage Backed Securities (CMBS) come up for refinancing. In fact, there are $1.4 trillion (with a “T”) that will come due by 2015, so this scenario will become more and more common.  Here are five ways that a commercial tenant can protect themselves:

1. Investigate Ownership – Especially for the last few years, landlords have been closely reviewing the financial statements of prospective tenants.  It is now conversely important for tenants to scrutinize landlords.  As we’ve seen with some of the largest investment funds, portfolio size has very little to do with financial strength.
2. Landlord Default – Most commercial lease documents are provided by the landlord.  It comes as no surprise then to find that more and more leases are tending to omit entirely any mention of provisions for a default by the landlord.  You can be certain that there will be plenty of language outlining rights for a landlord should the tenant default.  At the very least, make the process for declaration of default reciprocal. Better yet, add language that contemplates dealing with specific failures to comply with lease terms by the landlord.
3. Right to Offset Rents – Defining default provisions is a good start, however statutes probably only provide tenants the right to sue for costs incurred from a landlord default.  A better solution, from the tenant’s perspective anyway, is the right to correct any issues and deduct the costs from rent. As a particular protection in our case study above, the tenant should be able to fund the tenant improvement allowance or pay contractors if necessary and then deduct such costs from rent.
4. Right to Terminate - Suppose the landlord fails to repair the roof.  The cost to repair the roof might exceed the value of the lease, or otherwise be undesirable for the tenant to pay even if they have the right to offset rents.  If the landlord fails to cure a default within a reasonable time and the failure materially interferes with the tenant’s ability to operate their business, larger tenants might demand a right to terminate the lease.  Landlords, and their lenders, will hate this provision and probably fight it, although it is not unreasonable especially if there is any legitimate reason to suspect an impending financial default by the landlord.
5. Non-Disturbance Agreement – If a landlord loses it’s property to an underlying lender, the lender usually desires to keep existing tenants in place.  That is not always the case, however.  If the lender feels that a lease is too far below market, or there are obligations outstanding – such as an owner-provided improvement allowance pending, or a larger credit tenant wants to expand, the landlord can often terminate the lease – unless you have a Non-Disturbance provision in the lease.  This language says that any financing on the building will acknowledge the existence of the lease and the leasee will agree to be subordinate to any financing with the condition that the lender agrees to keep the lease in place. Lenders have to approve this provision of course, and in a time when landlord/lender relationships may already be strained, this can be tougher to obtain.

As some of the largest landlords default on their loans, there will be blood in the streets.  Use these strategies to make sure it isn’t yours.  Less is More.

The Only Two Ways to Protect Yourself on Operating Expense Pass-Throughs

I’m not crazy about condominiums.  Here’s why:  Other people (the condo association – which is often controlled by a very small group of individuals) get to vote on how to spend your money.  Some of those choices may not add value for you or to your property.  Operating expenses on leased commercial property work the same way.  The management company, which is the property ownership or someone under their direct control, gets to decide what expenses get passed through to the property tenants.  So what expenses do they pass through?  Every single one that they can possibly get away with.  There are only two methods of protection for tenants, and I’d estimate that more than half of all leases don’t fully take advantage of them.

Protection #1:  Operating Expense Exclusions.  Most commercial leases say something to the effect that the landlord may pass through all expenses (or the expenses over a base year) related to the ownership, maintenance, and operation of the project.  As long as these expenses are market competitive, that’s fair or at least customary, right?  Wrong. The landlord should only be passing through the costs of maintenance and operation, not ownership.  Ownership could include costs of refinancing, marketing the property for sale or lease, legal costs related to the ownership structure, accounting fees for ownership tax returns – even income tax.  Taxes are a cost of ownership.  My point is, you need to exclude those costs and any other costs with specific language because the landlord’s thirty or fifty page document (or more, I’ve completed leases of more than a hundred pages and the landlord’s attorney didn’t have a single word in there by mistake) allows everything including their Christmas party, executive meetings in Las Vegas, and hiring family members to provide management or lawn service.  You need to have a long list of what is NOT allowable, and argue to get them into every lease. You won’t always succeed on every item, though you should always try.

Protection #2: Auditing. You need to audit the Operating Expense Reconciliation that you receive from your landlord annually.  Why?  Because if you have used Protection #1 to modify your lease in any way, you can bet that whomever actually does the bookkeeping has never bothered to read the changes that you made to the provision.  My firm has seen landlords ignore negotiated caps or limits included in the lease and include capital improvement costs, expenses directly for the benefit of a another tenant, costs related to code issues that existed before the tenant’s lease commenced, and costs for services that were not competitively bid and significantly out of line with the market.  If you don’t have the time, expertise, or resources to audit the reconciliations yourself, hire an outside firm on a contingent basis. Most importantly, do it in the first year of your lease, so that you 1) put the landlord on notice that you are the “auditing type” – most tenants are not – and will nail them on any inappropriate charges and 2) identify any issues early in the relationship, since most leases prevent you from challenging expenses or auditing prior years after a certain period – some as short as 30 days after receipt of the reconciliation.

A recent trend that we’re seeing is the inclusion of six-figure executive salaries (with titles such as Asset Manager or Director of Properties) usually split between several properties.  As the economy puts the pinch on commercial landlords, they are allocating as much of their overhead as possible to their portfolio’s operating expenses.  If you are lucky, you’ll have inserted language into the original lease that prohibits salaries above a property manager.  And if you’re smart, you’ll audit the operating expense reconciliation to enforce your rights. When it comes to pass-through expense, Less is most certainly More.

Balance Sheet Blues

Just a quick mention in case you have not yet read your recent issue of CFO Magazine that had an article titled, Balance Sheet Blues, you can read it here.

Every finance executive and corporate real estate manager should be following and preparing for the upcoming change of operating lease to capital lease classification.  See my prior posts.

The Accounting Rules, They Are a Changin’ – Part 2

As a follow up to my previous post regarding the upcoming reclassification by FASB of operating leases to capital leases, which you can read here, I’ll outline a general strategy that companies can use to  minimize the reporting impact and unpleasant surprises.  Here’s what I recommend as a checklist of Top Ten Operating Lease to Capital Lease Actions:

1.  Begin Tracking Lease Present Value -  If your lease management software does not already do so, add a few columns showing the remaining obligation of every lease.  Ideally, you’ll show this in both a cash obligation and an amortized straight-line value, with a break out of payments for easy Present Value calculations.

2.  Begin Tracking Market Value - How does your current rental rate compare to market?  In today’s exciting commercial real estate arena, the rate you are paying might be significantly off what the current and competing landlords are charging for comparable space.  When the new rules kick in, you’ll probably need to adjust this number quarterly.  For now, simply make sure you know the current rates for the bulk of your locations and then tweak it every six months so that you can reasonably forecast the delta.  If you have any properties that represent more than 25% of your total rent obligations, start updating them quarterly.

3.  Meet with Your Accountants/Auditors – Discuss the proposed changes, and explore methods to minimize the potential impact.  Identify information that will be needed and establish a routine to gather necessary data and keep updated if you do no already do so.

4.  Prepare a Balance Sheet and P&L forecast under the new regulations - Since final details are not known, to start I’d suggest taking every lease with a term greater than 1 year and listing the present value of the remaining obligation as a long term debt.  Then list the same leases as an asset using a PV of the rent schedule (adjusted for market value if you know if – at face value if not).  Calculate the depreciation and amortizing interest costs using current Capital Lease rules and add to your P&L statement, removing the current rent expense.

5.  Calculate the New Debt/Equity Ratio and EBITDA - Any issues?  Consider any impact that the new numbers may cause with loan covenants or compensation agreements.

6.  Communicate Internally - Send a quick summary of the potential impact and the upcoming changes to the executive, financial, and legal staff within your firm who will be involved or impacted when the changes come through.  Ask them for feedback and for any issues that they foresee and/or want to avoid.

7.  Meet with Your Real Estate Advisors - They will be able to discuss a more detailed strategy based upon your particular property holdings and corporate structure, and can share ideas that other companies are doing to take a proactive approach.

8.  Begin Evaluating All New Leases as Capital Leases - Take whatever lease analysis method that you use now and show the impact of the potential future leases as capital leases as well as operating leases.

9.  Consider Lease, Purchase, and Sale Opportunities - Since the major deterrent to ownership of real estate by corporations has historically been having a depreciating asset and corresponding debt on the balance sheet, you should now also start evaluating purchase opportunities for long term space requirements as current lease terms approach expiration.  Likewise, using Sale/Leasebacks to free up operating capital will likewise have a lesser impact on the balance sheet.  Evaluate all feasible scenarios.

10.  Take Your Banker to Lunch - This would be a good time to discuss the proposed change and how the revised reporting rules will effect all corporations, and yours in particular.  If he/she gives you any assurances, ask for a follow up letter that you can distribute within your organization.  If you don’t get one, write your own.

Develop a strategy now to gain an advantage over your competitors.  Smart companies will take a proactive approach to optimally position themselves when these rules finally take effect.  Because when it comes to surprises on your balance sheet – Less is More.

The Accounting Rules, They Are A-Changin’ – Part 1

The Great Depression Ahead

I had lunch last week with Harry Dent, the Harvard MBA economist and NY Times bestselling author, to discuss the impact that the age shift of the population will have on commercial real estate. For those of you not familiar with Harry’s work, he’s written a number of books including The Great Boom Ahead in 1993, The Roaring 2000′s in 1999, and The Next Great Bubble Boom in 2004. Each of these books detailed well in advance the enormous gains in both stock and real estate markets that we experienced and their eventual collapse. While predicting the confluence of so many forces on the economy is not an exact science, Harry nailed the overall concepts and general timing of both the run up and downfall of these markets. Unfortunately for the U.S. economy, the title of his latest book, The Great Depression Ahead, gives away a bit of the plot of what is in store for us.

I’ll admit that I have always been skeptical of any economist’s ability to accurately forecast the future and still have a hard time accepting some of the cycles that many insist are as certain and predictable as the four seasons. Harry’s primary theory, however, is based solidly on population numbers and more importantly, the shift in the age of that population. By looking at when people enter the workforce, marry, have kids, and retire, you can very accurately determine when they are will buy cars, houses, kid’s clothing, pay for college, and buy second homes. Any one individual might be hard to predict. Tens of millions of people as a group are as predictable as the results of flipping a coin a thousand times.

Harry’s firm, HS Dent Investment Management, studies these habits to the finest detail. They can actually tell you statistically the percent of the population that purchases potato chips and hundreds of other expenditures by age. Drop that data onto the bell curve of the Baby Boomer population (hint: we are on the declining side now) and unfortunately we are generally headed for a 12-14 year sag until the Echo Boomer population reaches the age where they’ll have some real money to spend.

So what does this have to do with commercial real estate? Plenty. The overall decline in demand for houses, cars, and potato chips will require less distribution space and less workers to manage the production and flow of those products. In addition, there will be more workers leaving the workforce for retirement than entering it, so demand for office space will be reduced. Finally, shifting migration between states will pick up the slack in some areas while causing severe vacancy in others.  It will be a good decade to be a commercial tenant, which is very good news for most of my clients.

If you are an office or industrial space user, understanding this long term shift and creating a strategic plan to capitalize on falling rental rates is critical. There will be significant amounts of landlord ownership change in the next few years, and not all of it will be voluntary. Make sure that your lease documents address all of the understandings that you have with your landlord, and that any third party coming in to interpret your rights will be able to clearly understand the responsibilities of each party. Having a right to self-correct any defaults in performance of the landlord might come in handy as well.

There will be many changes besides rate that will benefit tenants. Watch for automatic escalators to fall or be diminished as property values continue to decline. Tenants with cash for their own improvements will be able to drive even harder bargains. Any company, large or small, with a product or business model experiencing growth will be the 500 lb. gorilla.

You need to have a strategic plan for your business real estate.  Harry’s book, The Great Depression Ahead, is a good first step to understanding the changes that will effect your business in the near future, and is an interesting read. Getting the timing right on your lease can give you an advantage over your competition. And as a commercial tenant looking at space occupancy rates, Less is More.

Another Great Thing About this Economy #47 – Corporate Politics

Cut Your Rent in Half – Blend & Extend

Many companies believe that either 1) They must live with whatever terms are stated in their existing lease until it expires or, 2) They can go to their landlord, tell them that they can’t afford to pay their existing high rental rate, and the landlord will willingly drop their rent to current market rates. Which is correct? Well….generally neither, exactly as described. Here’s how to get the most benefits:

First, I need to state that some landlords won’t renegotiate any terms – often because they are in financial straits and don’t have the latitude to do so. And some landlords, fearsome of losing a key tenant on whom perhaps renewing their financing terms is contingent upon, might just drop the rent in anticipation of future goodwill value. Most landlords, however, do not fit either of these categories.

If a property owner is most interested in long term yield, they are almost always willing to consider any proposal that will provide them with greater long term benefits. Most pension funds, private equity investors, and many individual landlords fit in this category.  The reduced rent goal of the tenant and long term value goal of the landlord are not mutually exclusive. They can each achieve their objectives with a formula that we call Blend and Extend.

In the same way that you can take a bank loan and amortize it over a longer period of time to reduce your payments, you can agree to extend your lease at market rates (if below your current scheduled rate) and get the landlord to effectively “tear up the lease” to provide an immediate rent reduction. For increased savings, or if market rates are equal to or above your current rate, you can also give a portion of the space back to the landlord.

For example, if the existing lease is for 10,000 SQFT of office space at $25/SQFT and two years remain, the remaining obligation is $500,000. If the market rate is now $20/SQFT and you only need 6,000 SQFT, restructure the lease by adding three additional years of term (6,000 x $20 x 5 years = $600,000). This provides the landlord with an additional $100,000 of value on the lease. It also drops the tenant’s rent by more than half, from $20,833/month to $10,000/month.

Will every landlord bite?  No.  Will most of them?  Yes, so it is worth the effort.  This is just one example, and there are many creative ways to accomplish similar benefits to create a win-win situation for both parties. The key to gaining the landlord’s interest is to structure the lease so that the new total obligation exceeds the obligation remaining on the existing lease. Blend and Extend – because Less is More.

Parting is Such Sweet Sorrow

In three separate incidents that I’ve witnessed recently, landlords have demonstrated their growing financial desperation. Two of the cases involved clients moving out of a property and debate over the “reasonable wear and tear” condition of the premises on vacating. The other issue involved a proposed new lease with a rider describing the required condition in which the space must be returned – in essence describing most of the preparation that a landlord would typically do to prepare a space for a new tenant.

The underlying issue here is not about the tenant’s treatment of the space, it is about the landlord’s increasing financial pressure to preserve precious cash.

In both of the “move out” circumstances above, the tenants planned and budgeted to: remove all trash from the premises and leave broom clean; make sure that the heating, cooling, plumbing, and electrical were in safe and proper working order, and; properly repair and restore any unfinished construction left by the removal of their trade fixtures.

After doing so and vacating the premises, both received demand letters from the landlords to perform additional work such as: power wash warehouse floors and VCT tile, paint walls that had been painted any color other than white, remove improvements that were performed by the landlord for the tenant’s benefit prior to the tenant taking occupancy, replace an HVAC unit that was in “poor condition” (although working), and clean cobwebs from the joists of a 24′ clear warehouse.

Notable is that both leases required the tenant to maintain the premises in good condition, “excepting reasonable wear and tear”. In one circumstance the tenant was in the space for ten years, in the other eighteen – so these are not new buildings. What is “reasonable wear and tear” after eighteen years? While you’d think that a landlord would be happy to have had such a good paying tenant for such a long run and no vacancy, in this case the landlord is threatening legal action if the tenant doesn’t meet the landlord’s (undefined in the lease) opinion of “reasonable” wear and tear.

The third case is perhaps a pro-active landlord’s way of protecting themselves from such an issue, by creating an addendum that gets inserted as Exhibit D to a lease that describes similar conditions as those above including “Replace or restore any loose, chipped, or cracked Formica on cabinetry or countertops”. At the end of a seven year lease? You’ve got to be kidding, right? Didn’t the tenant pay for that cabinetry with their improvement allowance?

I think the cases described here are not about the tenant damaging the property or not fulfilling reasonable obligations.  I think that the issue is that landlords are pinched for cash, and money to simply freshen up and prepare a space for the next tenant is not a cost that they can pass through in operating expenses or amortize into the next tenant’s improvement allowance. And, perhaps, it is also not something that they can easily borrow money from the bank to have done.

How to protect yourself? Notify your landlord of your intended actions prior to vacating the space. Do a walk through of the space with the property manager to note any damage or repairs required 30 days prior to vacating and make sure you each sign, date, and keep a copy. On new leases, be very careful as to what you agree to regarding the return condition of the premises. Companies are usually so focused on getting into a space that leaving conditions are not often a pressing concern.

That still may not be enough to protect you from an unethical or desperate landlord, although it will certainly help.

The Paper That it is Written On

It is a great time to be a tenant, and here is another example. Because almost all lease renewal options are written with the assumption that rental rates will climb forever upwards, we’re seeing some interesting effects as rates tumble.  Like many stock options, some renewal options are literally not worth the paper they were written on. However, declining markets have made some usually unattractive renewal options have new value. Here’s why:

In an appreciating market, it is typically most desirable for a tenant to have a “defined” option. That means that the rent is spelled out in an actual dollar rate/SQFT or a percentage increase over the last year of the original lease term. Simple enough, and in a declining market, of limited value.

In recent years, however, many landlords resisted defining future rates and instead insisted on “market rate” renewals. You can guess where this is headed, right?

If the options provided for market rate renewals and especially if the option has a well constructed method for determining market rate – such as an appraisal or “comparable space within the project adjusted for concessions and construction allowances” – there may be a tremendous opportunity to lock in attractive rental rates. Best of all, many options can be exercised at any time before a certain date meaning that the tenant can lock in while rates are low even if the expiration is years away.

Be prepared for the landlord to scream bloody murder because they may have a more optimistic view of future market conditions. At the time of writing, many markets are still in relatively early stages of decline so if your expiration is a long way off it may be best to wait it out a bit longer. Real estate values are difficult to predict more than 18 months out although can be gauged with relative accuracy within the next 18 months. Watch your market(s) closely and exercise your market options near the bottom of the cycle.

Better yet, simply inform your landlord that you will be exercising the option, show them the justification of rates, and then negotiate revised terms beginning now. You may be able to structure immediate rent relief and negotiate in expansion or contraction, immediate improvements, or other concessions. Either way, you should end up paying less rent. And of course, Less is More.