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.