"What should landlords and tenants be thinking about in this depressed-market environment?"
It's a question we're asked virtually every day.
Our firm's transactional counsel, Robert C. Epstein , has some insightful and timely analysis -- which should be particularly useful for commercial tenants about to enter into new lease agreements or renewals.
With the tightening of the credit markets and increasing economic concerns, some tenants appear to be postponing leasing decisions while awaiting the impact on the leasing market. Obviously, as the market softens, rents will drop, rent concessions will increase and work letters will improve. All of that is good news for tenants. On the other hand, a softening market will lead to other risks for tenants, and therefore will require tenants to shift their focus in negotiating leases.
Here's a list of some lease issues that will become more important to tenants if the market continues to soften.
1. Nondisturbance Protection. Almost all leases provide that the lease is subordinate to the lien of existing and future mortgages and ground leases. That means that if the mortgagee were to foreclose or the ground lease were to terminate, the mortgagee or ground lessor would have the right to terminate the existing leases and evict the tenants. While credit was readily available and building values were increasing, buildings and ground leases were being sold and refinanced over and over again, resulting in corresponding increases in the size of loan payments. Accordingly, unless market rents continue to rise enough to cover mortgage payments, the risk of mortgage and ground lease defaults will rise.
Due to the potential increase in the incidence of defaults, tenants should try to require their landlords to provide nondisturbance agreements from their mortgagees and ground lessors. In essence, nondisturbance agreements prohibit lenders and ground lessors from terminating leases and evicting tenants in the event of a default so long as the tenants continue to abide by the provisions of their leases. The lease remains in place between the tenant and the successor landlord. In the absence of nondisturbance protection, a tenant could find itself with a terminated lease after investing substantial sums in improving its space or negotiating a below-market rent. While it is unlikely that a performing tenant will be evicted in a softening market, it is better to avoid that risk altogether by obtaining a nondisturbance agreement. If a tenant is unable to obtain a nondisturbance agreement, it should at least request a representation from its landlord that it has not received a notice of default from its mortgagee or superior lessor; although this will not protect a tenant from a future such default, at least the tenant will know that it is not signing a lease with a landlord who may already be having problems with its lender or lessor.
2. Subleasing. Leases almost always provide that the landlord's approval is required before a tenant may sublet its premises or assign its lease. In order to prevent a tenant from circumventing such approval requirement, an assignment is typically defined to include the transfer of a majority of the interest in the tenant (for example, if the tenant were a limited liability company, a transfer of more than 50% of the interest therein would be deemed to be an assignment). There are typically a number of other limitations, such as prohibitions against subleasing to to other tenants or prospective tenants of the building or at rental rates below the rates then being offered by the landlord, that make it more difficult for a tenant to sublease or assign in a softening market. In the event of a business slowdown, a tenant may find itself with the need to reduce the size of its premises or restructure, including by recapitalizing, selling or merging. Consequently, a tenant expecting a slowdown should focus on softening the provisions in its lease that will make it more difficult to dispose of its premises. For example, at minimum the landlord should not be permitted to unreasonably withhold its approval to a sublease or assignment (or, in the provision addressing tenant alterations, to alterations that may be necessary in order to sublease or assign). The tenant should also be permitted to sublease its space at a rental lower than the rent it pays, even if below market, and to sublease or assign to other building tenants or prospective tenants so long as the landlord does not then have comparable space available. The use permitted by the tenant in the premises should be sufficiently broad to enable the tenant to sublease or assign to as many prospects as possible (for example, the use clause should permit office use as opposed to law firm use). The tenant should also be permitted to engage its own broker to assist it in its efforts to assign or sublease as opposed to using the landlord's leasing agent; the landlord's leasing agent may have a conflict of interest since it might seek to lease the landlord's space ahead of the tenant's. With respect to restructuring, the tenant should be permitted to merge or sell a majority interest so long as it maintains a minimum net worth. The net worth should ideally be pegged to the lease obligation, such as a net worth equal to some multiple of the annual rent. Most leases provide that the minimum net worth must be the greater of the tenant's net worth on the date of the lease or the date immediately preceding the sale or merger, but this might require a net worth that is much greater than is reasonably required to assure the availability of assets needed to pay the rent during the lease term.
3. Build-Out. Leases often provide that the landlord will furnish the tenant with funds for the tenant to use in improving their premises or that the landlord will carry out all or some of the work needed to improve the premises for the tenant's occupancy. If a tenant is concerned that the landlord might default in its obligations to provide such funds or perform such work due to the weakening economy, it needs to protect itself. With regard to the funding of the improvements, the tenant could require the landlord to place the funds in escrow upon lease signing to ensure their availability or require that the landlord's contractor furnish a labor and material payment bond or a performance bond. Another alternative would be for the tenant to reserve the right to complete the work if the landlord fails to do so and offset the cost of such completion against the rent.
4. Services. Most leases require the landlord to provide some services and utilities to the tenants, such as cleaning, common area maintenance and repair, heating and air-conditioning, electrical power and water, and elevator services. If the landlord fails to provide such services due to insufficient funds, the tenant might not be able to continue to occupy its premises. Accordingly, if a tenant is concerned that such a situation could arise and does not want to be limited to attempting to terminate the lease by suing for constructive eviction, it should try to negotiate for the right to provide its own such services and deduct the cost from rent. Obviously, in a multi-tenant building, it would be more difficult for a tenant to provide a service that is furnished by the landlord on a building-wide basis, such as air-conditioning. However, a tenant might be able to make arrangements that are sufficient in the short term to enable it to remain in occupancy pending resolution of the landlord's situation.
5. Termination Option. If a tenant is concerned that its business might slow due to a recession and therefore that it might be unable to pay the rent, it may want to try to negotiate for a termination option. Termination options are difficult to achieve, and when they are obtained they typically include a number of landlord protections. These include the obligation of the tenant to reimburse the landlord for its out of pocket expenses incurred in connection with the lease, such as the unamortized cost of the build-out, free rent and commissions. They also typically require that the tenant provide a few months of notice prior to the effectiveness of the termination in order to afford the landlord the opportunity to re-rent the space, as well as the payment of a few months of rent to provide the landlord with a cushion in case it has trouble re-leasing the premises. Termination options also normally may not be exercised until after a minimum portion of the lease term has expired. Such options may also be limited to a portion of the premises, as opposed to the entirety of the space, such as a particular floor or floors of a multi-tenant premises.
Obviously, if a tenant is a single purpose entity or is otherwise insolvent and there is no guaranty of the lease by a third party, the tenant will have a de facto termination option. In such event, it can just shut its doors and its exposure will be limited to its security deposit. Also, as discussed above, a tenant can still take advantage of its ability to sublease or assign in order to reduce its leasehold obligations if it is unable to negotiate for a termination right.
The softening of the economy will improve the leverage tenants have in negotiating their leases. This should result in lower rents and increased concessions. However, it will also require tenants to place a greater emphasis on issues that were of less concern when the economy was strengthening. A failure to focus on these issues could cause more harm than the higher rents and smaller concessions faced by tenants in a strengthening market.