Options for Commercial Landlords to Manage Distressed Tenants in New York
August 6, 2020
The full economic impact caused by the pandemic is not yet known, particularly in the area of commercial tenancies. As businesses assess their long-term viability, landlords may face an increase in rent payment defaults, fewer prospective tenants, or a drop in rental rates. There are a number of options that commercial landlords may consider to mitigate the effects from the COVID-19 business interruption including: lease workout, lease buyout, eviction and insurance claims. With each option, landlords must navigate several key issues to determine the best solution for their particular needs.
Landlords can continue receiving a rental income stream by restructuring the lease terms with a workout that reflects the tenant’s new economic reality. An inquiry into a tenant’s financial status will be necessary to accurately evaluate their ability to pay rent. This may involve reviewing a tenant’s current cash flow, profit and loss statements, projections, and any other outstanding debt. The rental rate structure in a lease workout may take a variety of forms:
- paying only current market rent;
- paying a percentage of the tenant’s gross revenue;
- paying a rental rate based on a tenant’s proposed business plan; or
- deferring rent or amortizing over the remaining lease term.
The workout negotiations should also include a reassessment of other terms in the lease to appropriately compensate and protect a landlord for any concessions made on rent reductions. Among others, landlords may consider an increased lease term; additional security or guaranties; repossession of unused portions of the leased premises; a waiver of legal claims; and, protections in the event that the tenant files for bankruptcy. Before considering a lease workout, landlords should carefully review any loan documents associated with the premises as it is common for lenders to require their prior approval of the terms of any lease and may even prohibit any lease modifications.
If the tenant has the funds to make a one-time, lump-sum payment, then a lease buyout may be a good option to relieve a struggling tenant from its rent obligations. The lease itself may authorize a lease buyout but the amount to be paid may need to be negotiated between the parties. While the payment will necessarily be less than the total of the remaining payments on the lease, it is important to quantify the risks involved in reletting the space to calculate a suitable sum. Ideally, the payment amount will account for:
- recurring expenses;
- capital improvements;
- market rates;
- unamortized portion of commissions paid; and
- vacancy costs.
Typically, a tenant may seek to be released from any guarantees as part of the buyout agreement. For the owner of a small building, an additional option may be to consider selling the building at a discount to its tenant, particularly if the tenant has access to a lender for a mortgage.
Once a tenant fails to make rent payments, landlords may avail themselves of legal remedies to enforce the lease including initiating an eviction proceeding. Due to the pandemic, however, this option has limitations for tenants who face financial hardship due to the pandemic. As of this writing, eviction proceedings in the State of New York have been suspended for qualifying tenants until at least mid-August. Nonetheless, it is prudent to prepare to bring such a proceeding once the suspension is lifted. Landlords should scrutinize the terms of their lease and the latest Executive Orders by the Governor to determine if they can:
- make a demand for payment on guaranties;
- draw down on a letter of credit or apply a security deposit to the unpaid rent;
- start the clock to terminate the lease by commencing any cure periods; or
- serve rent demands.
The legal landscape in connection with evictions may continue to change but adhering to the requirements under the lease will ensure that the landlords’ rights are protected.
Even with eviction proceedings on pause, landlords must still consider their own obligations to their lenders. New York has a moratorium on foreclosure actions until at least August 20, 2020 giving landlords some respite from their own financial difficulties. Moreover, the State Assembly has introduced a bill authorizing a 90-day commercial mortgage forbearance to qualified mortgagors. But all options to mitigate losses from non-paying tenants should be explored including potential insurance claims for business interruption.
Many insurance policies for business interruption, by their terms, may not cover the COVID-19 disruption. However, New York State is currently considering a bill that would expand coverage by requiring certain commercial property insurance policies to cover business interruption during the period of time when a state of emergency was declared due to the pandemic. If passed, the bill would also automatically extend any policy that expired during the emergency period without increasing the premium. The bill applies only to:
- policies in effect as of March 7, 2020;
- insureds with fewer than 250 eligible employees; and
- policies covering business interruption.
Whether or not the bill passes and survives any legal challenges from insurance carriers remains to be seen.
Now is the time for landlords to have a keen understanding of the terms of their leases, the requirements of their loan documents, and the scope of their insurance policies. There are a number of alternatives to minimize losses due to the pandemic but landlords must thoughtfully consider all implications of any particular course of action.
For more information on this or other commercial real estate issues, contact Alfred E. Donnellan, Esq. (email@example.com) or Nelida Lara, Esq. (firstname.lastname@example.org).
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