Even during normal times, risks abound for landlords owning and leasing real property. But the risks have multiplied this year during the current COVID environment due to closures, travel restrictions, shutdowns, work-from-home policies, supply chain interruptions, just to name a few problems.
The general economic downturn that all of these problems have caused has created significant stress on the entire real estate industry. The impending second wave of COVID cases this winter now threatens to intensify these problems.
In the current perilous environment, it is even more critical for landlords entering into lease agreements and loan agreements to carefully scrutinize the terms of each of the documents in relation to each other and to coordinate the negotiation of the terms of each respective document. The goal is to avoid situations in which an event of default by a tenant triggers a default under the landlord’s loan documents, but also in which the landlord lacks sufficient rights under its tenant lease to declare a default and seek enforcement against the tenant. This is especially problematic with single-tenant properties since the rental income stream depends entirely on a single tenant. Below are some guidelines for avoiding such a predicament.
Carefully review and compare the respective default sections in the leases and loan documents. Negotiate the longest cure period possible in the loan documents and be wary of lease cure periods that provide the tenant with an indefinite timetable. In all cases, the cure periods in the loan documents should be as long or longer than the cure periods in the tenant leases. It will be easier to incorporate all the desired provisions into the lease when the parties first enter into the lease rather than to attempt to add those provisions later via an amendment, since lease modifications, forbearances and abatements must generally be approved in advance by the lender.
Landlords must understand the covenants in the loan documents that also apply to the tenant and ensure that those same covenants also appear in the leases with proper landlord enforcement rights. Examples of covenants for which the landlord must also rely on the tenant for compliance include: (i) compliance with laws and regulations; (ii) maintaining operational licenses and permits; (iii) not allowing litigation or claims against the property, landlord or tenant; (iv) maintaining the property in good condition and (v) not allowing liens on the property.
Landlords may suffer violations of their loan document covenants due to matters that are out of the landlord’s control. Some examples include government-mandated shutdowns, limitations on in-person meetings and transactions, as well as restrictions on accepting new residents into an apartment high-rise or a senior living facility. These external circumstances can diminish a tenant’s ability to pay rent, or can reduce occupancy levels, and these decreases in rent and occupancy can in turn result in violations of debt service coverage ratio covenants or occupancy level covenants under the loan documents.
When negotiating the loan documents, a landlord should seek express exceptions to these covenants that provide the landlord with a relaxation of the covenant requirements or an extended opportunity to cure a breach, if due to a COVID-related cause. In the absence of built-in exceptions, a landlord who has breached these loan covenants will need to seek a loan modification agreement or a temporary waiver agreement from the lender.
If the landlord’s loan documents include a borrower loan guaranty, insist on a guaranty that is non-recourse and limited to “bad boy acts” such as fraud and misappropriation of funds, and avoid agreeing to any guaranty that could be triggered by defaults under the tenant leases.
Cessation of operations
Due to the risk of government-mandated shutdowns, landlords should review the loan documents for any defaults triggered by a cessation of operations at the property (aka “going dark”) and incorporate an exception for cessations in operations due to a government-mandated shutdown. Also, avoid lease provisions that allow a tenant to abate rent in the event of a casualty that prevents the tenant from occupying its premises, and be sure that the definition of casualty is narrowly defined to exclude COVID or other pandemics.
Business interruption and loss of rent insurance
Because the risks of government shutdowns and eviction moratoriums are an ongoing concern, every landlord should require its primary tenants to obtain business interruption insurance and should obtain rental interruption insurance for itself. These insurance policies typically cover business interruptions and rental losses resulting from casualties at the premises. However, the policies don’t always cover business interruptions and rental losses stemming from diseases and pandemics like COVID, so landlords should seek out policies that expressly provide such coverage and should avoid any policies that contain exclusions for diseases and pandemics.
For properties under construction, the COVID environment has elevated the risk that labor shortages, interruptions in the supply of materials and slowdowns in the issuance of building permits and operational licenses could substantially delay the completion of the property. It is important to incorporate sufficiently generous completion deadlines into both the lease and the loan documents to protect against defaults due to such delays.
Lawsuits stemming from employees and visitors contracting COVID while at the premises are on the rise. Tenant leases must include sufficient indemnity clauses and tenant insurance requirements to protect the landlord in the event that a visitor or employee of the tenant contracts COVID and files a lawsuit naming the landlord as a defendant simply based on premises liability. Such clauses are especially valuable in single-tenant, senior living and multifamily facilities where the landlord may not be the party who actively manages the day-to-day operations of the building, but instead relies on the tenant or a property manager for such oversight.
To avoid budget shortfalls, and their effect on the funds needed to also service the landlord’s mortgage loan, tenant leases should allow the landlord to pass through the costs of any additional cleaning or structural modifications to the building required by regulations for matters such as COVID, even though such expenses may not have been expressly included within a particular annual budget for operating expenses.
With the proper diligence devoted to the respective terms in the lease and loan documents at the document negotiation stage, and with particular attention paid to the matters discussed above, landlords can significantly reduce the risks posed by the current COVID environment, which will, in turn, promote greater financial stability throughout the ownership of their properties.
About the author
Thomas W. Slover is an of counsel attorney for Spencer Fane LLP in the firm’s Plano, Texas, office. He focuses his practice in commercial real estate, leasing, financing, corporate and partnership law.