How to Not Let Unpaid Rent Ruin the Financial Relationship
We’re a long way from those early COVID-19 pandemic days when California businesses were ordered closed and emergency regulations were enacted to stop evictions. It was clear even then that rent would not be forgiven, and landlords were encouraged to be creative — not punitive — with their tenants.
Many landlords, informed or uninformed, still attempted to evict or lock-out tenants who did not pay due to COVID-19-related financial difficulties. These efforts are illegal under the current emergency orders, but also often misguided from a long-term occupancy and economic view, in particular for commercial landlords. There is no one magic solution for any commercial landlord or tenant – each situation is as unique as the real estate it rests on. Therefore, careful examination of each party’s position is important.
Tenants need to understand that the landlord:
- May have debt on the property requiring monthly loan payments that require all tenants to pay rent;
- Has other operating expenses to pay, including property taxes, insurance, utilities, security and maintenance, which, when unpaid, may have significant impacts to the property;
- May not understand the tenant’s business model or how much income the tenant had before the pandemic or during the shutdown — or what the income and ability to pay looks like in a re-opening scenario and
- May rely on the property cash flow as his/her primary income.
Landlords need to understand that tenants:
- May have little or no emergency funds or cash resources to re-open or pay;
- Have no idea if their customers will come back 100 percent or if their customer base still exists;
- May have to re-open at 25 percent capacity but with 20-40 percent more costs due to COVID-19 requirements;
- May not be ready to commit more liability in the form of an additional renewed term because they don’t see a future;
- May or may not have received a forgivable federal PPP loan or other financial assistance or debt relief;
- May have incurred rioting or looting losses;
- May be considering bankruptcy and
- May not be able to handle any rent increases or to repay a rent deferral for many years — if at all.
Further, given the number of businesses unsure of whether to open at all, the pool of possible new tenants to fill any vacancy is thin. The cost of re-tenanting a space with vacancy loss, broker fees and possible improvements is significant.
For these reasons, commercial landlords and tenants should both recognize that this is a crisis of nobody’s causing. On this basis, they need to work with each other to absorb some of the loss associated with the crisis as, simply, a risk of operating a business and owning real estate — and meet in the middle.
The approaches discussed below assume local or regional tenants, often called mom-and-pops, not tenants who are national credit or publicly traded companies. Such larger tenants have different resources and their ability to pay requires a separate analysis.
Both parties need to figure out a workable rent that pays the expenses and contributes to the landlord’s obligations. Tenants need to understand that it may be break-even for their business for a while, as if they were starting up from scratch, and will need to estimate how many months they can survive at that rate. Reopening based on pre-COVID-19 “normal” projections on revenue and rent are unrealistic. Landlords may need to accommodate a ramp-up period for the business to re-open, or the tenants may not re-open at all. Tenants may need to commit to a reasonable deferral of rent (with or without interest), additional lease term, liability or repayment of some abatement/expenses. If a tenant has received a PPP loan from the SBA, the tenant should be able to pay its rent for at least the period covered by the loan.
Such business plans should be shared with landlords. If the landlord is unwilling to work with the tenant and negotiate rent, then the tenant can make decisions accordingly and let the landlord know it can’t reopen on those terms. There will be some financial pain on both sides of the lease transaction, and neither party should expect that things will be the same as before given the current economic impacts. Seeking advice from accountants on the financial projections, and advice from legal counsel on contract remedies and ramifications is wise at this point. Agreements regarding such accommodations should be in writing. Tenants who are asking for rent relief should expect to share their financial records and situation honestly with landlords, which may be uncomfortable for some tenants, but which is not unreasonable given tenant’s request.
One solution, which aligns both parties’ interests, is an agreement that involves minimum rent and a percentage rent on additional revenue as the business ramps back up until pre-COVID revenue levels are reached. This requires additional reporting on the tenant’s part, and careful definition of gross revenue to account for actual funds received less refunds and credits, but can accommodate the return to business and a sharing of risk. If the business does not return, there may be a lease termination clause at a certain point. Landlords and tenants will need to explore whether such clauses would apply to extensions or any assignees, and possibly repayment terms if the tenant decides to close.
Another solution, because there is a high level of uncertainty about how long it will take to reach familiar territory again, is to defer some decisions until later. Business owners need to get back to business and try to restore their basis, so landlords may offer some current rent relief based on performance going forward. This might involve a combination of deferred past due rent that is partially or fully forgiven over a period of full and timely performance. However unfair it may seem to the tenant, the tenant’s behavior in trying to restore business, obtain additional resources such as PPP loans or grants or operations at a maximum legal level in order to survive all will be judged by the landlord in gauging how or if they offer relief. A landlord wants to see the tenant is as committed as the landlord in the success before offering its support.
Not every landlord will be willing to offer support, and not every tenant will be honest about its resources or ability to pay. These solutions assume that the parties are working in good faith to achieve a mutually satisfactory and workable relationship that can continue in the difficult times they find themselves.
There will be many economic casualties in this crisis due to undercapitalized businesses, failed business models, new ways of doing business in the COVID-19 era, and high leverage or expenses. Many landlords may lose tenants because their businesses are not sustainable in the reduced-contact environment we may live under for a while, or due to the landlord’s high-leverage and low-cash reserves. The commercial landlord and tenant must start working together now to recognize the issues and find a path to sustainable survival for both parties.