With the uncertainty of the duration of the downturn in the commercial leasing market, the vast amount of available first and second generation space and the increasing number of tenant bankruptcies, how can landlords position themselves to endure these uncertain and potentially devastating economic times? Cutting rental rates and providing previously unheard of tenant concessions such as short term leases and long periods of "free rent" may seem like the only alternatives, but they are not. Landlords can enforce existing provisions in their leases and incorporate additional provisions into their lease forms which will improve their position in the marketplace.
Since the real estate market was booming for so many years landlords did not have the time or the desire to closely monitor their tenants or to enforce certain lease provisions. Landlords need to make the time to clean up their records, familiarize themselves with their tenants and enforce existing lease terms. Specifically, landlords should request updated financial statements from their tenants and more closely monitor tenants' current financial status. A hotly sought after tenant a year or two ago could very well be on the brink of bankruptcy today. Make sure leases have not been improperly assigned or the premises unknowingly sublet. Each landlord should always know who its tenants are in case it has to evict one. Check the existing amounts in all tenant security deposit accounts and require tenants to bring any security deposit shortfalls current. Confirm the expiration dates of any letters of credit and the location of the originals. Make sure each letter of credit has been assigned to the current landlord; a generic assignment of security deposits is not sufficient. Each issuing bank has strict assignment procedures that must be followed closely. If a letter of credit has not been properly assigned, the prior landlord (beneficiary) will have to be located and the letter of credit formally assigned or endorsed pursuant to the issuing bank's internal requirements before the current landlord can make any draws under it. In many instances prior landlords no longer exist and it may take several months to locate the former officers or company officials to accomplish this task. These common sense "house keeping" suggestions may seem overly simplistic but they will save precious time and prevent unnecessary aggravation when dealing with defaulting tenants.
Landlords should also closely monitor delinquent rent payments and formally document tenant payment plans. Do not let any one tenant get more than three months behind in its rent. If a defaulting tenant files for bankruptcy protection the landlord usually becomes an unsecured creditor of the tenant and rarely recovers the sums due it. Landlords should not fall into the trap of entering into informal payment plans. All too often property managers jump at the chance of signing a letter agreement with a defaulting tenant when a tenant agrees to bring its rent current. An improperly drafted informal agreement can unintentionally modify the terms of the lease, cure the tenant's default and waive the landlord's right to recover all sums due it if the tenant fails to timely perform under the payment plan. Instead, landlords should enter into "forbearance," "work-out" or "settlement" agreements with defaulting tenants. These agreements do not have to be overly complex or lengthy but should contain the following basic elements: (1) the tenant should stipulate the amount of past due rent and other sums payable under the lease and acknowledge that the lease remains in default until all past due sums have been paid in full; (2) the tenant should stipulate that it will immediately vacate the premises upon a default under such agreement, consent to a final judgment of eviction being entered into against it, and agree not to contest any eviction proceedings; (3) if a discounted pay off amount has been agreed to, the tenant should acknowledge that the full amount is due if the tenant defaults under the settlement agreement; (4) the tenant should acknowledge that the landlord is not in default under the lease and release any potential claims it may have against the landlord; and (5) if there are extensive personal property or tenant improvements in the space, the parties should set forth which property belongs to the tenant versus the landlord upon termination of the lease. When negotiating such an agreement, consider terminating additional rights of tenants such as expansion rights, rights of first refusal and renewal options. With a properly written agreement the landlord can expedite the eviction process by circumventing the notice of default and cure periods set forth in the lease (and depending on state law, the statutory notice procedures) and weaken the tenant's ability to allege any defenses in an eviction proceeding and simply remove the tenant from the space faster. If an informal agreement is not properly drafted the landlord will have to start the default process all over again by providing the written notice required under the lease and the landlord will have waived its right to collect certain past due rent if it agreed to a discounted payoff. The key to a tenant eviction is to complete the process and get a paying tenant in the space as soon as possible.
Be mindful of current market conditions when entering into new lease agreements; do not just sign "any lease." Admittedly, tenant negotiations are tough in this market and landlords of existing buildings are having increasing difficulty competing with new buildings containing the latest technology and below market sublease space that is completely built out. This does not mean that landlords cannot implement a few landlord protections such as requiring letters of credits as security deposits and adding "protectionist" assignment and sublease provisions to their leases.
It may seem counterintuitive but letters of credit are better in certain circumstances than cash security deposits. How can this be? In the event a tenant files for bankruptcy protection a cash security deposit held by a landlord is deemed property of the debtor’s bankruptcy estate, is subject to the automatic stay in bankruptcy and the landlord's use of the security deposit requires a court order. On the other hand, a letter of credit is viewed as an enforceable third party agreement between the landlord and the issuing bank and is not deemed property of the tenant's bankruptcy estate. Of course there are a few exceptions to this general rule. For instance, if a letter of credit was provided to a landlord as a security deposit under a lease during the 90-day preference period it may be voidable by the bankruptcy court. Letters of credit are preferable to cash security deposits in tenant bankruptcy situations but they are not a panacea.
With a letter of credit it takes more time for a landlord to actually receive the money due it than with a cash security deposit. In most instances the original letter of credit must be presented, in person, in some usually obscure office of the issuing bank. The landlord must incur the travel expense and time delay. Letters of credit also cost the tenant an annual fee (usually 1% of the amount of the letter of credit) and have firm expiration dates. Letters of credit can easily become worthless without the landlord even realizing it. Many landlords have had the experience of sending a representative to the issuing bank's office to make a draw under a letter of credit and made the shocking discovery that the letter of credit has expired and is worthless. Worse yet, is the realization that the original letter of credit is lost. Since letters of credit are negotiable instruments they will not be replaced by the issuing bank if they are lost or stolen. Letters of credit should only be accepted from issuers with strong credit ratings and landlords should attempt to secure a local office for presentation purposes.
The terms of a letter of credit must also be very carefully written and drawing funds under a letter of credit can not be contingent on any event or circumstance within any third party's control. The issuer must have precise instructions when to disburse draws under the letter of credit or it will refuse to do so. At most, a draw under a letter of credit should be conditioned upon the submittal of the original letter of credit by the beneficiary with a short note signed by the beneficiary stating that the tenant has defaulted under the lease. There should not be any requirement for the beneficiary to specify the type of default, prove that it properly complied with the notice provisions in the lease, or for the tenant to acknowledge that a default occurred or it received a written default notice. All of these contingencies will enable the issuer to deny the landlord's request for a draw. Because of the number and complexity of issues related to the use of letters of credits, they may not be best alternative for small security deposits or for unsophisticated landlords.
One of the worst situations for a landlord is to negotiate the terms of a lease with a prospective new tenant (or even a renewal with an existing tenant) and have the prospect sublease other space in the building from an existing tenant at below market rates. This situation is becoming a significant problem in the industry due to the significant amount of sublease space available in the market today. To prevent this from occurring, more and more landlords are incorporating provisions into their assignment and sublease clauses specifically enabling the landlord to deny consent to an assignment or sublease of an existing tenant's space where the proposed assignee or subleasee is an existing tenant in the building or is a prospect that the landlord has negotiated with during the last 12 months. Some landlords are even going so far as to incorporate a clause in their letters of intent requiring prospective tenants to pay the landlord's attorney's fees if the prospect negotiates a lease with the landlord and then leases space elsewhere at the last minute.
Another difficult situation landlords are facing is how to deal with the dramatic and unexpected increase in the cost of insurance. After September 11th many lenders gave landlords an ultimatum: obtain terrorism insurance coverage regardless of the cost or be in default under your mortgage loan. Few insurance companies are writing terrorism insurance and the premiums for Class A high rises in metropolitan areas and buildings with a significant amount of space leased to government tenants are exorbitant. Fortunately for a number of landlords their existing leases expressly permit estimated operating expenses pass-throughs to be increased at any time during the lease year. Other landlords have been forced to wait until the end of the lease year to make such increases and have had to come out of pocket to pay these insurance premiums. Landlords with gross lease provisions were not as fortunate. Be mindful of unexpected increases in costs that are not within the landlord's control when negotiating the economic terms of leases. Specifically exclude taxes, insurance, utilities and now expenses required by a mortgagee when agreeing to caps on operating expenses.
Hopefully the market will turn around soon and landlords will have stronger negotiating positions. Until then, landlords should carefully monitor the status of existing tenants and defensively position themselves in future lease negotiations.
Suzanne M.Amaducci is a partner in the real estate transactional department with the Miami law firm of Bilzin Sumberg Baena Price & Axelrod LLP
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