How to Protect From Landlord Default?
Office building owners are facing the most challenging environment of the past 50 years due to substantial reductions in demand for space. The shift in demand is not cyclical; it’s a systemic shift caused by changes in how work is done in the information economy. In other words, investors can’t count on a swift reversion to the norm. This dynamic is playing out globally. There are geographic differences, but the fundamental trend is the same. The impact on office investors has been swift and brutal, leaving many in a precarious financial position.
From the occupier perspective, understanding the landlord’s capital stack is now of vital importance. It’s also imperative that transactions are appropriately secured against landlord default. While landlords are skilled at protecting against tenant default, requiring large lease security, parent guarantees and other mechanisms to secure the lease, it’s less common for tenants to properly secure the deal. Indeed, landlords have historically rebuffed attempts to assess their position and capacity to fulfill transactional obligations. No landlord, regardless of scale, is immune to financial distress at the asset level. Landlords can and will walk away from obligations. Today many large-scale office owners are carefully evaluating their portfolio to determine which investments are worth keeping and which should be terminated. While terminating an investment doesn’t necessarily mean default, it is an option. In such a case, the lender’s recourse is the asset. Yet given the scale of declines in value, the lender(s) position may also be “under water”. However, unlike the investor, the lender can’t simply walk away. Its options are either to sell or to step into the landlord’s shoes and run the building.
What are some of the ways landlord default can impact the tenant? One example is a failure to fund capital obligations related to the lease. Depending upon the scale of the lease, these obligations can run into the millions of dollars. When the landlord entity defaults, it’s not a given the lender will step into their shoes to fulfill the obligation, even when the tenant has a subordination, non-disturbance and attornment (“SNDA”) agreement from the lender. The implications for the tenant can present many challenges. Work stops, the schedule is disrupted, and the target relocation date is delayed. This may put the tenant in a holdover scenario, typically at a prohibitive cost; or, worse, expose the tenant to consequential damages because in holding over it has delayed the existing landlord in accommodating a new lease it has structured for the space with a third-party tenant (a domino effect).
How does a tenant protect itself? Firstly, self-help. Self-help is exactly what it sounds like. It’s a mechanism in the lease that enables the tenant to step into the landlord’s shoes and fulfill its obligations, for example, funding the unfinished tenant improvement project. Funds so allocated are recouped by the occupier through deduction from future rent. Another important protection is to have the lender explicitly guarantee aspects of the landlord’s obligations – like funding tenant improvements – in the event the landlord defaults.
Landlords won’t enjoy a conversation about their ability to perform. But it’s a conversation that must be had. Tenants must be careful to put this topic on the table early, while they still have time and options, because not all landlords and lenders will agree to protective measures.