While the US market for residential real estate continues to run hot, ongoing fallout from the pandemic has created hardship and an uncertain outlook for many commercial real estate sectors. Warehouse space for industrial and e-commerce users remains in high demand, but it’s no secret that the retail and office buildings market has taken a major hit.
At the recent Wiss Commercial Property Summit, Richard Lyons, Partner at New Jersey firm Bertone Piccini, spoke with Re-Leased about what’s impacting the market and how to protect assets in the face of change. Richard is the firm's go-to advisor on commercial real estate leasing, serving clients that include publicly traded entities with a national footprint and small “mom & pop” real estate investors in New York and New Jersey.
Observations on market conditions
The pandemic escalated the already growing gap between the market for retail space, which has been in decline, and the robust market for industrial and flex space, especially space well-suited for e-commerce tenants.
Over the past 18 months, commercial property owners in New York and New Jersey, have faced additional pressure from eviction moratoriums, effectively forcing some landlords into the role of lenders. On top of this, increased construction costs have complicated the progress of new and planned commercial developments.
- Eviction moratoriums and tenant bailouts - To buffer the impact of pandemic shutdowns and loss of customer traffic, these programs made it possible for tenants to stay in place without paying rent for as long as 18 months. Tenants could apply for PPP money to help with rental costs, buying them time to weather the slowdown and reconfigure their business.
- Landlords becoming lenders - Landlords suffered months of rent losses, with no assurance that their non-paying tenants would get PPP funds. Some tenants left because their business failed. To keep buildings running and utilities turned on, landlords paid the mortgage with reserve funds rather than cash flow –essentially borrowing from themselves.
"That to me, was one of the most shocking aspects of legislation around COVID-19 relief. Landlords still had to make their mortgage payments and provide all the standard services and utilities to their tenants, but not collect any rent.”
- Rising construction costs - Across the board, construction costs increased by 20 to 35% over this period. Rents are starting to increase, causing some existing space to become less competitive/attractive because the landlords can’t build out space. Tenant improvement allowances are not an incentive if you can’t get materials or anything done.
Professional tenant vetting to protect income
Pre-COVID, landlords had a different mindset about leasing their property. Then, a landlord was happy to get a deal done; they wanted tenants to sign the lease to boost the rent roll. This take-all-comers approach helped keep the CAP rate strong. Now, landlords are coming around to a more rigorous vetting of tenants to protect themselves and their income base.
Two practices landlords must change when vetting tenant financials
Landlords are starting to take a thorough look at tenant financials, asking more questions and changing standard procedures to protect themselves. First, they are asking for a higher security deposit if the financials are not sound. Second, they are asking for personal guarantees so that the individual business owners are on the hook to pay rent if the business fails to do so.
1. Security deposits
For years, commercial landlords have used the security deposit as a negotiation tool. They often traded the security deposit for other legal provisions to be added to the lease. Unfortunately, those trades shifted risks and costs to the landlords, and we now see situations where landlords should have retained the security deposit clause to cover the non-payment of rent during a time like this.
“This is where I think landlords need to start to be a little bit more cautious."
“It is a big red flag if the tenant is unwilling to pay out three to five months of rent as a security deposit. Typically, in the pre-COVID market, we probably saw zero to two months as the industry standard for security deposits.
At the same time, financial institutions were usually escrowed three to five months' worth of mortgage payments. There's a reason why there's that sweet spot of three to five months. It gives the lender a level of comfort to know that you're going to have that amount of money in your back pocket if something goes wrong. Landlords should follow suit.”
2. Personal guarantees
Many mom-and-pop commercial landlords have always used personal guarantees. However, this was not the case on the corporate side. Before the pandemic, asking business owners to take on that level of personal risk was inconceivable.
A personal guarantee helps share the risk between the business owner who leases the property and the landlord. There is always some level of risk unless you’re leasing to a large, financially solid, publicly-traded client. Some level of personal guarantees will help landlords. It may not be for the entire lease term; for instance, it may be a rolling guarantee with a burndown, but a guarantee in some form would be beneficial.
“Where the market is going now, I think landlords need to have both provisions in their leases. There's too much exposure. These provisions need to be stronger.
Instead of putting the security deposit on the table, landlords could negotiate with indemnities, reduced insurance provisions, or shifting of liabilities. There is peace of mind knowing, as a landlord, you have three to five months in the bank for this tenant plus a personal guarantee to go after if the business fails to pay.”
Recommendations for moving forward
During this time, landlords should make it a point to re-evaluate leases when they see an underperforming business, but the principals are doing very well. Without personal guarantees and larger security deposits, landlords could not go after the principals to pay the rent, causing the landlords to assume all the risks and costs.
The time is now to make thoughtful changes to the due diligence requirement. Landlords need to look closely at financials, and review tenants’ tax returns for the last few years, boost those security deposits, and get personal guarantees in some form.
Watch the full session with Richard Lyons from the Wiss Commercial Property Summit HERE.
The information provided in this article does not constitute legal advice and is for general informational purposes only. Contact your attorney to obtain advice with respect to any particular legal matter.