Lease Wisely: Understanding Landlord Stability Before You Sign

It’s increasingly important for tenants to be proactive when it comes to ensuring their landlords’ performance and stability. Consider the WeWork collapse in 2023, a company which once operated 720 coworking spaces across the globe and had a valuation of $47 billion, only to have it all come crashing down in the wake of COVID and remote work, leaving many tenants stranded. Meanwhile the delinquency rate for Commercial Mortgage-Backed Securities is at 6.5%, up from less than 2% in early 2023, and office vacancy rates remain at record highs in major cities including Chicago, New York City and San Francisco.

The rise of remote work combined with the surge of online shopping has left an indelible mark on the nation’s cities, and landlords are not able to recoup the projected rental rates that once validated their high purchase prices. The commercial real estate market is still recovering and tenants, now more than ever, must ensure that they are well positioned to protect their interests, by understanding their landlord’s ability to perform per the lease.

When a lender forecloses on a property, it puts the tenant at risk in several ways. In some cases, the tenant may lose their lease and be effectively kicked out. The tenant’s agreed-upon allowances—including the free rent period and tenant improvement allowance—may not be honored. And there are questions about building maintenance: who does the tenant turn to if there is a problem? While it is impossible to eliminate 100% of the tenant’s risk if the landlord goes out of business, it is important for lessees to underwrite their business partner’s financial stability before executing a lease.

Here are six areas to focus on in order to assess a landlord’s ability to deliver on promises, and steps tenants can take to reduce their risk when leasing space:

1. Landlord Equity: Tenants need to know whether the landlord’s equity has evaporated, putting them in a position where they owe more than the building is worth. If this is the case, it’s a major red flag and spells troubles unless the landlord has deep pockets to weather the storm. Tenants need to understand the current value of their building, the owner’s purchase price and the loan amount.

2. Debt Stacks: Institutional investors often cross-collateralize a loan on a single building with several buildings in their portfolio. This strategy helps lenders reduce their risk. Similar to item 1 above, if a property is cross-collateralized, a tenant needs to understand how the landlord’s entire portfolio is performing in order to accurately assess its risk. If a single building in a portfolio is underperforming but the balance of the portfolio is solid, it’s a low-risk situation for the tenant—the opposite scenario, however, brings serious risk.

3. Subordination and Non-Disturbance Agreement (SNDA): This is an agreement between the lender of the property and the tenant. With an SNDA, the tenant’s lease remains intact in the event the lender takes possession of the building. While it offers some protection, it can pose challenges in regards to the free rent period or tenant improvement allowance. Lenders often won’t agree to assume those obligations even if they foreclose on the asset. There are other avenues tenants may pursue should the lender become difficult when negotiating this agreement.

4. Offset Rights: This lease clause is fairly standard in today’s environment. With offset rights, tenants have the ability to fund their own tenant improvements or other monies owed by the landlord in lieu of paying rent should the landlord fail to perform.

5. Cash Position: It’s important for tenants to understand the landlord’s cash position in order to assess tenant risk. It’s fairly easy to determine cash position for a publicly traded REIT, but can be more difficult when underwriting private ownership of real property. Tenants should engage an experienced real estate professional who has the market intelligence to investigate this situation with private landlord entities and counsel their client accordingly. Cash-strapped landlords pose a real risk to tenants’ lease security.

6. Building Maintenance: If tenants are in a newer building—or one that has been recently renovated—there’s a lower risk that they’ll face imminent issues around building maintenance. An older building or one that contains deferred maintenance presents a high risk for tenants. Building owners of older maintenance deferred properties may not be willing or able to provide needed repairs and service, leaving tenants in the lurch.

To illustrate the risk, here’s a possible scenario: Imagine a tenant executes a lease and during the tenant improvement process the landlord defaults on the loan and stops funding the construction. What are the options for the tenant? Will the tenant business spend capital to finish construction? What happens to its free rent as stated in the lease? Who maintains the building?

To ensure that the tenant is properly protected regardless of a landlord’s financial standing, enlist the support of an experienced real estate advisor who understands the market, landlords’ positions and how to navigate the terms to get the best accommodations.

Commercial real estate foreclosures continue to rise. Tenants must assess their risk when leasing space to ensure the lease remains intact, that their place of business is secure, their assets are protected and a smooth transition occurs once the deal is closed and a lease is put in place.

#lease #cre #tenants #foreclosure #maintenance

Anna Kaplan Amanda Chung Michael Capek Shay Hughes John Jarvis David Marino