Companies looking for rent relief can no longer expect landlords to come to the negotiating table just by raising the specter of bankruptcy, attorneys said last week in an O'Melveny & Myers podcast. These days, tenants must actually file for bankruptcy to gain leverage.
"The world has changed," Steve Warren, an O'Melveny & Myers restructuring attorney, said. "It's no longer 1% of your tenants who are in a position to credibly threaten bankruptcy. Landlords, looking at someone who's threatening bankruptcy, [will say] it doesn't matter; everybody's threatening bankruptcy. So, the threat doesn't really work. To get traction, you actually have to be in bankruptcy."
Already this year, over two dozen retail companies have filed for bankruptcy, which is more than all that filed in 2019, and more filings are likely to come as the pandemic continues, according to reports.
Compared to other commercial real estate asset classes, retail, including restaurants and entertainment venues, are in a rent-payment crisis. Rent collections in the sector have plummeted to between 30% and 40%, and, among some portfolios, have dropped to below 20%, O'Melveny & Myers real estate lawyer Michael Hamilton said.
Comparatively, other asset classes are doing well. Collections among offices are above 90%, and among industrial properties, which are benefiting from the move to remote work and online shopping, they're above 95%. Multifamily is also doing better than retail, although it's seeing a drop in rent collections now that government stimulus payments to households have stopped.
Filing for protection
Companies seeking bankruptcy will gain an immediate increase in their negotiating power, Warren said, starting with their power to assume or reject a proposed lease modification.
"The power to reject is really the critical driver," he said.
That power faces a key legal limit — time. The tenant must decide on the restructuring plan within a period set by the judge. From a practical standpoint, the time limit is typically even more constrained; lenders putting together debt-in-possession financing usually pressure the tenant to finalize the resolution well before the judge's timeline.
"They aren't going to let them run all the way up to the limit, so decisions have to be made even sooner," Warren said.
But bankruptcy gives tenants other powers, too. It imposes a cap on how much rent landlords can charge during the restructuring plan. The cap is based on a formula that typically works out to one year's worth of rent for leases shorter than seven years. "That limitation puts the landlord in a tough position," Warren said.
Increasingly, there's a third power: the ability to stop paying rent entirely, something unheard of in the past. But bankruptcy judges in at least two states, Virginia and New Jersey, have given the go-ahead for that, citing the unique conditions the pandemic has created.
"[Launching a rent strike] could really further tip the balance of power," Warren said. "You can imagine a whole range of decisions, like selective rent payment, that could create a new dynamic."
Tenants might be tempted to point fingers at landlords for pushing back against rent concessions, since tenants' business disruption is beyond their control. But landlords face their own constraints from lenders, especially since the commercial mortgage backed securities (CMBS) market became the predominant means of property acquisition funding.
"With the expansion of the CMBS market, the concept of calling your lender and saying, ‘My tenant is not paying; I need some relief on my mortgage,' has been thrown out the window," Hamilton said. "There's no one to call in a CMBS context. As a result, whereas [in the past] we may have been able to have a corresponding relief on mortgage debt at the same time the tenant's getting relief on the rent, we no longer have that correspondence. It's putting landlords in a major bind."
Within or without the context of bankruptcy, tenant-landlord negotiation should start with recognition of both parties' circumstances.
"From a landlord's perspective, we can look at challenged and distressed tenants [empathetically]," Hamilton said, "and understand we have to share in the pain. It's not a zero-sum game."
Tenants might enter the negotiation expecting to claim a force majeure right to have their debt performance excused, but that's not a basic right of law; it's a right that's either in the contract or not.
"If tenants are under the impression that they have some sort of cause beyond their control excuse for payment of rent, the only place they should be looking for that is in the lease itself," Hamilton said. "What they will find, for the most part, is the payment of rent is not one of the items constituting an event beyond their reasonable control. In fact, many leases, if written correctly, will include an expressed statement that the inability to pay rent in and of itself is not a force majeure event that gives rise to the excused performance."
There's a broader right being considered in some states, called frustration of purpose, that can excuse performance under the contract in much the same way as force majeure, but it's not a contractual term; it's implied by law.
"If two parties enter into a contract and each of the parties is informed about the primary purpose of the contract, and if that purpose is later nullified or substantially nullified by events beyond the control of either party, than the court may conclude the parties are excused from their performance," Hamilton said.
Courts have been reluctant to allow excused performance based on frustration of purpose claims, but some courts have shown sympathy.
"At the end of the day, if you don't have a contractual right to force majeure, it's probably unwise to hope for, or rely on, a frustration of purpose excuse to performance," Hamilton said.
That puts the onus on the two parties to think creatively at the negotiating table to find a deferral or other concession that can get both of them through the crisis.
"Work beyond the four corners of the document, and beyond what would typically be conventional thinking about how we lease space," Hamilton said. "The world is changing, and the solutions will be unique."