As a tenant in an office or industrial building, it’s important to be aware of your landlord’s financial health, especially in the wake of the recent banking near-crisiswhere many landlords of office buildings are facing financial challenges.
It’s crucial to ensure your landlord can fund the necessary improvements and commissions required in your lease and their responsibilities for ongoing maintenance to the building.
In this article, we’ll discuss why evaluating your landlord’s financial health is necessary and offer tips on how to protect your investment in that location.
The Landlord’s Situation:
Many landlords are facing a challenging financial situation with mortgages expiring in the next year or two in an environment of higher interest rates, lower demand for their space, and lower building values.
These factors will negatively impact their ability to refinance their mortgages, fund tenant improvements and commissions, and maintain their buildings. They are facing a situation where they may have to find a new lender which will likely require additional equity be contributed due to a lower building valuation or to reduce the loan-to-value ratio.
Landlords must then decide if they can afford to invest additional money. If not, they will face foreclosure or a deed in lieu of foreclosure. Either way, their decision will be to invest more money or lose all they have invested so far.
The Tenant’s Situation:
As a tenant, your first decision is whether you intend to keep an office at all. If you do, how do you plan to use it, how should it be configured, and how big should it be? Keeping an office likely means that significant improvements will be required to your current space or to a new space. New space and a longer term means someone must pay for those improvements and the commissions for your real estate advisor. As refinancing challenges force landlords to be more careful with their cash, they will likely offer less for tenant improvements and may ask tenants to pay some or all of the upfront construction costs, especially for improvements they deem to be esoteric to the tenant.
The Problem:
How can a tenant be certain that: 1) the landlord can fund the tenant improvements and commissions required in the lease, 2) make sure the landlord spends the money to maintain the building, and 3) ensure that the lease remains intact if the building is foreclosed? Lenders that foreclose on the mortgages of buildings have the right to terminate any lease they don’t like.
The Solutions:
There are several steps tenants should take to protect themselves, including:
- Require the landlord to provide financials. Landlords require tenants to provide financials (and rightfully so) to judge the relative risk of receiving future rental payments. Tenants have risk ask well and should require the same of the landlords. The tenant’s CFO or CPA should evaluate these to get comfortable that the landlord has the resources to fund its obligations.
- Ask when the mortgage expires, how much principal remains outstanding and what the current interest rate is. Knowing this information can provide insight into the landlord’s financial situation and the risks associated with signing the lease.
- Require a subordination non-disturbance and attornment agreement from the lender. This agreement ensures that the lender will recognize the lease in the event of foreclosure and not cancel it. This must be a requirement in the lease when first signed. Otherwise, the landlord has no obligation to provide such an agreement nor would it have any way to force its lender to sign it.
- Require that funds be escrowed for tenant improvements and commissions. This is done at the time the lease is signed and ensures that the funds required for tenant improvements and commissions are held by a third party (title company or attorney) and will be available when needed.
- Require offset rights in the lease. This allows the tenant to redirect rent payments to any costs the landlord owes the tenant and tenant’s advisor and possibly required maintenance the landlord isn’t performing. The goal is to have a mechanism to get the things promised in the lease without having to go through a lengthy process and possible lawsuit.
- Ensure that your corporate real estate advisor (tenant rep) has no conflicts of interest. Working with an experienced corporate real estate advisor with no conflicts of interest can help you navigate the process and ensure your lease is protected. Their interests are perfectly aligned with your interest. If you work with an advisor who works for the company that owns, leases and manages the building, it may be more difficult to negotiate.
While these recommendations can help tenants mitigate risk in these uncertain times, the reality is that you can only get these things if your lease is large enough to give you the power to demand them. A 2,000 square foot (SF) lease in a 800,000 SF building won’t have that power. A 10,000 SF tenant in a 20,000 SF building probably does.
Finally, the language for all of these issues must be carefully crafted by attorneys with extensive commercial real estate leasing experience to have any hope of being useful. Don’t come up with the language yourself and don’t ask your real estate advisor to provide it. They (we) aren’t qualified to do that.
Conclusion:
Be proactive in evaluating your landlord’s financial health and negotiate provisions in the lease to protect yourself. Consider having a forensic analysis of your lease done today, even if your lease doesn’t expire for a few years. Book a call with an experienced, unconflicted corporate real estate advisor to learn more about how to protect your business and ensure that your lease remains intact regardless of what happens to the landlord. I would appreciate your thoughts and feedback. To schedule a free consultation, please contact me here.