Toward the end of 2011 we completed a deal that helped our client, an international manufacturing company, expand its operation by 30% and extend its lease for ten years. Not a complicated transaction, right? Quite the opposite, actually. The landlord with whom we negotiated our expansion was in default of its mortgage. Foreclosure proceedings had commenced, a receiver was in control of the property and the building was falling into neglect. It might sound unwise for a tenant to sign a long term lease for and invest significant money into a building that is in financial trouble. However, these conditions can create exceptional opportunities for tenants and, if handled correctly, can result in significant economic benefits and long-term stability for the tenant’s business.
With trillions of dollars of commercial mortgage backed securities loans (“CMBS”) coming due in the next several years, many with loan balances far in excess of the underlying asset’s value, there will be more and more distress situations in the commercial real estate market.
Tenants in the market for commercial space should not necessarily avoid buildings in financial trouble. In fact, they may want to pay particular attention to them if the properties otherwise meet the company’s general operational needs. Since a single tenant can sometimes mean the difference between a total loss and a turnaround opportunity for the landlord or lender, these distress situations can often provide tenants with unique leverage and, ultimately, sweetheart deals.
A tenant considering a lease or lease renewal in a financially distressed building should proceed with caution and follow the guidelines below:
1. Start Early. Depending on the size and complexity of the requirement, tenants should give themselves at least 18-24 months prior to their existing lease expiration. Because there are often multiple interested parties including owners, lenders, special servicers and other creditors, and several layers of required approvals, these transactions can take more time than a typical deal. In the case of properties financed with CMBS loans, the loan may actually need to go into default and have a special servicer appointed before progress can be made on a loan, and therefore, lease structuring. The process is slow, so prepare for the long haul.
2. Assemble a Team with Workout Expertise. Navigating through the process of receivers, special servicers and lenders is not for the faint of heart. Be sure to assemble a team of advisors who have experience dealing with these parties, as very technical rules apply in many cases. A savvy advisor can not only identify the pitfalls and needed protections in these types of deals, but can also accelerate the process.
3. Identify who is Actually Controlling the Asset. It is critical to identify which parties actually have the authority to make a deal (landlord, receiver, special servicer, etc) and what the decision making process is for approving deals in the building. In some instances, the landlord may actually be in default of its loan or no longer has any equity in the property and, therefore, has lost the authority to agree to terms even though, to the outside world, he appears to still be in control. Even if they are not in technical default, they might not have the financial resources to perform under the lease terms and may require lender participation in the form of funds or loan restructuring to make the deal work. In these instances tenants can waste a considerable amount of time negotiating a deal with the landlord only to find out weeks or months later that the deal cannot work or will not be approved. Insist up front that the landlord (1) make representations about the status of the loan and his authority to enter into a lease transaction and (2) provide the full contact information for all of the parties in interest and any documentation that confirms the legal status of the property (i.e. “receivership order”) to ensure you are dealing with the right parties. Also understand the capital sources of the landlord and be comfortable that he either directly or indirectly controls sufficient cash to fund your lease deal.
4. Understand your Unique Leverage with the Landlord. Remember, the property is in financial distress. If the tenant occupies (or will occupy) a meaningful amount of space in the building, it will be starting the process with a great deal of leverage. The building is worth a lot more to a prospective purchaser (and lender) with the tenant’s lease in place than if the space remains vacant. Further, your lease may be the only thing that can save the landlord from losing his property or the lender from suffering a major write down of its loan.
5. Secure Meaningful Remedies to Protect Your Bargain. As most leases are nonrecourse to the landlord, and the owners of these distressed assets have little or no equity in the underlying building, it is imperative that the tenant secure assurances from the lender or other credit worthy party in interest that they will fund the transactions costs, including tenant improvement allowance, base building work, deferred maintenance obligations (if any), and any other costs of the deal should the landlord lose control of the asset before it has fully performed its lease obligations. These assurances are often handled in a Nondisturbance Agreement among the lender, tenant and landlord. The Nondisturbance Agreement should, among other things, confirm the availability of the necessary cash to fund the landlord’s obligations under the lease and commit the lender or servicer to fund these amounts should the landlord default. Tenants should also require that the controlling entity put the transaction costs in an escrow exclusively dedicated to the tenant’s deal. The tenant may also want to secure self help and related rental offset rights, should the landlord and/or lender fail to provide the agreed to concessions.
Considering a lease, or lease renewal, in a financially distressed building has certain inherent risks; however, for the opportunistic tenant, these circumstances present great economic opportunities. For those tenants whose leases are expiring over the next several years (when many of the CMBS loans originated during the boom years will be maturing), they may very well find themselves confronting these issues. With enough time, an experienced team, and a commitment to following the steps described above, tenants can secure fantastic lease deals and feel confident in their commitment to these buildings.
For more information contact Glenn Blumenfeld