The real estate industry has already been impacted by the virus and the fallout will inevitably persist well into 2020, particularly in terms of landlord-tenant transactions.
Because of the sudden and restrictive shuttering of the economy, commercial renters in all business sectors were forced to cease operations either in part or completely. This subsequently led to their inability to make timely rental payments—forcing them to turn to the force majeure clauses incorporated into the majority of commercial lease agreements.
Put simply, a force majeure clause assigns relief and risk between parties in instances such as natural disasters, conflicts, terrorist attacks, governmental actions and other events outside the control of the parties to the contract.
Although force majeure language is not currently boilerplate contractual terminology, it typically allows for time extensions or deferment of a party’s contractual obligations. In the majority of instances, however, the renter would usually be held liable per the terms of the rental agreement for monthly payments even if pandemics were explicitly mentioned in the contract’s force majeure provision—even in cases where the renter’s business were forced to close while the preventative lockdown is in effect.
Still, due to the unique circumstances of the ongoing coronavirus social distancing efforts, landlords and renters are expected to be cooperative in implementing some form of the following lease restructuring alternatives, as the virus is having a significant economic impact on all entities.
Lease Restructuring Options
Complete or Fractional Abatement
Landlords and their tenants can agree on a temporary deferral ranging from a full abatement of all charges to include maintenance and tax expenses to a fractional abatement of the standard rental payment—with the deferred amount to come due at an agreed-upon date following the resumption of normal business operations.
A temporary rent payment deferral can be negotiated so that the tenant consents to extending the preexisting loan term by the number of months in which the rental payment is waived. This method averts the negative impact on asset valuation, with the landlord retaining the number of income-generating months that had existed before the shutdown.
Renter Improvement Funds
In exchange for the tenant consenting to a lease extension, the landlord may agree to offer the tenant funds to be put towards refurbishing the interior space of the tenant’s rental unit—such as putting in new appliances, replacing fixtures or acquiring new furniture.
Credit Enhancements & Percentage Rent
The tenant and landlord could agree on a deferred rental payment combined with an updated corporate guaranty. Or, alternatively, the parties could content to an implement a percentage rent component to the renter’s contractual obligations. This would result in a quid pro quo scenario in which the landlord is cooperative in the renter’s current reduction in income, but benefits when the market recovers and the tenant experiences marked revenue increases.
If the parties are unable to agree on a lease modification, they could opt for an early termination of the lease—to include a liquidated settlement as well as the release of any guarantors or security deposits. Typically, this type of action is a last resort, though it may be the best option in scenarios where the tenant’s cash flow is unlikely to return or there is not a substantial amount of time left on the exiting rental term.
Handling Lease Security Deposits Amid COVID-19 Complications
The majority of California commercial lease agreements require an initial security deposit to either protect the landlord’s interests in the property or to cover the final rental payment at the end of the term.
In light of the ongoing coronavirus pandemic, which has resulted in a significant number of commercial tenants being unable to timely pay their rent, the issue as to how security deposits are subsequently handled in the event of missed or delayed payments is at the forefront of tenants’ and landlords’ minds alike.
However, California law places certain restrictions on both parties from resorting to utilizing these funds as a result of financial stress—and doing so may still impact the underlying lease agreement as well as have large economic implications in the COVID-19 marketplace.
Security deposits are usually made in cash or, alternatively, can be satisfied by the tenant providing a letter of credit from a bank in which the landlord is named as the beneficiary. The deposit is usually equivalent to the monthly rental payment but may additionally include projected operational expenses and annual rent increases.
Security deposits for California non-residential rental agreements fall under the purview of California Civil Code Section 1950.7—which restricts the utilization of the deposit to curing defaulted rental payments, repairing property damages, and maintaining/cleaning the property following the expiration of the rental term. The law also mandates that the landlord return any remaining amount to the tenant that have not been devoted to the aforementioned purposes within 30 days of the landlord having reacquired possession of the property. These provisions, however, can be waived by the tenant—and the majority of California commercial lease agreements incorporate these waivers that grant the landlord the power to apply security deposits to any contractual default on the party of the tenant—including missed rental payments.
Due to the COVID-19 pandemic, additional restrictions have been placed on the eviction of commercial tenants across the state. Still, these imposed eviction limits do not prevent landlords from applying security deposits if their tenants’ default on their rental payment or any other contractual obligations. Typically, after the security deposit has been applied by the landlord, the tenant is obligated to replenish it either immediately or by a certain deadline spelled out in the contract.
Landlords can be tempted to access security deposits in the event of a default where no other remedies are readily available—but they should keep in mind that taking such action typically requires them obtaining approval from the landlord’s lender per its loan contract. Additionally, tapping into a security deposit can potentially prompt a distressed tenant to enter into bankruptcy due to their perception that the landlord is uncooperative—which could lead to bigger issues for the landlord as far as the lease agreement is concerned.
In the event of a tenant’s bankruptcy, the landlord is typically barred from accessing the security deposit due to the resultant automatic stay. If the deposit was provided via a letter of credit, however, the automatic stay would usually be inapplicable, and the landlord would be able to apply the draw as permitted by the clause.
Landlords applying their tenant’s security deposits could potentially trigger a landslide of defaults that, in light of the ongoing coronavirus-ravaged economy, could prolong the subsequent recovery of the real estate industry writ-large in the post-pandemic era.