With historically high vacancy and interest rates, it’s becoming a regular headline that office landlords are defaulting on their building loans. As tenants today strive to create an ideal workspace, those in distressed buildings face additional challenges. Such properties not only hinder the creation of a vibrant work environment where landlords are unable to fund construction costs, but also fall short in upkeep, leaving tenants grappling with subpar services and amenities.
Unlike a home mortgage, most commercial real estate (CRE) loans are non-recourse and do not expose the owner to personal liability. Moreover, most office buildings are owned by a special purpose entity (e.g., 123 Main Street, LLC) which isolates liability to just that property as opposed to the owner’s larger portfolio and other assets.
I point out this dynamic to help explain why office building owners are more inclined to default and frequently use a “strategic” default in negotiating with their lender. As property values have dropped and as most CRE loans are interest only and short-term (i.e., 5 –10 years), many lenders are hesitant to extend financing unless the owner contributes more equity. Many owners, however, are reluctant to throw good money after bad and would rather surrender the property to the lender.
Against this backdrop, what can tenants do to safeguard their interests?
- Underwrite your Landlord: Before entering into a lease, you need to closely scrutinize your landlord’s financials and cash flow (see our blog for more details at Tenants’ Due Diligence of Landlords: Landlord Background Check – Blackacre Advisors LLC). Just as a landlord will want to know about your business’ financial health, you have every right to make the same inquiry including into their debt service coverage ratio (DSCR). DSCR is a critical metric measuring the health of a building’s cash flow. To calculate DSCR, divide annual Net Operating Income (NOI) by Debt Service. For example, a building with $10M NOI and $8M in annual debt service would have a DSCR rating of 1.25. Lenders consider a healthy DSCR above 1.25, preferring 1.35 or higher.
- Tenant Profile: Before entering into a lease agreement, you should have a good understanding of the tenants in the building, their size, expiration dates, etc. A building that is dominated by one or two large tenants can put the building in a very vulnerable position these days.
- Lease Protections: Hopefully, you were able to negotiate certain protections in your lease. To avoid a lender from possibly negating your lease, does your lease specify that the lender will provide you with a Nondisturbance Agreement? Importantly, does this pertain to all current and future lenders? (see our blog on Nondisturbance Agreements – Plugging the Lender Loophole: Tenants need Nondisturbance Agreements – Blackacre Advisors LLC). Does your lease offer any self-help rights if the landlord defaults? While it can be a challenge to negotiate, are there a short-list of landlord defaults that would allow you to cure and off-set the amounts against your rent?
- Escrow: If you are in negotiations with your landlord, will the landlord agree to escrow funds for improvements, etc?
- Debt Monitoring: Does your broker keep you up to date on the status of the debt on the building? It’s typically of public record. For CMBS loans (see our blog What Tenants Need to Know About CMBS Loans – Blackacre Advisors LLC), as these are publicly traded instruments, alerts and debt status are readily accessible.
- Security Deposit & Letter of Credit: Does your lease make clear that any security deposits or letters of credit shall be transferred to the lender in the event of foreclosure and/or change in ownership? What is the process?
In navigating the turbulent waters of the commercial real estate market, tenants must adopt a proactive stance to safeguard their interests. By meticulously underwriting landlords, monitoring debt status, and fortifying lease protections, tenants can mitigate risks associated with landlord loan defaults.
Don Wenig
Blackacre Advisors LLC
info@blackacreadvisors.com
312-345-4778
DISCLAIMER. Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax, or architectural advice. Please consult with the appropriate professional(s).