Critical Lease Provisions from a Tenant's Perspective

The U.S. Congressional Oversight Panel recently released their report regarding commercial real estate losses and the risk to financial stability. The objective of the report was to identify the scope of potential commercial real estate loan failures that are on the threshold to occur between now and 2014 and the risk that those failures will pose to the U.S. financial system and the public. As a tenant in a commercial real estate project it’s important to mitigate the potential risks associated with this issue by including protective provisions within your lease whether it may be up for renewal or initiating an origination.

Present Condition of Commercial Real Estate

The Panel recognized that the commercial real estate market is currently experiencing considerable difficulty for several reasons created by the financial crisis that commenced in late 2007 and the ensuing economic recession. 1. The economic turndown has resulted in a dramatic deterioration of commercial real estate fundamentals. Increasing vacancy rates and falling rental prices are affecting the ability of borrowers to make required loan payments. 2. Commercial values have fallen about 40 percent since the beginning of 20071 as a result of the decline in fundamentals. 3. Falling values result in higher loan-to value ratios, making it more difficult for borrowers to refinance. 4. The development of the commercial real estate bubble resulted in the origination of a significant amount of real estate loans based on unsound underwriting standards (i.e. overly aggressive cash flow projections and overly high levels of leverage).

1 Moody’s Investors Services and Massachusetts Institute of Technology Center for Real Estate

The Risk Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present “underwater”. The largest real estate loans losses are projected for 2011 and beyond. As can be seen from the following charts from Real Capital Analytics both the percentage and volume of defaulted loans are accelerating upward.

The Congressional Oversight Panel did not attempt to forecast the number of foreclosures or who may be most affected although the greatest concentration of risk lies within midsized and small banks which are proportionately more exposed than large banks with assets greater than $10 billion. For loans that do reach maturity, borrowers may face difficulty refinancing either because credit markets have tightened or because the loans do not qualify under new, stricter underwriting standards.

Mitigating Risk

As a tenant, there is possibility that the project(s) you occupy today or in the future become involved in a default scenario or at the least a distressed situation. As a result, it’s essential that the following provisions lie within your lease.

Subordination Non-Disturbance and Attornment Agreement (SDNA)

The SDNA is really three agreements in one and is an agreement between a tenant, landlord and a landlord’s lender.

The tenant agrees that his /her interests in the premises are subordinate to lender's interests.

The non-disturbance portion assures tenants that their rights to their premises will be preserved (“nondisturbed”) on specified conditions within their control, even if the landlord defaults on its loan and the lender forecloses.

The Attornment component of the SNDA agreement provides that the tenant will continue their obligations under the contract in the event that a new landlord takes over the contract.
· Landlord should be required to provide a non-disturbance agreement from its current and future lenders or ground lessors.

Operating Expense Payments

Either through your rent payment (as structured in a full service rent price typically associated with an office or retail lease) or as expenses that are passed through from the landlord directly from the vendor (as structured in a “NNN” lease typically associated with industrial properties), tenants are responsible for reimbursing the landlord for the expenses associated with property taxes, property insurance, managing, maintaining and operating the facility. Exclusions to this usually involve reserves set aside by the landlord to maintain the structural integrity of the building.

There are multiple risks to you as a tenant associated with these expenses:

a. Given these expenses are merely “passed through” in one manner or another to the tenant, the landlord may not be overly concerned with the competitive level of pricing secured through the vendors and readily accept price increases.
b. The proper accounting and reconciliation of these expenses may not be adequate on the landlord’s behalf resulting in billing errors to tenants.
c. Cash flow pressures in a given property may prompt landlords to increase fees that they control. (I.e. management and administrative fees).
The result of these risks is higher occupancy cost to you as a tenant.
· Landlord should be required to deliver an annual statement of actual operating expenses, certified as true and correct, within a reasonable period of time after the end of each year. Landlord should promptly reimburse tenant in the event of any overpayment.
· Landlord should not be entitled to invoice tenant for operating expenses after an outside date following the end of any year or the lease term.
· Tenant should have the right to audit landlord’s books and records relating to operating expenses. In the event of any errors, proper adjustments should be made and in the event of a signature error (3% or more), landlord should pay for the audit.
· There should be a cap on annual increases in operating expenses. The cap should be non-cumulative as opposed to cumulative. If required; the cap could apply only to controllable expenses but not uncontrollable expenses. Uncontrollable expenses should be limited to taxes, insurance and utilities only.

Given the previously mentioned decline in property values generally, determine if in fact the associated property taxes related to your facility have been adjusted to reflect the new lower values.
The CPI has been particularity low over the previous two years. Have the building expenses been growing at a significantly higher rate?
The most common billing error we encounter is capital expenditures erroneously passed through as expense items.

The Panel concluded, supported by current data, that commercial real estate markets will suffer difficulties for a number of years. Those difficulties will weigh most heavily on midsize and smaller banks but also large banks reliant on Commercial Mortgage Backed Securities (CMBS). They also could not predict with any assurance whether an economic recovery of sufficient strength will occur to reduce these risks before the large-scale need for commercial mortgage refinancing that is expected to begin in 2011-2013.