Lease workouts - realities, remedies and restructuring.

A multitude of tenants entered into long-term leases at market rates prior to the current recession. These tenants now find themselves in leases with rents which may be fifty percent or more above current market rates. Many of these tenants now want to receive a reduction in rent or other concessions from their landlord. Although a landlord is not legally obligated to modify an existing above-market lease, a prudent landlord will grant rent or other concessions once it is convinced that it would cost more to lose the tenant than it would to grant such concessions.

Tenant's Threats and Landlord's Remedies

Negotiations for rent reductions and other concessions usually start with the tenant's proclamation of impending doom ("if you don't, we will be forced out of business") or threat ("If you don't, we will move out and you will be left with an empty building"). The landlord's response to the tenant primarily depends upon the creditworthiness of the tenant and the guarantors of the lease, if any (when reference is made in this article to the creditworthiness of the tenant, it refers to the creditworthiness of the tenant and its guarantors) and the long-term viability of the tenant's business.

To understand why the creditworthiness of the tenant is important, it is necessary to understand that the remedies available to the landlord revolve around judgments for damages. If the tenant breaches its lease by not paying rent or by vacating the premises, the landlord generally can (i) terminate the lease, evict the tenant and obtain a monetary judgement for the damages caused by tenant's breach of the lease (e.g., lost rent, necessary renovations and tenant improvements, additional brokerage commissions, attorney's fees, etc.), or (ii) keep the lease in effect and obtain monetary judgments for rent as it becomes due. In either case, the landlord's ability to collect a judgment is directly dependent upon the creditworthiness of the tenant.

The Rich Tenant

If a creditworthy tenant threatens to breach its lease and move into less expensive premises, the landlord knows that the tenant will incur expenses and lost productivity during the move, will pay rent for its new premises and will have to pay the judgment obtained by landlord for rent and damages related to the tenant's breach of its existing above-market lease. Accordingly, a creditworthy tenant may threaten to move, but is not likely to do so because of the expenses which it will incur. The landlord, armed with this knowledge, has little motivation to grant an existing creditworthy tenant rental or other concessions.

However, not all hope is lost for a financially strong tenant who could benefit from a short-term rent reduction. A creditworthy tenant may be able to reduce current rent obligations by negotiating to extend the term of its lease, because a lease extension often saves a landlord considerable reletting expenses, and part of this savings can be passed on to the tenant. For example, if a tenant has three years remaining on its lease, the landlord knows that in three years the landlord will face the prospect of the tenant moving out of the building and leaving the landlord with vacant space to rent. In such event, the landlord will incur expenses and lost opportunity costs, including lost rental income during the time required to locate a new tenant and enter into a new lease, expenses for free rent, tenant improvement allowances, additional brokerage commissions and other market concessions (e.g., moving allowances, etc.) which must be given to a replacement tenant.

If, for example, the landlord estimates that the expenses of reletting the premises to a replacement tenant for a five year period will be $500,000, the landlord can afford to give a portion of these anticipated expenses to the existing tenant as a concession in negotiations to extend the term of the lease. Even after granting this concession, the landlord will end up in a better financial position than if it allowed the existing lease to expire and then entered into a lease with a new tenant.

To illustrate this further using the example above, if the tenant is able to negotiate an extension of its existing lease for a period of five years at fair market rent and receive the benefit of 60% of landlord's anticipated savings of $500,000, the tenant can apply the $300,000 (60% x $500,000) credit to the obligation to pay rent over all or a portion of the remaining term of the existing lease. If the landlord reduces the tenant's rent by $300,000 during the existing lease term, the landlord will still save $200,000 of the anticipated expenses which would be incurred if the tenant vacated the premises at the expiration of its existing lease. With a negotiated lease extension, the landlord and tenant can create a win-win situation which satisfies the creditworthy tenant's short term goal of reducing its rent obligations, while providing the landlord with a beneficial solution for its long-term leasing plans.

The Poor Tenant

If the landlord is dealing with a tenant who is having serious financial problems, has fallen behind in the payment of rent and does not have a reasonable prospect of surviving, then it does not make sense for the landlord to grant rent or other concessions. To do so would be throwing good money after bad. It is simply not a prudent investment of the landlord's resources. In this situation, it is generally better for the landlord to recapture the space and lease it to a new tenant. Since a judgment against the tenant would, as they say, not be worth the paper it is written on, the landlord may be better off negotiating the termination of the lease and the tenant's abandonment of the premises, even if the landlord has to waive delinquent rent. If the tenant voluntarily vacates the premises, the landlord will avoid the expenses and delays of an eviction proceeding and, worse yet, a bankruptcy proceeding.

The Struggling But Viable Tenant

If the landlord believes that the tenant is experiencing short-term financial problems, but believes in the tenant's long-term viability, the landlord may decide to grant the tenant rent or other concessions. For example, the landlord may grant rent or other concessions to a tenant who lost a large contract, but has new contracts which will replace the lost revenue within six months to a year. From the landlord's perspective, it may be better to receive some rent from a troubled, but viable, tenant than to receive no rent at all.

The form of the rent concession granted by the landlord can either be an absolute forgiveness of all or part of the rent for a specified period of time or a temporary rental reduction of all or part of the rent with a requirement for tenant to repay the abated rental amounts during the later years of the lease (landlords should be sure to consider the tax consequences, if any, as part of its cost in granting concessions). Other concessions which may be granted by the landlord include anything which would reduce the tenant's expenses or increase its revenue generating abilities, such as termination of the lease as to a portion of the premises if the tenant has excess capacity, expansion of the use clause (e.g., allowing a retail tenant to sell a broader range of goods), deferral of non-critical maintenance, and abatement of common area maintenance expenses. The landlord, with a prudent investment in the form of rent or other concessions, can help an existing tenant survive difficult times, and the landlord can thereby avoid litigation expenses, lost rent during the period required for reletting, free rent required to induce a new tenant to enter into a lease, tenant improvement costs, brokerage commissions and other expenses. When these savings are greater than the cost of rental and other concessions to the existing tenant, if may be in the landlord's best interest to grant such concessions.

In negotiating its concession package, the tenant should realize that it may be required to give as well as receive. The landlord may require concessions from the tenant as an inducement to modify the lease. The most common demands made by landlords are the requirement for a guaranty of all or part of the lease obligations and additional security. Of course, the landlord should not expect additional security in the form of a cash deposit from a tenant that is experiencing short-term cash flow problems. However, the landlord may be able to obtain additional security in the form of a letter of credit or a lien on personal or real property of the tenant.

During the course of negotiations, the tenant should expect to engage in open and frank discussions with the landlord concerning its financial condition and the prospects for the future. In this regard, the landlord should demand and the tenant should be willing to provide pertinent financial information and a sound business plan. In essence, the tenant should look to the landlord as a lender and should be willing to provide the information and documentation that would be required when obtaining a business loan.

Conclusion

Landlords and tenants are principally motivated by their own economic self interest. Although a tenant may wish to take advantage of the currently depressed market by demanding a rent reduction or other concessions, a landlord generally will only capitulate to the tenant's demand if the landlord believes that it would cost more to lose the tenant than it would to grant such concessions. As can be seen, there are situations where the parties can accommodate their disparate interests to the benefit of each.