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Legal safeguards against problem tenants.

Due in large part to the current recession, owners and managers must deal with an increasing number of situations where a tenant defaults (or threatens to default) under its lease obligations. While all may seem lost, there are many strategies and techniques that a manager can implement to minimize the impact of problem tenants.

Avoidance techniques

First and most obviously, a manager may minimize the number of defaulting tenants by not leasing to those prospective tenants who are likely to have problems. Steps that a prudent manager can take, at nominal cost, to minimize the potential of leasing to such tenants include:

* Have the prospective tenant provide a current credit report. The credit report should be for both the tenant and the tenant's current owners. The credit report can be obtained quickly from a credit bureau at a nominal costs. Frequently, the credit report for the owners will reveal problems that do not appear for the tenant, especially if the tenant has been in business for a limited period of time.

* Obtain a Dun & Bradstreet or similar report on the prospect. If you do not subscribe to this type of service, require the prospect to provide a copy of its own report.

* Request a copy of the prospect's "track record" with its prior landlord, and then check it out. The track record should include the locations where the prospect or any affiliate leased space during the past five years, together with the name and address of each landlord, the dates of the lease terms, and the reasons that the prospect moved out.

* If the prospect is a start-up business, obtain and review the loan (and business or franchise) packages that the prospect has compiled to obtain financing (and its franchise).

* Ask your attorney for assistance in learning whether the prospect or any owner or affiliate has been sued during the past several years.

* Obtain a list of the prospect's customers, competitors, and current suppliers, and ascertain how the prospect is viewed by these business..

* Decide whether you would be better off with a weak new tenant - someone who may be difficult to deal with as well as costly and time-consuming to evict - or if instead you should continue with vacant space. Pay particular attention to the cost of preparing the space for a tenant who may not have the financial ability or business expertise to persevere in a start-up situation.

* Have competent personnel or professionals assist you in reviewing and evaluating the financial, credit, and other data that the prospect provides. Valuable data improperly analyzed is no better than no data.

Lease clauses

If the decision is to lease space to the prospect, require a security deposit and guaranty. Other lease provisions that should be considered include:

* Require the tenant to repay an amount equal to any "free rent" or other monetary considerations given to the tenant at the inception of the lease should the tenant default or terminate. In addition, if the tenant is receving free rent at the beginning of the lease, require additional security, at least for the first lease year, to provide some assurance that the tenant will not default or disappear immediately after the free-rent period.

An alternative to free rent is requiring the tenant to pay half of the rent for a period equal to twice the proposed free-rent period. While the economics to you are the same, by receiving half rent immediately and on a continuing basis you have an earlier gauge on how the tenant will perform when it is obligated to pay full rent.

* Require the tenant to repay the "unamortized" cost (including interest) of any improvements made for the tenant at the inception of the lease. If a principal of the tenant is not guaranteeing the entire lease, the principal may be willing to give a limited guaranty to cover this out-of-pocket item.

* Require the tenant to reimburse the owner for the "unamortized" cost (including interest) of any lease commissions paid at the beginning of the lease if the lease is prematurely terminated.

* Eliminate the right of the tenant to any "exclusive" if the tenant defaults and does not promptly remedy the situation.

* Have the tenant grant you a security interest in the tenant's personal property and equipment, even if the security interest is secondary to a security interest of someone else. Then be sure to "perfect" the security interest in your favor according to state laws. This legal technicality must be addressed or the security interest may be invalid.

* If state law permits, include a "confession of judgment" or "cognovit" cause whereby, at least in an eviction proceeding, the landlord unilaterally can obtain judgment against the tenant upon default, thereby minimizing the delays otherwise involved in an eviction proceeding.

* Use a "repeat default" provision stating that if the tenant defaults more than twice in a 12-month period, the manager may treat any additional default as not being curable and as not requiring any notice of default. Without this provision, rent may not be paid repeatedly until the cure period is about to lapse.

* Require the tenant to increase the security deposit, to prepay estimated expenses, or both, if there is more than one monetary default in any 12-month period, even if the default was cured.

Frequently, little or no security deposit is required because in a soft rental market the owner wants to get the space leased with minimal negotiation. However, if there is no initial security deposit and the tenant does not meet its obligations, the tenant should be required to provide security at the time of non-performance as part of the "cure" obligation.

* Include a provision cancelling all options of the tenant to extent the term of the lease, to assign the lease without the owner's consent, or to take additional space if the tenant defaults, even if the default is cured. This provision is justified on the theory that options in favor of the tenant should be available only to a tenant that fully performs its obligations on a timely basis, not to one that must be threatened with litagation to perform.

The vigilant manager

Once the lease is executed and the tenant has commenced operations, the most important tool available to the manager to avoid or minimize the problems cause by tenants is vigilance. A tenant having financial difficulties frequently will deal first with its suppliers and last with its landlord. Giving a tenant time, without receiving reasonable evidence rather than mere assurances that the tenant can and will rectify the problem, only exacerbates the potential for serious problems.

One way to be vigilant is to require the tenant to provide monthly financial reports. While not customary for a landlord, monthly reports often are required by lenders. Landlords who view themselves as lenders and their tenants as borrowers (as landlords have expended money to make the space available, to pay brokers, and to pay taxes) are more likely to identify a potential problem quickly.

If the tenant prepared a pro forma for its lender or franchisor, then comparing the periodic reports with the pro forma gives the manager an opportunity to make an informed decision as to the seriousness of a potential problem. If the tenant is a franchisee, then obtaining similar reports about the franchises (which the franchisee will frequently receive from its franchisor) helps the manager determine if the problem is specific to the tenant rather than a general business problem.

In addition to monthly financial reports, the manager should require copies of the tenant's sales tax reports and income tax filings. The lease should require the tenant to provide this information, and the manager should make sure to obtain the information and review it.

The manager should also act as a lender would in a default situation. If the tenant defaults on its monetary obligation, the manager should require the tenant to execute a demand promissory note, including a cognovit provision if permitted by state law. By obtaining a note, the manager minimizes the likelihood of the obligation being disputed and enhances his or her ability to recoup the amount.

If the tenant is unwilling to sign a promissory note, then the tenant really is sending the manager a signal of its ultimate intent regarding the default. The note should include a default interest rate, which may be the same as the default rate in the lease. Attaching a sample form of a promissory note to the lease as an exhibit can eliminate negotiations as to the form of the note when the default has occurred.

Handling defaults

Once a tenant has defaulted, what else should the manager do? A manager should make certain that he or she properly notifies the dafaulting tenant and any guarantor according to any lease notice requirements. In addition, if the tenant is the assignee of a prior tenant, then unless the original assigning tenant was released from its obligations under the lease, the manager should give the default notice concurrently to all prior assigning tenants.

The manager also should evaluate immediately which alternatives are best for the owner in the given situation. For example, in a retail situation, if the manager successfully evicts a significant tenant, the manager must ask if any other tenants have the right to terminate their leases, to suspend operations, or to reduce rent because a major tenant is no longer in operation.

If the tenant appears to be in serious financial difficulty, the manager also should review whether to terminate the lease immediately so as to avoid having to deal with a tenant bankruptcy situation. Once a tenant files for bankruptcy, an owner has few options.

In addition, the manager should evaluate the time and cost necessary to force the tenant to vacate if a replacement tenant has not been found.

In a soft rental market, some managers believe it is better to have a location occupied than vacant because it is easier to re-rent occupied space and because vacant space may have an adverse effect on other tenants in the building. However, if the tenant has the potential to remain in the space for an extended period of time in an eviction proceeding, the better decision may be to have the certainty of the available space by evicting sooner rather than later.

When dealing with a tenant who has defaulted and who cannot immediately remedy the default, the prudent owner will emulate the role of a lender in a workout situation. Typically, the first thing a lender does with a defaulting borrower is require the defaulting borrower to enter into an agreement reconfirming the borrower's obligations, waiving its rights, and admitting the default.

While a tenant "estoppel" letter may cover some of these points, a manager who requires the tenant to enter into a workout agreement will be better prepared to quickly and effectively exercise the owner's rights. As with the promissory note, a tenant that indicates that it requires time to work things out and asks the manager to be patient, but that is unwilling to sign a workout agreement is, by its refusal, giving the owner a clear message of how it will act if its promises to remedy the situation do not materialize.

Moreover, if the owner is considering giving the tenant an opportunity to cure the default over a period of time, then the manager should obtain a personal guaranty by the owners of the tenant - if not for the balance of the lease, then at least personally guaranteeing that the tenant will vacate the space if the tenant does not fulfill its obligations under the workout arrangement. It is difficult for a tenant to object to a personal guaranty to vacate on a timely basis as the tenant has little to lose by closing and vacating if it is not making enough to pay its rent.

Dealing with your lender

When a manager is trying to work things out with a tenant, whether in the context of a premature termination of the lease, a deferring of obligations, or a waiver of certain obligations, an owner must review its own obligations to its lender. In almost all cases, an owner will either have assigned its rights to deal with the lease to the lender on some basis or will have agreed not to amend, modify, or otherwise waive any rights under the lease without the consent of the lender.

From a practical standpoint, an owner should usually notify the lender of what management intends to do with the tenant and request the lender's consent to the proposed action. Assuming the manager has prepared adequately, the owner should be able to convince the lender of the reasonableness of whatever action the manager intends to take.

If the owner is unable to convince the lender of the proposed action, then the owner should learn the lender's objections and decide whether they are reasonable. The owner may run the risk of notifying the lender of a potential loan breach if it does not do what the lender desires.

The alternatives is for the owner to "intentionally" breach its various agreements with the lender by not requesting the lender's consent to the proposed action. If the lender has refused to consent and will not give reasons for its decision, the owner may be able to demonstrate in a loan default action that it was acting reasonably but that the lender was not.

In such a situation, having the opportunity to demonstrate the reasonableness of the owner's actions as contrasted with the unreasonableness of the lender often is valuable. In addition, a lender who refuses to consent without a reasonable basis for the refusal may be subjecting itself to a claim by the borrower that the lender's action (or failure to act) caused or contributed to the mortgage default.

Bankruptcy considerations

The rights, opportunities, and alternatives available to the owner when a tenant files a case under Chapter 11 of the Bankruptcy Code are controlled by Section 365. Generally, the tenant must pay post-petition rent on a timely basis in the amount required under the lease. A tenant also is required to determine whether to assume or reject the lease within 60 days after the bankruptcy filing, unless the bankruptcy court extends the time period.

If the lease is assumed through the Chapter 11 proceedings, the owner is entitled to have all prior defaults cured (or be assured of a prompt cure) and also must be assured of future performance by the tenant. If the lease is rejected, then the owner is entitled to claim in the proceeding as an unsecured creditor for the damages suffered as a result of the default.

In addition, irrespective of what the lease provides, unless the lease is for space within a shopping center, the rights of the tenant under the lease may be assigned through the Chapter 11 proceeding without the consent of the owner. Moreover, the owner will not be permitted to exercise any right to terminate or otherwise modify the lease if prior defaults are cured and the owner is adequately assured of future performance by the assignee.

A further problem can arise for the otherwise prudent owner who receives a guaranty of a lease if the tenant files in bankruptcy. Unless the guaranty is properly drafted to address the issue, payments by an insolvent tenant may be attacked as a "preference" in favor of "insider" guarantors. If the attack is successful, the owner must pay into the bankruptcy estate any payments made by the tenant for the period of the preference.

Avoiding problems

Unfortunately, no matter how much care a manager exercises, how skillfully the owner prepares a lease, and how well-advised by professionals an owner may be, nothing can completely insulate a property from problem tenants. However, by investigating and evaluating a prospect and by preparing a lease with imaginative safeguards, a manager can reduce risks and maximize his or her ability to deal with difficult situations when a problem tenant appears.

Norman W. Gutmacher is a partner with the Ohio law firm of Benesch, Friedlander, Coplan & Aronoff. Mr. Gutmacher, a member of the firms's Real Estate Practice Group, is resident in the firm's Cleveland office.
COPYRIGHT 1991 National Association of Realtors
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Gutmacher, Norman W.
Publication:Journal of Property Management
Date:Nov 1, 1991
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