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We need you to know that security is our top priority and that we hold any information we have about you under lock and key. In the wake of the coronavirus (COVID-19) pandemic that has been sweeping the country, commercialrealestate landlords are increasingly receiving notices from their tenants asking for relief from rental payments due to the ever changing protocols and mandates by federal, state and local county officials.
As COVID-19 continues to change the face of the real estate industry, it is increasingly important that both landlords and tenants understand their lease rights and obligations. Force Mature Social distancing recommendations, mandates to avoid gatherings of 10 people or more, stay-in-place orders and mandatory closures of nonessential businesses across the United States due to COVID-19 have significantly impacted the day-to-day business operations of tenants, with some opting to completely shut down their operations indefinitely.
This has led to an upsurge in notices from tenants claiming that this COVID-19 event has rendered the contractual obligation to pay rent excused. The first essential review is to determine whether there is a force majeure clause in the lease and, if so, whether it applies to the situation at hand.
Force Mature Events The most common term describing a force majeure event in commercial leases is the term “act of God.” Black’s Law Dictionary defines an act of God as “an overwhelming, unpreventable event caused exclusively by forces of nature, such as an earthquake, flood, or tornado.” In most jurisdictions, acts of God are interpreted as natural disasters; however, some courts have broadened the term to include “all natural phenomena that are exceptional, inevitable, and irresistible, the effects of which could not be prevented or avoided by the exercise of due care or foresight.” Because textual interpretation varies among jurisdictions, most commercial leases expand upon the definition of a force majeure event to cover war, acts of terrorism, government regulations, disasters, strikes and civil disorder. This is another critical factor in determining whether a landlord should honor a tenant’s request for non-performance of their obligations under the lease, as most states have issued ordinances and proclamations declaring mandatory closures of commercial buildings and businesses due to COVID-19.
Where the continuing obligation to pay rent is not explicitly stated, tenants may argue that the force majeure clause excuses their obligation to pay rent under the lease; however, there is little precedent to support this notion generally. In fact, courts have found that financial frustration in and of itself is not enough to excuse a party’s performance, even where an unforeseeable event has occurred.
It is imperative to the financial viability of landlords and tenants alike to maintain a business relationship throughout the COVID-19 event. If the lease does not excuse the rent payments during a force majeure event, landlords may consider alternative ways to provide temporary relief for their tenants, such as rent abatement and/or an extension of time for completion of performance.
The Doctrine of Impossibility and Everything In Between The absence of a force majeure clause in a lease does not mean that a tenant may not raise other arguments in support of a defense for nonperformance. In cases where leases do not expressly include a force majeure clause, the common law doctrine of impossibility may be raised to excuse contractual performance.
Similar to the force majeure clause, the common law doctrine of impossibility is a factual determination that is narrowly construed. The courts will first look to the lease for guidance for any terms or conditions that may limit the use of this doctrine, such as no abatement provisions.
Another similar common law defense to excuse contractual performance that tenants may look to raise is the concept of frustration of purpose. The Second Restatement of Contracts § 265 provides that a party may discharge its performance where “a party’s principal purpose is substantially frustrated without fault by the occurrence of an event, the non-occurrence of which was a basic assumption on which the contract was made.” Both the doctrine of impossibility and frustration of purpose rely on the foresee ability factor; that is, whether the event could have been addressed in the lease.
Similarly, the absence of a force majeure clause could be a fair argument against applying such theories to a contract since force majeure clauses are generally available for negotiation and the parties could have agreed to address the issues specifically. Although both doctrines depend on the specific terms of the lease analyzed against the associated facts presented by COVID-19, along with applicable laws, these doctrines offer another avenue that tenants may pursue in the event a force majeure clause is not expressly addressed in the lease.
This includes checking lease agreements for force majeure, default, rent abatement and notice clauses; business-interruption insurance policies; and loan documents, where applicable. There are countless creative solutions available that may benefit both the landlord and tenant during the COVID-19 event that will help preserve the business relationship and the financial stability of each.
Baker & Hosteler LLP publications are intended to inform our clients and other friends of the firm about current legal developments of general interest. They should not be construed as legal advice, and readers should not act upon the information contained in these publications without professional counsel.
According to analysis by S&P Global Ratings, the indirect impact of sharply slower economic growth and financial market volatility could be felt across all property types, as the effects of social distancing, travel restrictions, and lower oil prices deteriorate the financial health of tenants. The economic and credit implications of the coronavirus outbreak have already weakened the credit quality of real estate investment companies in Europe, according to S&P Global Ratings, as tenants' creditworthiness and capacity to pay contracted rents starts to falter.
In addition, most governments have announced measures to contain the virus and support corporate in difficulty, some of which are credit negative to landlords, such as stores and hotels. With these fast changing market conditions, staying on top of the creditworthiness of commercial property tenants will become more paramount.
Having a baseline understanding of their financial viability and overall credit risk is an important starting point. This can help drive decisions around pricing strategies, deposits requirements, and any potential enhancements/incentives over the life of a lease, plus serve as a benchmark for monitoring changes in a tenant’s ability to pay.
Credit risk analysis in the CRE sector can be challenging, however, given that many tenants are smaller and/or unrated companies. S&P Global Market Intelligence Credit Analytics provides a suite of capabilities for tenant and overall Industry/sector assessment, including three quantitative models that generate probabilities of default (PDS) and credit scores for rated, unrated, public, and private companies around the globe.
PD Model Market Signals that provides apoint-in-time view of credit risk for public companies based on a sophisticated model that captures equity market sentiment, providing signs of potential default for 71,000+ public companies. In addition, deeper analysis using fundamentals-based indicators that also incorporate early-warning metrics can confirm market-based signals and/or highlight risk factors that could lead to a default.
To complete the picture, Credit Analytics enables scenario analyses to help evaluate how tenants may be impacted by potential future financial, macroeconomic, and business factors. Users can also easily monitor companies in their lease portfolios through dashboards or custom Excel® templates, plus activate alerts to be notified about any changes to a tenant’s creditworthiness.
We looked at the median PD from PDMS for several CRE and real estate investment related sub-industries globally between April 2, 2019, and April 1, 2021 to illustrate some market trends mentioned in the introduction to this article and identify any patterns in the evolution of credit risk in these sectors. In particular, Hotel and Resort RealEst ate Investment Trusts (REIT) experienced the sharpest increase in the PD.
This represented more than a 900% increase, from 0.346% to 3.532%, between March 2, 2021 and April 1, 2021 as the restrictions on travel and tourism took their toll on these businesses. On the other end of the spectrum, the PDS for the Healthcare Rests are showing some resilience to market conditions.
This is partially due to companies having healthy balance sheets with demand for hospitals and testing facilities increasing as a result of the pandemic. Also, notable are the Office Rests that have seen a slower increase in the PD over the past month, due to the strength of their financials that have been enhanced, in many cases, with long-term leases.
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S&P Global may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obliges. “COVID-19: Implications For European RealEst ate Investment, As Tenants Begin To Suspend Rent Payments,” S&P Global Ratings, March 26, 2021.
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