Working with struggling tenants is one of the many skills owners and asset managers must learn to handle effectively in order to maintain the financial stability of their real estate assets. Those phone calls or emails from tenants are dreadful, but inevitably, it is part of the business. It’s part of the life we’ve chosen as owners of real estate. This article seeks to describe the most effective and most common strategies landlords can implement to handle these situations while maintaining the financial stability of the asset.
After a tenant requests a rent reduction, it is important that the landlord become familiarized with the lease, the landlord/tenant responsibilities under the lease, the financial performance of the business, and any other factors that may come be helpful in negotiating with the tenant and coming to a solution.
Listed below are a few steps landlords should take when considering a rent reduction or rent relief request:
First Step: Lease & Tenant Analysis
Lease Review: The first thing a landlord should do is review the lease. Review all the important terms: the lease structure, landlord and tenant responsibilities, critical dates, rent escalations, the guaranty, security deposit, etc.
Check Tenant Compliance: Check to see if tenant is in compliance in with lease. Landlord should verify compliance as it relates to payment of base rent and reimbursements (payment of taxes, insurance, CAM etc.), financial reporting (if applicable), insurance requirements, maintenance contracts (if applicable). Be sure to make it clear to the tenant that any rent modification is expressly conditioned upon tenant not being in default. Use their request as leverage in your negotiations.
Review Tenant Financials: Landlords should evaluate the tenant’s financial performance. Typically, tenants cite a decline in performance as the primary reason for their rent relief request. Landlords should verify that the tenant is in fact struggling. If the tenant is not required to report financials per the lease, make the tenant aware that their request will only receive consideration if their financials are provided. Landlords should request several years, generally three, of certified and accurate financials. Landlords want to see if their revenues and profitability are in decline. You also want to calculate the rent-to-sales ratio as a measure of tenant health.
Market Analysis: Do an evaluation of the current market. Landlords should determine market rents by looking at comparable transactions. Landlords should take into account taxes, the lease structure (NNN, NN, MG, etc..) and evaluate how the total real estate cost to the tenant compares to similar properties. Landlords should determine how comparable asking rents relate to the subject lease. It’s also important to see how the business could be impacted by external forces. For example, if a median is built directly in front of a retailer which negatively impacts access, then the tenant may have a legitimate reason as to why their business is struggling.
Tenant Reviews: In the digital age, it is worthwhile to Google the tenant and consider the online reviews of the tenant (if the tenant is a retailer or service provider). If the tenant’s reviews are reflect poor operations and bad service, it is not unreasonable for the landlord to encourage the tenant to improve the product, service, or experience for their customers. The landlord should not have to pay for a tenant’s inability to operate their business effectively.
Second Step: Determine the Rent Relief Structure
The following are typical rent relief structures. Landlords may use one or a combination of several of these structures in their efforts to provide relief to struggling tenants.
Reduce Tenant Operating Expenses: To preserve the lease income yet provide relief to a struggling tenant, landlords may consider taking on additional landlord responsibilities to reduce the tenant’s share of operating expense. For example, it the lease is NNN, the landlord may restructure the lease into NN or N. Landlords may agree to pay for any combination of taxes, insurance, maintenance of roof, HVAC, parking lot, or any other tenant expenses. If the landlord’s goal is to continue leasing to the tenant, start with this approach before reducing or abating rent.
Rent Reduction: The landlord may agree to lower the rent for a specified period of time or for the remainder of the lease term.
Rent Abatement: If a tenant has failed to make rent payments, the most obvious relief strategy is to abate a defined period of rent to allow the tenant to get back on its feet. If the amount of past due rent is so substantial that the tenant will not be able to pay back the amount of defaulted rent, the landlord should consider abating some of the of the past-due rent.
Progress Payments: If tenant is not current on their rent payments, it is generally advisable to structure a defined number of progress payments, either weekly or bi-weekly, to create a roadmap for the tenant to become compliant. If an attainable plan is not created and defined, then the tenant likely will never get out of default. Additionally, landlords may consider converting the past due amount into a loan payable over time. The tenant would pay both the loan payments and the current rent to keep them from slipping further behind. This strategy would require the use of a promissory note that would be cross-defaulted with the lease.
Third Step: Clean up the Lease
Any rent relief considerations should come with landlord benefits. As the landlord, you are providing the tenant with a huge benefit. As a result of this consideration, you should get something in return. Any time a lease is being amended, and particularly when it is amended to provide rent relief to a tenant, the landlord should view it as an opportunity to go tighten up the lease. Anything that is not particularly favorable to landlord can be altered to better suit the landlord as part of the amendment. For example, a landlord may want to tighten up language relating to the repair and maintenance responsibility of the HVAC or roof. Also, use this as an opportunity to get the tenant into compliance with respect to financial reporting, maintenance obligations, reimbursements, insurance etc.
Landlords should also consider using this request as a time to negotiate lease terms for favorable to the landlord. You may consider requiring the following:
Landlord Termination Right: By offering rent relief, the landlord has the ability to terminate the lease at any time with 30 or 60 days’ notice. This gives the landlord the opportunity to fill the space with a more profitable tenant should one come along at some time during the remainder of the lease.
Right to Market for Lease or Sale: If the tenant is no longer paying market rent, the landlord may want the ability to market and show the property to prospective tenants or buyers.
Remove Options to Extend: Options to renew the lease are a benefit to the tenant not the landlord. Consider eliminating those options as part of the restructuring. Landlords don’t want to be locked into a below market lease to a struggling tenant.
Assignment/Subletting: In the event of an assignment or sublease, the rent relief should be eliminated. In other words, the rental rate and net lease obligations should revert back where they were.
Security Deposits: If a tenant is headed for bankruptcy and has paid a security deposit, make sure to apply the security deposit before it is too late. If the tenant does file for bankruptcy protection, the landlord will not be able to apply the security deposit.
These are just a few of the more common strategies landlords use to take back control of the lease. Each lease is different and in each situation the lease should be scrutinized to discover opportunities to improve the landlords position.
As landlords, we have to remember that our tenants are our livelihood. Without them and their rent payments we would have nothing. Many of these tenants have invested personally, sometimes everything they have, and professionally into these businesses and generally do everything they can to be successful; as such, we should by empathetic. At the same, however, a lease is a contract and the tenant has agreed to make the scheduled rent payments. As a landlord, it is your responsibility, to ensure that you do what is in the best interest of your company and its owners. It is tough to balance the two, however, it helps to approach these situations with the goal of seeking a win-win outcome for both parties.