We’ve heard much about the financial impact COVID-19 has had on real estate. But as with the rest of life, money isn’t the only factor to consider. The legal aspects of real estate play a big role, from contract creation to lease enforcement.
The latest entry of our Real Estate Industry Update video series features Phil Kabler, an attorney and partner with Bogin, Munns & Munns. Phil spoke with James Moore partner John VanDuzer about the legal considerations facing the real estate industry during the pandemic. Up for discussion were leasing trends, force majeure, landlord/tenant relationships and more.
Weathering the Legal Storm of Rent Shortages
As we know, commercial and residential tenants alike have had trouble making rent during the pandemic. And while statutes have been in place to prevent evictions, it doesn’t change the fact that landlords have bills (and sometimes mortgages) to pay. How does a property owner deal with these factors?
Kabler emphasized the importance of retaining clients through lease contract negotiations. In normal times, there’s not much motivation to change anything after a contract is signed. But these aren’t normal times.
“There’s more of that ‘work it out’ mentality that’s needed right now, where the parties have to work together,” he said. “It plays out perhaps in loan terms, extended interest rates being adjusted. Same thing with leases; perhaps base rent can be suspended or even better… forgiven.”
Even as courts reopen and eviction moratoriums are lifted, Kabler advocates for a continued emphasis on negotiation. First, he predicts a possible bottleneck of legal proceedings. So if you do take the step to evict, the process will take longer than usual.
Second, eviction leaves a vacant space in your property. And right now, the market is full of prospective tenants with similar difficulties in paying rent. By evicting instead of negotiating, property owners could go from limited rent collection to no rent collection—risking another type of real estate crisis.
“Hopefully, creative people will get involved over time… to come up with methods structurally, working together so that we don’t end up with a wide flood of evictions and foreclosures. Because then you have a lot of REO (real estate owned) property out there.”
Kabler also suggests keeping the physical property in good shape. Temporarily forgiving rent means you’ll lose some of the money you’d have for repairs or upgrades. Maintaining your property reduces the chance of major repair expenditures during an income shortage.
Transactions in the Time of COVID-19
If you’re looking to buy or sell during the pandemic, Kabler has three words for you: proactive risk management. When asked about transactions that were pending when COVID-19 hit, he said all of them went through despite the crisis.
He credits his proactivity in using checklists and forming a good contract for avoiding problems. “When we start off with a good, well-formed, well-negotiated contract between buyer or seller with an eye towards the lender and insurance, it makes the deal flow through due diligence much smoother,” he said.
Proactive risk management includes spending a lot of time on due diligence for the structure, the land, the financial aspects, potential liability and more. This is where the checklists come in; missing one small aspect now could mean a big financial consequence later.
Kabler and VanDuzer agree that the rent roll requires a good, long look during due diligence to evaluate the likelihood that rent will be made. Sometimes a seller might “prop up” a tenant to make it seem they’re on solid financial footing. If you haven’t scrutinized the rent roll, you might not see that they’ve missed payments—a possible indicator of problems down the road.
Proactive risk management “makes it that causes a transaction to go all the way from contract to closing, particularly in a challenged environment like this one,” Kabler said. “It’s better and it’s easier to try to work through issues upfront as opposed to having to clean them up later.”
How has COVID-19 Changed Provisions and Purchase Agreements?
With both sales and commercial leases, contracts and closings are more complex due to social distancing. Inspections are a little more difficult and timing needs to be considered. And while banks and lenders are beginning to work from offices again, some closings are still happening remotely (in one case for Kabler, the backyard of a closing agent). The underwriting process is also a bit slower because lenders are scrutinizing the long-term economic standing of borrowers.
All these changes impact the contingencies included on the contract.
Kabler also said the definition of force majeure will likely be impacted by COVID-19. Traditionally known as the “act of God” provision, force majeure protects contract parties from unforeseeable circumstances. The clause historically covers extremely remote possibilities; with current events, however, that definition is up for debate.
“If I own a shopping center and an asteroid falls out of the sky and blows up the shopping center, then… until I can reconstruct the shopping center, I’m not responsible for providing an area for my tenant to lease,” said VanDuzer. “Fast forward to March, and all of a sudden, the interpretation is a little bit different when you have local governments closing down businesses.”
Kabler agrees and cites the common thread between the two wildly different scenarios. “Usually what we’re worried about with regard to force majeure (is) our changes in law, our unavailability of labor, unavailability of materials and supplies,” he said. Indeed, the pandemic has brought about the same kind of challenges you’d normally see with a natural disaster. This will affect how attorneys, lenders and other parties interpret the definition of force majeure.
With financial stress running high, there’s a lot of tension to go around. It’s why Kabler emphasizes cooperation and patience in his advice. He also wants people to understand that everyone in a real estate arrangement is affected by financial difficulties.
“COVID, from the tenant all the way to the bank and the bank’s investors has created stress and is requiring flexibility and resilience among all the parties,” he said. “People think banks are cold and heartless. They’re not. They’re businesses. Their job is to basically rent money, rent principal. The interest that they’re paid is how they pay their operating expenses and how they repay their investors as well.”
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