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After the Gold Rush: Rethinking Leasing Issues
By Dennis L. Greenwald
The consequences of the dot-com crash and the general economic recession during the past few years have caused what can best be described as a “paradigm shift.” This shift has resulted in dramatic ramifications to the real estate industry that, although not equal in magnitude to the real estate recession of the early 1990s, have nevertheless been enormous. The first of these events was the spectacular—and spectacularly sudden—burst of the technology bubble.
Referred to by such names as the “tech wreck,” the “dot bomb,” the “dot gones,” or the “dot-com crash,” the collapse of the technology sector of the American economy affected the real estate industry with an immediacy and a directness not seen in recent history. Yet to some extent the real estate industry has itself to blame. Many landlords (just like many lenders, real estate brokers, investors, stockbrokers, and venture capitalists) lived by the infamous words of Gordon Gecko (from the movie Wall Street) in their belief that “greed is good.” What happened in the commercial leasing market mirrored the spike in technology prices in the stock market; that is, in many instances there was a feeding frenzy to throw money at the latest company whose business involved cyberspace. Just like investors, many landlords took the technology bait. They have paid for it dearly.
At first, technology tenants appeared heaven sent. In some markets (notably, of course, the ones that are presently suffering the most), each new tenant seemed willing to pay a higher rent than the one before—each tenant therefore driving rents up and setting a new platform of rent for the next tenant in the building or in the building across the street, or across town. Not only were rents skyrocketing, but landlords were delighted to discover that, unlike tenants of old who required elaborate build-outs and correspondingly substantial tenant improvement allowances, many technology tenants tended to prefer more open, less elaborate space, with fewer traditional workplace accoutrements. Indeed, “young, funky, and edgy” were the words of the day. Bandwidth, not wainscot, was what tenants wanted—and they wanted it fast. These tenants were often start-up companies, so the sooner the landlord could deliver the space, the happier everyone would be. They wanted their businesses up and running, so they didn’t have time to wait for an extensive build-out of their space. Besides, the “modified industrial look” often suited these tenants just fine. Because many technology start-ups were created and owned by young people, they intentionally did not want a workplace that looked and operated like the stuffy old offices of their mothers and fathers.
The consequences of this phenomenon were not only increased rental rates, but often the transformation of entire neighborhoods seemingly overnight. (The so-called “SOMA” area (south of Market Street) in San Francisco is an example of one area that was greatly and quickly enhanced during the technology boom.) So not only were technology tenants paying higher and higher rents, but they were also pulling the market up with them, particularly in the technology regions (or technology “corridors”). With so many new tenants vying for space and with so many paying increasingly higher rents, the market for space became tighter and rent became more expensive.
Of course, the combination of high rents and a shortage of product is not that terribly unusual for those who have been in real estate long enough to see the vicissitudes of the real estate market. But two aspects of this market made it particularly volatile. First, unlike tenants in previous real estate booms, many technology tenants were start-ups with the dangerous combination of operating in an entirely new industry and having little cash, no operating history, and a management team with little or no experience. Second, when it came to technology tenants, landlords seemed to abandon many of the fundamentals of leasing and managing real estate assets. Just like investors who were willing to purchase any “Internet” stock no matter what the business plan of the company, no matter what its duration of existence, and no matter who comprised its management team, many landlords abandoned traditional, prudent thinking.
Landlords should learn a number of lessons from both the “tech wreck” and the general economic conditions that face us now, which, because of the inevitable periodic rise and fall of real estate, will undoubtedly be of value in any market.
Spreading Your Risk
One of the most devastating mistakes many landlords made during the technology bubble was to lease a large percentage of their space to technology tenants. Perhaps it was because technology tenants were generally willing to pay the highest rents (and with a generally lower demand for a tenant improvement allowance) that landlords could not pass them by. But sound leasing practice suggests that a landlord devote only a portion of its building to the highest risk tenants. More stodgy businesses may not have been willing to match the “tech rents,” but businesses in more traditional industries would more likely still be tenants today. So while the most creditworthy tenants might generally pay the lowest rent, there is an obvious and very good reason for that: they are generally better able to survive bad economic times. What maximum percentage of a landlord’s space should be leased to tenants from a single, new industry, nobody can say for certain. But putting almost all of a landlord’s tenant eggs in one industry basket—especially a new one with no track record—is risky business.
Taking a Piece of the Action
Either in addition to rent or as a separate inducement to the landlord to enter into the lease, a number of tech tenants gave landlords stock, stock options, or warrants. Irrespective of whether such stock or rights to purchase equity in the tenant constituted “rent,” this arrangement can have a variety of adverse, if not bizarre, consequences for the landlord. For example, if the tenant is unable to pay rent, should the landlord back up his or her bet on the tenant by allowing the tenant a couple of months’ grace period in the hope that the tenant will bounce back and the landlord will be able to cash in on its equity? And if the landlord has a sufficient amount of equity in the tenant, could the tenant claim that the landlord has some good faith obligation to refrain from terminating the lease under the theory that the landlord is, in essence, a joint venture partner of the other shareholders (or of the tenant) and therefore owes some duty of good faith to the tenant? (Weaker claims of a de facto partnership have prevailed in some courts, particularly in California.) In any event, such a claim by a tenant might at least transform what would otherwise be a relatively simple eviction proceeding by the landlord into a full-blown trial, preceded by months of discovery.
The other difficulties with the landlord’s having a right to acquire an equity position in the tenant are the basic structure of the securities to be acquired and the terms and conditions of the stock acquisition. Many landlords are unsophisticated in dealing with stock options and warrants. Unfortunately, many tenants—especially the new tech start-ups—were equally in the dark about precisely what was being offered to the landlord and how to effectuate the transfer of shares lawfully. As a result, many landlords thought they were legally vested with some right to acquire shares of the tenant when, in fact, they were not. For example, it was often unclear what class of stock could be purchased, whether the value of the stock could be diluted by the tenant’s issuing more shares, when the right to purchase vested, what the purchase price was to be, or whether the shares were restricted. Indeed, this author suspects that many such preemptive stock purchase rights violated various securities laws.
Bottom line: The landlord should decide whether it wants to be a landlord, an investor, or both. If the landlord wants to be both, the lease should clearly state what the landlord gets and precisely how and when the landlord gets its equity position. Even if such share ownership is lawful, the landlord should know that it might be later subjected to some claims by the tenant that transcend the landlord–tenant relationship.
Should the Broker Feel the Pain?
If there is any segment of the real estate industry that can be said to have truly profited from the rise and fall of the technology industry, it would have to be the real estate brokerage community. In fact, one could say that the brokerage community is actually getting two bites of the technology apple: one bite for leasing so much of the dot-com space so quickly (and at such high rents) and another bite for leasing the same space again—as they are now in the process of doing.
With many of their landlord clients suffering a double dose of pain by enduring a decrease in rents along with an increase in vacancies, shouldn’t landlords consider tying at least a portion of the broker’s commission to the fate of the landlord? Even in strong, steady markets it is advisable to structure the payment of the broker’s commission in stages so that if the tenant breaches the lease during the initial part of the term, the broker’s commission is at risk. Although it would be unrealistic to expect a broker to accept a commission payment schedule that spreads commission payments over the term of the lease, it is certainly reasonable to defer a portion of the commission until some point in the future when the tenant is “seeded” and has actually paid rent for some period of time.
The problem with some tenants—and this problem was especially acute with certain tech tenants—is that they sometimes get into their premises with “no money down.” In other words, they have a rent-free period, they receive a tenant improvement allowance, and they don’t post much of a security deposit or any guaranty. The not-surprising result of this situation can be that when the free rent burns off, a struggling new tenant defaults and the landlord is left with nothing but vacant space and a bunch of invoices the landlord has already paid to its broker, lawyer, space planner, and contractor.
To spread the risk of a tenant default early in the lease, at least a portion of the commission ought to be contingent on the tenant’s surviving for some minimal period of time. In the alternative, or in addition, any commission due the same broker upon the reletting of the property should be at a rate that is less than is customary for a new lease.
Commercial landlords routinely grant new tenants a variety of monetary concessions. Tenant concessions come in a variety of forms, but the most typical include a tenant improvement allowance, a rent abatement period (during which all or part of the monthly rent is forgiven), a move-in allowance or perhaps even a furniture allowance, or the buyout by the landlord of the tenant’s existing lease of a different premises. Although the amount of such concessions is, in reality, entirely market-driven (that is, more concessions are given during periods of high vacancies, and more concessions might be given to more creditworthy tenants), the rationale for granting such concessions is that they are necessary to allow a tenant time to absorb various costs inherent in moving to new premises. In any event, the net effective rent to be paid by the tenant is what is critical in analyzing rent, and concessions should always be factored in when calculating net effective rent.
Good business practice and common sense suggest two rules landlords should follow when granting tenant concessions. The first is that not all of the concessions should be front-loaded to the first months of the lease. Concessions should be staggered (spread out) over a broader period of time. Otherwise, a tenant may have virtually no obligation to pay any improvement cost or even to pay rent for several months. This results in a particularly dangerous situation when dealing with new businesses because when the time comes for the tenant to actually write a check for its rent, it may have run out of money. By staggering the concessions (for example, instead of making the first six months rent free, staggering those six months of free rent periodically over the first three years of the lease term), the landlord will start receiving some rent early on as a buffer against the loss it might suffer from a tenant whose business fails during the first year.
The second thing a landlord should do is to include a provision in the lease that upon a default by the tenant (beyond the applicable cure period), the landlord is entitled to recoup any monetary concessions as part of its damages. In other words, the grant of concessions should be conditioned upon the tenant’s performing under the lease. (“After all,” says the landlord, “I wouldn’t have given you any concessions had I known you were going to breach the lease.”) Such a recoupment provision may be of little value against a defunct tenant, but not all tenants who breach become defunct. Moreover, if there is a viable guarantor, a concession recoupment provision may be of significant value because the guarantor would still be liable for the amount of the concessions.
Letters of Credit and Guaranties
The posting of a letter of credit by a tenant is a relatively infrequently used but nonetheless very valuable method of securing a portion of the tenant’s lease obligations. Letters of credit are infrequently employed for three basic reasons. First, weaker tenants often cannot obtain them (or those weak tenants do not want to pay the fee for the letter of credit or cannot post collateral with the issuing bank to secure their obligation to reimburse the issuing bank). Second, the most creditworthy tenants usually are not required to post them. Third, letters of credit seem to intimidate landlords, tenants, and their respective lawyers. This third reason is unfortunate because one need not be an expert in letters of credit or commercial paper to arrange for a legally enforceable letter of credit that can easily be drawn upon by a landlord following a tenant breach.
When obtaining a letter of credit, the landlord’s counsel should keep the following in mind. First, the issuer should be a reputable, local financial institution that regularly issues letters of credit. Second, the term of the letter of credit must be long enough to cover the lease term. This is sometimes problematic because some financial institutions will issue a letter of credit for only a fairly short term (a year) and the letter of credit must therefore be renewed throughout the term of the lease. Even if the letter of credit is automatically renewed, the issuer usually reserves the right to terminate it. One way to avoid this problem is to provide that if the letter of credit is not renewed (or replaced with a comparable letter of credit) within a certain number of days before its expiration, the issuer is required to give the landlord notice, the landlord can thereupon draw down on the letter of credit irrespective of whether a default exists, and the cash will then serve as a security deposit. Third, the letter of credit should provide that the only condition to payment is the landlord’s written statement that the tenant is in breach of the lease beyond the applicable grace period. It is critical that the letter of credit be clear and direct on this issue and that the tenant have no right to contest the landlord’s claim of default. Remember, what the landlord wants is the quick and easy ability to draw down on the letter of credit without the issuer’s having its lawyers analyze the demand and without any right of the tenant to challenge the validity of the landlord’s claim of a default. Fourth, because the letter of credit may be in an amount that exceeds the actual amount of any specific monetary default by the tenant, the letter of credit should provide for partial draws so that the landlord can draw down what is owed. In the alternative, the landlord might want to be able to draw the entire amount down upon any default, apply a portion to the existing default, and retain the balance as a cash security deposit.
Landlords should bear in mind, however, that the bankruptcy (or potential bankruptcy) of the tenant can significantly affect when a landlord would want to draw upon a letter of credit. Although this area of bankruptcy law is still evolving (and although this subject is beyond the scope of this article), for as long as the security is in the form of a letter of credit, it might not be subject to the limitations on recoverable damages by a landlord under the Bankruptcy Code. Once the letter of credit is converted to a cash security deposit, that security deposit may then become subject to limitations of recoverable damages under the Bankruptcy Code. Because the value of any security is an important element in any lease transaction, bankruptcy counsel may need to be consulted when taking or drawing upon a letter of credit.
Lease guaranties are also a traditional method of providing a form of security for the landlord. Although this article does not deal with the many issues pertaining to lease guaranties, two issues are germane to the current economic situation. One recent phenomenon (and again, with particular reference to new technology tenants) was the situation in which a landlord accepted a lease guaranty from an individual whose net worth was entirely or substantially tied to the value of the stock of the tenant. So when the tenant failed, the net worth of the guarantor went down with the tenant. The obvious rule that landlords so often fail to remember is that the guarantor’s financial strength needs to be independent of the financial health of the tenant.
The other lease guaranty issue to bear in mind is the inclusion in the guaranty of what is colloquially called a “bankruptcy revivor” provision. In essence, that provision provides that if a tenant’s payment is required to be disgorged by the landlord (for example, the payment is deemed to be a preferential transfer or a fraudulent conveyance under bankruptcy laws), that payment amount is “revived” as an obligation of the guarantor. It’s bad enough that the landlord might have to return a payment previously received from the tenant, but to then find that the guarantor might be exonerated with respect to that payment adds greatly to the landlord’s woes. So a bankruptcy revivor provision can only help clarify that the guaranty applies to all obligations of the tenant, even if some of them were—at one point in time—actually paid by the tenant.
Renegotiation of Leases Following Foreclosure
Part of the fallout of the real estate recession of the early 1990s was not only a massive number of foreclosures but also the renegotiation of leases following such foreclosures. Although the current economic downturn might not be as severe for the real estate industry as it was in the 1990s, the market has been soft, and whenever there is a weak market, foreclosures are often not far behind. The degree of lease renegotiations following foreclosures will depend principally upon whether or not the leases are subject to some form of subordination, nondisturbance, and attornment arrangement with the lender.
A discussion of subordination, nondisturbance, and attornment agreements is beyond the scope of this article, but suffice it to say that if such an agreement has been executed by the tenant and the lender, the lender (or the successful bidder at a foreclosure sale) basically steps into the shoes of the landlord following the foreclosure sale. When there is no nondisturbance agreement by the lender and the lease is subordinate to the loan, however, the foreclosure can wipe out the lease. Obviously, there are state-specific rules about how and when a lease is foreclosed on, but if the lease is wiped out under applicable law, then the tenant is free to negotiate a new lease or vacate the premises. In certain (if not most) jurisdictions, if the tenant remains in possession and continues to pay rent, the leasehold will probably be deemed to be a month-to-month tenancy. This result was an unpleasant surprise for many lenders that did not want to lose their tenants. In fact, many leases that were inadvertently wiped out in foreclosures during the 1990s were at rental rates well above the market prevailing at the time of the foreclosure. Consequently, we may see the same feeding frenzy by tenants’ brokers and tenants to renegotiate their leases in a soft market because many of those leases will have actually been terminated by foreclosure.
Technology’s Continuing Impact
Although the burst of the technology bubble accounts in large measure for the state of the commercial real estate economy, the flipside of technology is that it continues to affect the development, use, and leasing of real estate in significant and positive ways. Cyberspace and other forms of technology have now been around long enough for trends to emerge. But certain previously anticipated trends have not developed. It was not long ago, for example, that many real estate gurus were predicting the demise of shopping centers along with the end of certain kinds of retail establishments that they believed could not compete with Internet sales of the same product. A 1998 Time magazine cover story was about “kissing your mall goodbye” and how Internet sales were “faster, cheaper and better.” But because shopping is considered by most to be as much a form of entertainment as anything else, the customer base for retail stores has not necessarily eroded. Indeed, technology now seems directed toward enhancing in-store sales to the extent that many retailers believe their Internet sales augment—and do not detract from—in-store sales. In fact, many retailers are moving to install in-store, online kiosks that allow the customer to order from a broader range of merchandise than the retailer can maintain in stock at any particular store. In addition, some online sales provide that the item will be available at the store and the customer can pick it up at his or her leisure and, if unsatisfactory, return it on the spot. In short, retailers are discovering that technology is an opportunity to provide what is called “multichannel shopping,” whereby in-store sales, catalog sales, and online sales are blended.
It is increasingly interesting how technology will affect the entire “shopping experience.” Developers and retailers are keenly aware that, just as some sociologists saw the evolution of the shopping center into a social center with historical roots in the village green, the shopping center of past decades is now evolving into a combined shopping, entertainment, cultural, and community experience, in which everything from shopping, dining, a variety of forms of entertainment, child care, senior care, spas, museums, cultural centers, and performance venues all blend together to provide an environment for leisure time.
The real estate economy may be soft, but these times will pass. The exciting things on the horizon are how “smart shopping” (that is, technology enhanced shopping) will mix with other forms of entertainment and cultural activities to form the next generation of the village green.
Dennis L. Greenwald is a member of the Santa Monica, California, law firm of Greenwald Pauly Foster & Miller.