This issue of REcap considers how post-pandemic concerns over building environment, real estate economics, and risk allocation may impact the commercial lease agreement.
Before COVID, landlord and tenant perceptions of “standard industry practice” placed soft boundaries on commercial lease documents. While negotiating leverage always affected outcomes, opinions of what was “fair, market, or standard,” limited how far a party might push on deal points.
The pandemic may cause the parties to discard the past. Social distancing, business shutdowns, and greater awareness of infectious disease add a new dimension to the risks associated with owning and leasing property. Since a commercial lease is a risk allocation tool, the character of post-COVID lease negotiations may be very different from the past.
The Common Perspective
The pandemic created heightened sensitivity to health and safety issues in public areas and work environments. The public is divided among those who fear infection and those who feel the hazards are overblown. In theory, landlords and tenants share an interest in finding cooperative solutions that protect property values while maintaining a tenant’s business continuity. In practice, their common objectives for fiscal conservatism and risk.
The Tenant Perspective
Even with re-opening, health officials recommend masks and social distancing. Employees may demand barriers between workspaces. Tenants are now concerned about anything their employees and visitors might breathe or touch in the physical environment.
Businesses are coping with adverse economics. The disruption is choking cash flow. Cutting expenses through consolidations, layoffs, and inventory reductions is a path to survival. Fixed financial obligations likely frustrate business managers. With business closures, fewer employees and smaller shifts, long-term leases prevent companies from making immediate cuts to occupancy expense. Future regulation is uncertain. Under revised codes, office space may allow fewer workers, salons may have less chairs, and restaurants might reduce tables.
And there are liability issues. Many insurance policies don’t cover COVIDrelated losses. Employees and visitors may seek recourse against businesses if health issues develop. Entrepreneurial lawyers will invent new causes of action. Tenants will try to shift these risks to landlords under future lease agreements.
The Landlord Perspective
Landlords face possible costs from new building code standards. One small tenant may require a disproportionately expensive building upgrade that other tenants do not need. Regulations may limit the intensity with which persons can use a property. New requirements may apply for public common areas.
A decline in business earnings places downward pressure on rents. Landlords might support higher rents by implementing improvements to make their properties more valuable to tenants but, whether rents decline, or costs increase, landlords cannot insulate real estate profits from tenant profitability. In many ways, landlords are partners in their tenants’ businesses.
Landlords will face liability issues similar to those of tenants. If a lawsuit names the tenant as a first defendant, the landlord will likely be the second defendant. Landlords want to shift new risks onto tenants.
Landlords may be locked into loans that limit management’s flexibility for dealing with crisis.
Summary
Increased sensitivity to possibilities once considered improbable will have far-reaching implications for how properties are managed and financed, bringing increased tension to landlord-tenant relations. What may have been a standard lease deal in the past, is now subject to dramatic change. It’s safe to assume that parties are rational and seek to maximize profits. Therefore, the insecurity associated with social uncertainty encourages the parties to shift risks onto the other. Negotiating power and fear of the new normal will be the motivating forces that shape the post-COVID lease agreement.
These forces could bring significant change to real estate leasing, management and finance.
The following outline identifies lease concepts that may be scrutinized in a post-COVID world and offers some thoughts on how parties may evaluate alternatives.
