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Special Report Commercial Landlord Strategies in a Tenants’ Market
WHAT EVERY LANDLORD MUST KNOW BEFORE EVICTING A TENANT
By Jeffrey H. Lerman, Esq.
This Special Report is being written in August, 2001. Approximately one year ago, commercial real estate markets were generally very strong. Rents were high and vacancy rates were low. Fast forward six months to 2nd quarter, 2001. The commercial real estate market has softened; tenants are much more pessimistic and concerned about their ability to continue paying their now above-market rent long term. The combination of these factors has resulted in four common challenges facing many commercial landlords:
- tenant threatens to stop paying rent as it becomes due;
- tenant threatens to abandon the premises before the expiration of its term under the lease;
- tenant actually fails or refuses to pay rent when it is due;
- tenant actually abandons the premises.
This report provides alternatives and strategies in negotiations and disputes for the commercial landlord in each of these circumstances.
1. WHAT IS INCLUDED IN THE TERM “RENT”?
There is no one standard form lease that is used for all commercial tenants. However, in the twenty years I have practiced law, I have seen countless different forms and most of them have one thing in common: they require the tenant to pay not only the “base” or “basic” monthly rent, but also other lease-associated expenses which are usually lumped together in the definition of “rent”. The most common of these other expenses relate to the operation of the building in which the premises are located (for example, taxes, insurance and maintenance). For purposes of this report, all lease-related economic obligations of the commercial tenant are included in the definition of “rent”.
2. FIRST RESPONSE: EVALUATE THE TENANT’S SITUATION.
Regardless of which of the above challenges confronts the commercial landlord, one thing is inevitable: you will ultimately end up in some form of negotiation with the tenant. However, each tenant is different. Each tenant’s situation is different.
You cannot approach these negotiations with a “one size fits all” mentality. You must be like a surgeon, evaluating what you are trying to accomplish and then select the instruments (or negotiating strategies) that will be most effective to achieve your desired outcome in each situation.
One constant in any negotiation, however, is the preparation you must do before you even make first contact with the tenant:
2.1 Review all lease documents to determine “effective” rent.
The rent the tenant is paying today may not be the “effective” rent. The effective rent is calculated in three steps:
STEP 1: Review all lease documents (don’t forget to include any amendments, supplements, modifying letters, etc.) to determine all base rent tenant agreed to pay over the base term (include any fixed increases; disregard any increases based on the consumer price index, and disregard any option periods), subtract from that all “free” rent, any “over-standard” tenant improvement allowance and any other economic rent concessions that diminished your total rent revenue from this tenant;
STEP 2: Divide the total from Step 1 by the total square feet occupied by the tenant;
STEP 3: Divide the result from Step 2 by the number of months in the term.
To appreciate the significance of understanding this number, consider the following hypothetical:
Assume a lease with the following lease terms:
Premises area: 1,000 square feet
Year 1 $3.00 per square foot
Free rent: 5 months
Over-standard tenant improvement allowance: $25/square foot
If your tenant problem arises, say, in Year 4, its rent under the lease is $6.00 per square foot. Now, however, let’s calculate the effective rent:
STEP 1. Add up all rent consideration and subtract free rent and over-standard tenant improvement allowance:
Base Rent-Year 1
Base Rent-Year 2
Base Rent-Year 3
Base Rent-Year 4
Base Rent-Year 5
Total Base Rent:
Total net rent:
STEP 2. Divide the total net rent by the square feet:
STEP 3. Divide that number by the number of months in the original term:
$260/60= $4.33/square foot effective rent
How do you use this information? If the tenant is complaining that it is paying above-market rent, it may be effective to walk the tenant through this exercise and demonstrate to him that his effective rent is actually much less than his current rent. Remind the tenant that it previously enjoyed the benefits of significant rent concessions you gave him.
2.2 Check the lease documents for time left on the lease term.
If there is significant time left on the base term, the landlord might be less motivated to make a deal and less flexible in its negotiations, assuming the tenant is “collectible”. That is, if the landlord is reasonably confident it would be able to collect or recover any money from a defaulting tenant, the landlord may have fewer reasons to renegotiate its agreement with the tenant.
If, on the other hand, there is less than eighteen months left on the original term, consider negotiating an extension of the term (again, if the tenant is creditworthy) as part of any compromise. Why would you want to extend the term for a tenant who is trying to renegotiate its original deal? Again, assuming the tenant is otherwise collectible (and is just complaining about paying “above-market” rent), and assuming the new rent is not below market, it may benefit the landlord (for purposes of refinancing or sale) to have tenants with longer as opposed to shorter leases.
2.3 Request updated financial information from tenant and guarantor.
Include in this request:
- Financial statements
- Last two years’ tax returns
- Address and account number for all checking, savings and deposit accounts
- Last 3 months’ statements for each deposit account
- Credit report
Ask for this information up-front, as a condition to considering any request, “as a matter of policy”. Why ask for it at this particular time? When a tenant is requesting a favor from the landlord (for example, a rent reduction), it is more likely to cooperate on providing this revealing and important information than after settlement discussions break down.
Why ask for this information at all? Several reasons:
First, if a tenant is asking for a rent reduction by pleading “poverty” or tough economic times, landlord’s request for tenant’s updated financial information to verify tenant’s claims is an absolutely legitimate and necessary request. Never take a tenant’s word that it can no longer “afford” to pay rent it previously agreed to pay under the lease.
Second, the documents and information provided by tenant and guarantor in response to such a request should be attached to any lease amendment (or at least referenced in the amendment) along with a representation and warranty by tenant and guarantor that these documents and information are “true and complete”, a statement and acknowledgment by tenant that such representation is a material inducement to landlord’s entering into the amendment, and that such reliance by landlord is reasonable. Your attorney can assist you in drafting this important language. Then, if it later turns out that any of the documents or information were materially false (either through active misstatement or through concealment of information), that representation and warranty and the related financial documents may lay the foundation for the landlord to assert a fraud claim in addition to any other rights and remedies available.
Third, landlord’s good faith inquiry may delay having to deal with the tenant’s request while it assembles all the information. In the meantime, you should require tenant to continue paying rent.
Fourth, this exercise may identify potential personal and/or real property to use as collateral to secure tenant’s obligations (past or future) or to attach in future legal action. Fifth, this information will assist landlord in evaluating the collectability of any future judgments in any future litigation.
2.4 Evaluate landlord’s situation.
You need to understand how motivated you are-or how motivated you should be-based upon current market conditions. Some questions to ask yourself include:
How certain am I that if I lose this tenant I can replace it with another tenant of equal or better credit and quality?
Where can I find that tenant?
Are there other tenants in the same building that want to move or expand?
How long will it take to replace this tenant?
How much will it cost to replace this tenant (don’t forget to include broker commissions, demolition of tenant improvements, new tenant improvements, free rent, attorneys’ fees, etc.)?
What effect will this tenant’s vacancy have on my over-all building? On other tenants?
After evaluating tenant’s situation and your own, you are almost ready to negotiate. Let’s assume you have determined you have a tenant who cannot or will not pay full rent, but whom it makes more sense to keep than terminate. Now what? You prepare to embark on what is commonly referred to as the tenant “work-out” negotiation.
3. THE TENANT “WORK-OUT” NEGOTIATION
Once you determine you are headed in this direction, you still have a little more homework before you can agree to any modification of the lease.
3.1 Additional preparation.
3.1.1 Review loan documents.
If there is any loan secured by the building in which the tenant is located, pull out all loan documents and check them for any possible language that could affect your ability to modify the lease. Examples of such language include restrictions on landlord’s ability to amend the lease, requirements to maintain a certain minimum “loan to value” ratio, and any other language which, if breached by landlord, could trigger a potentially non-curable default and, consequently, an acceleration of the loan.
3.1.2 Confidentiality Agreement.
Before engaging in any substantive discussions with your tenant, require the tenant to sign a confidentiality agreement and make on-going confidentiality an express condition precedent to the effectiveness and enforcement of any compromise as documented in any lease amendment. There are at least two important reasons for this. First, it sends an important message to the tenant that you are giving that tenant such a special deal that you do not want the other tenants to find out about it (regardless of whether or not this is true, this is an important message for the tenant to believe). Second, such an agreement may present an important deterrent to prevent the tenant from discussing any compromise with other tenants; a very important concern to avoid a “domino” effect where a settlement with one tenant opens a floodgate of requests from other tenants for similar concessions.
3.1.3 “What’s in it for me?”
Just because it is the tenant who is asking for concessions does not mean this has to be a one-way street. To the contrary, it would be a serious mistake to make any concessions to the tenant without going through the important exercise of evaluating the situation to determine what additional concessions you can extract from the tenant in exchange for anything the tenant is asking you to give up. There are several steps in this exercise.
STEP 1: Review, or have your attorney review, all drafts and final versions of all lease documents, exhibits, amendments, supplements, and modification letters to refresh your memory as to all concessions you originally gave up to make the deal in the first place. The purpose of this exercise is to determine if it makes any sense to try to take back or renegotiate any of those concessions now that tenant has essentially placed the original deal “back on the table”.
STEP 2: Call your attorney and ask if there have been any new statutes, cases or other legal developments since the lease commencement date that would make any lease modifications desirable.
STEP 3: Consider asking the tenant to extend its lease term. Why would you want to extend the term of a tenant who is trying to renegotiate the last deal? It may help you determine the tenant’s thinking about its long-range prospects of staying in business and, accordingly, the collectability of any judgment you may obtain. It may avoid having to go through another renegotiation when the current lease term would otherwise expire. And, as stated in Section 2.2, an extended lease term could assist in the future sale or refinance of the property. Moreover, even if the tenant ultimately defaults, it increases the period of time for which the landlord can collect rent.
3.2 The Negotiation.
After you have prepared yourself by following the above steps, you are finally ready to engage in negotiations with the tenant. If you feel boxed into a corner and that your only viable “strategy” is simply to respond to the tenant’s request for a rent reduction by trying to minimize the amount of the reduction, think again. You have many potential arrows in your quiver that you can use to try to hit the target of a successful, mutually acceptable compromise.
3.2.1 Defer rather than forgive.
Always explore the concept of a short, temporary, rent “vacation” rather than a permanent rent reduction. Through extensive discussions, try to really understand the cause and expected duration of your tenant’s problems. If they sound temporary, you may offer a reduced rent or complete rent abatement for a few months with an interest accrual component. This alternative also preserves your higher lease rate which maintains a higher rent roll and the ultimate value of the property for refinance and sale purposes.
3.2.2 Confession of judgment.
If the tenant is already delinquent on its rent obligations, consider asking, as part of a compromise, that the tenant enter into a “confession of judgment” for the amount of the delinquency along with an interest factor. You could agree not to enforce or seek collection of the judgment as long as the tenant fully and timely performs under the compromise amendment. This provides many important benefits. It provides a big “stick” to deter future non-performance. It also avoids the embarrassing situation where you agree to reduce a tenant’s obligations, then the tenant defaults again and, because of your compromise, you have inadvertently reduced the amount of potential damages you may now claim and collect against that tenant. And, it saves you the time, money and effort required to bring and prosecute a lawsuit for the delinquent rent.
3.2.3 Convert yourself from an unsecured creditor to a secured creditor.
If your tenant is in financial trouble (and, if it is not, why would you give it any concessions at this time??), and if you did not get some kind of collateral or security for the tenant’s obligations at the beginning of the lease, consider asking for it now. By doing so, you will transform yourself from an unsecured creditor to a secured creditor which could place you in a better position if the tenant goes bankrupt. Before accepting any security, it may be worthwhile to invest in an asset search and a UCC search to investigate the condition of the asset’s title, whether there are any senior liens and how much (if any) equity the tenant has left in the collateral.
Tough times require creativity. If your troubled tenant sells a product or service you can use, think about accepting a certain quantity of that product or service in lieu of rent. I had a client who owned a shopping center. One of his troubled tenants sold carpet. My client also owned several large apartment buildings. I suggested to my client that he accept significant quantities of carpet in trade for certain portions of the rent obligation. This was a “win-win” situation that bridged the gap and kept everybody happy.
3.2.5 Revoke concessions upon subsequent default.
It is critically important to include a provision in any compromise amendment that all new concessions given to the tenant are revoked in the event of future default. Again, as discussed in Section 3.2.2, it avoids having the tenant take advantage of you by getting you to reduce its lease obligations, then defaulting on its reduced obligations and cheating you out of damages you would have otherwise been entitled to under the original lease terms.
Regardless of which compromise you reach, DO NOT ATTEMPT TO DOCUMENT THIS IN A LETTER ON YOUR OWN. Work closely with your lawyer to negotiate and document any compromise or modification of the lease.
What happens if, notwithstanding all your good attempts, you cannot agree upon a compromise?
4. LITIGATION: THE LAST RESORT
Why do I call litigation “the last resort”? After all, I am a litigator. I do this for a living. I enjoy it. But let me tell you the dirty, dark secret that all litigators know (and one I always share with my clients): it is quite often a bad business decision. It is expensive. It usually gives a poor economic return on investment. It takes tremendous emotional and psychological toll on all involved. It is much easier to start a lawsuit then end one. That being said, litigation can be extremely effective and, in many cases, it is the only action that gets a tenant’s attention. So, when should it be considered?
4.1 When is the right time to litigate?
4.1.1 Tenant threatens to abandon or has already abandoned the premises.
If a tenant threatens to abandon or has already abandoned its premises, these developments should be taken seriously. Both situations demand immediate response and litigation may be the most appropriate action.
4.1.2 Tenant negotiating in “bad faith”.
What constitutes bad faith? This is subjective. However, typical examples include low-ball offers, long delays in responding to landlord’s communication attempts, and threats.
4.1.3 No compromise reached after 30 days.
A trap for the unwary is the tenant who takes advantage of the landlord’s good faith negotiation approach to buy time and delay the inevitable eviction and/or collection action. Don’t let this happen to you! Before you know it, 30, 60, even 90 days may pass and you’re still trying to hammer out a deal. The better approach is to tell your tenant, “My attorney says I should really get the clock ticking. So, I’m going to go ahead and file a complaint. If, in the meantime, we can reach a settlement, great. If not, we’ll just go forward with the lawsuit.” You would be amazed at how many dragged-out negotiations come to a sudden resolution a day or two before a tenant has to spend money on a lawyer to file an answer to a complaint.
4.2 Preparing to Litigate.
As with everything else, once the decision has been made to litigate, there are certain preliminary steps that every prudent landlord must take.
4.2.1 Calculate your damage claims.
You must determine how much your damages are as a result of tenant’s breach. Your attorney can assist you on this. Be as all-inclusive as possible and leave it to your lawyer to fine-tune your numbers with you. Include all delinquent rent (don’t forget to include base rent, operating expenses and any other past-due economic obligations), estimated future rent (until re-leasing or termination of this tenant’s lease), the difference between the lease rent and the market rent, any unamortized tenant improvements and broker commissions, all estimate costs of replacing this defaulting tenant with a new one (including tenant improvements, broker commissions, and free rent).
4.2.2 Litigation budget.
Ask your lawyer to prepare a litigation budget. Preparation of these budgets is necessarily an imperfect exercise due to all the unknown variables that come into play in a lawsuit, not the least of which is how the other side will respond to your attacks. However, I strongly recommend obtaining the budget if for no other reason than to try to minimize the surprises you are faced with once litigation starts.
4.2.3 Consider the “hidden costs” of litigation.
When evaluating litigation as a strategy, don’t forget to consider the “hidden cost” of the time it will consume for all the landlord’s personnel to deal with the lawsuit. For example, significant time, money and effort will be required to prepare and respond to discovery requests (interrogatories, requests for admissions, requests for production of documents), to prepare for and attend depositions, to stay involved in general with case strategy discussions and, if it gets that far, to prepare for and attend trial. These costs can add up to extremely significant amounts, even if it is simply in the form of distracting you and your staff from revenue-producing activities.
4.2.4 Anticipate tenant’s affirmative defenses and cross-claims.
As the old saying goes, “The best defense is a good offense.” Accordingly, once you “throw down the gauntlet” by filing and serving your complaint, you must anticipate that one of the first questions the tenant’s lawyer will ask his/her client will be, “Do you have any claims against the landlord?”. Typical cross-claims asserted by commercial tenants include fraud (false promises, misrepresentations, concealment), breach of quiet enjoyment, constructive eviction, breach of contract, and others. Recently, we are seeing an increasing trend for tenants to include a cause of action under Business & Professions Code Section 17200, the unfair business practices statute. This statute contains very broad language allowing tenants to sue landlords for “any unlawful, unfair or fraudulent business act or practice”. It also has a 4-year statute of limitations instead of the 3-year statute of limitations for fraud actions, thereby giving tenants an extra year to assert their claims. If you believe there is potential for any of these claims, you may want to think twice about how you approach enforcing your rights against your defaulting tenant.
4.2.5 Evaluate insurance coverage.
As part of your analysis of the tenant’s potential claims against you, review your insurance policies or call your insurance broker to determine what coverage, if any, would be available if you do become the subject of a cross-complaint.
4.2.6 Evaluate how this tenant’s situation will affect other tenants.
Do you have other tenants at this same property? If you do, you must think about the impact anything you do, or don’t do, will have on those other tenants. For example, if you sue one tenant, triggering a counter-attack by the tenant, could that result in other tenants joining in the counter-attack? Conversely, if you have a problem tenant, the other tenants may be watching closely how you deal with it. If they see inaction on your part, they may be emboldened and encouraged to take advantage of what may be perceived as a passive approach. Again, involve your attorney in this critical, technical analysis.
Let’s assume you have gone through each of these steps and litigation seems attractive. Before you give your attorney his final “marching orders”, consider finally these advantages and disadvantages of commencing a lawsuit.
4.3 Litigation advantages.
Litigation can be a tremendously effective negotiating “tactic. Among its numerous benefits, commencing a lawsuit will:
- Demonstrate the landlord’s seriousness
- Avoid prolonged compromise discussions
- Strengthen the landlord’s negotiating position
- Set in motion court-imposed deadlines to keep momentum of discussions proceeding at faster pace
- Position the landlord to seek a prejudgment writ of attachment to increase the chances that there will be assets to collect if a judgment is obtained (assuming the landlord can satisfy the necessary showing for an attachment).
4.4 Litigation disadvantages.
On the negative side, prosecuting a lawsuit
- Requires a tremendous expenditure of time, money, effort and emotions
- May side-track any compromise discussions, at least temporarily
- May irreparably damage the landlord-tenant relationship
4.5 Election of remedies. THIS IS PERHAPS THE MOST IMPORTANT SECTION OF THIS ENTIRE REPORT. YOU MUST READ THIS SECTION BEFORE DOING ANYTHING THAT MAY BE CONSTRUED AS A TERMINATION OF YOUR TENANT’S LEASE.
If a tenant breaches its lease by breach of a covenant of the lease (e.g., nonpayment of rent and/or abandonment), the landlord may bring a contract action for damages (including unpaid rent). There are two potential statutory damages remedies:
- Immediately terminate the lease for the breach and sue for past, present and future damages pursuant to California Civil Code Section 1951.2. A claim under this statute will lie when the tenant breaches the lease and abandons before the end of the term or, after the tenant’s breach, if the tenant’s right of possession is terminated by a three-day notice forfeiting the lease. OR
- If the tenant has abandoned the premises, elect to continue the lease and sue for rent owed as it comes due under the balance of the lease term pursuant to California Civil Code Section 1951.4 . . . provided the lease expressly allows such remedy and the tenant has the right to sublet or assign subject only to reasonable limitations.
In the “good old days” (last year), landlords could typically elect the first remedy without much risk. They could evict the tenant and pretty much count on finding a higher paying tenant before the ink was dry on the eviction notice. What a difference a year makes.
In today’s softer market, the knee-jerk eviction response presents another trap for the unwary: serving a tenant with a Notice to Pay Rent or Quit, cuts off the landlord’s ability to elect the second alternative remedy above; they can no longer elect to continue the lease and sue for rent as it comes due.
There are other consequences of selecting each of the alternative remedies set forth above. Some of the more significant consequences of this important decision are set forth in the table on the following page:
COMPARISON OF TERMINATING VS. CONTINUING LEASE
(CIVIL CODE § 1951.2)
(CIVIL CODE § 1951.4)
|Landlord has duty to mitigate damages||Yes||No|
|Tenant may re-take possession||No||Yes|
|Tenant may submit proposed subtenants and assignees||No|
|If tenant files bankruptcy, the lease becomes property of the bankruptcy estate||No||Yes|
|Landlord can recover all damages caused by tenant’s breach and abandonment||Yes||No, unless the lease term ends before date judgment is entered. Landlord can only recover for rent due prior to judgment. Landlord may need to file multiple actions to collect delinquent rent as it becomes due.|
What’s the lesson? If the tenant breaches or abandons the premises, and if the tenant is collectible, you should seriously consider proceeding under Section 1951.4. That is, instead of terminating the lease, continue the lease and preserve your right to continue receiving the high rents you are entitled to under the lease.
Before selecting the Section 1951.4 remedy, however, you must make sure you are entitled to take advantage of it under the requirements of Section 1951.4. This is something you should consult with your lawyer about. However, to give you some idea of what your lawyer will look for, Section 1951.4 requires:
- That this specific remedy be provided for in your lease, and;
- The lease must also include language that gives the tenant the right to assign or sublet with landlord’s reasonable consent.
Markets in transition present challenges for landlords and tenants. These challenges are most successfully dealt with first through negotiation and, if unsuccessful, litigation.
Successful negotiators are prepared, creative and flexible. Always look for the win-win. This Special Report has given commercial landlords tools to help all commercial landlords embody these characteristics.
If, however, the negotiation proves unsuccessful, this Report has guided you through the critical litigation decision-making process. If you decide to litigate, strike first, strike hard and, of course, work closely with your lawyer every step of the way.
If there is any way our Firm can be of assistance, please do not hesitate to contact Jeff Lerman directly at (866)671-5902 or e-mail: [email protected].