Timothy M. Smith is a partner in the real estate and finance department of the Boston law firm of Nutter McClennen & Fish.
With the economy teetering on the edge of recession and the number of corporate bankruptcies on the rise, landowners face a heightened risk of business tenants defaulting on their leases. While the commercial real estate market has not yet felt the tremors that have rocked the residential market, there are signs of increasing commercial lease defaults, and landlords should keep a close eye on their lease portfolio to identify current problems and avoid making mistakes that may burn them in the future.
Massachusetts law is not friendly to landlords, placing strong limitations on the actions that landlords, both residential and commercial, can take to protect themselves in the event that a tenant defaults on a lease. A landlord can not start eviction proceedings until the tenant has actually violated the terms of its lease agreement beyond the expiration of any notice and cure periods. Massachusetts also does not grant landlords any “self help” rights, meaning that landlords, without invoking judicial process, can not change the locks or take other steps to impel a tenant in default to vacate its space.
Landlords are generally last in the defaulting tenant’s payment food chain, with suppliers and other vendors enjoying priority over land-lords. Most tenants have pledged all or substantially all of their assets to their line of credit lender. Thus, a landlord’s security deposit, the credit of the tenant and the strength of the terms of the lease agreement are of vital importance.
A significant security deposit is often the best way of either keeping a defaulting tenant’s attention or making up for lost rent and reletting expenses in the event a lease has to be terminated. Although bankruptcy courts have imposed upper limitations on excessive security deposits, this should not deter landlords from asking for security deposit amounts that are reflective of a landlord’s cash outlay for the particular lease, a period of lost rent and potential restoration costs. In assessing restoration costs, the “fungibility” of a tenant’s leasehold improvements should be considered. The more specific the improvements, the smaller the market of potential future tenants who can occupy the existing space without significant modification, which justifies a larger security deposit in the event of a tenant’s default. Since security deposits in the form of a letter of credit are viewed as being insulated from the reach of a defaulting tenant’s bankrupt estate, most prudent landlords will require this in negotiating a lease.
Of course, landlords also need to evaluate the credit of the tenant both at the outset of the lease and in a particular default scenario. Many tenant entities are thinly capitalized and are formed for the sole purpose of occupying the particular lease location. At the inception of the lease, the landlord should endeavor to secure the strongest corporate entity as the signatory on the lease agreement or a lease guarantee. Reviewing financial statements for both the proposed tenant entity and any guarantor is a vital part of any landlord’s due diligence and should not be overlooked. Often times, the party which ends up as the legally responsible entity under the lease does not match the entity on the financial statements. Moreover, in order to track a tenant’s (and/or guarantor’s) financial status, landlords should include in their leases, and invoke, clauses that require tenants and guarantors to submit updated financial statements.
Landlord should also inventory their leases, and include in future leases, provisions that encourage tenants to make rental payments to the landlord. Lenders will impose penalties on borrowers for late payments, and landlords should include similar fixed late charge and late interest payment provisions for late rental payments in their leases. Another key incentive is the denial to the tenant of certain rights (such as extension and expansion options) in the event that a tenant has been in monetary default during the term of its lease. Prudent land-lords will also negotiate strong but enforceable liquidated damages clause enabling the landlord to collect a fixed period of future rent from the tenant or enabling the landlord to accelerate some portion or all of the remainder of the rent under the lease. These clauses help to avoid the “chase me” scenario that delinquent but still credit-worthy tenants often employ.
Landlord should also evaluate their leases, and negotiate for, provisions that enable the landlord to take control of the space as soon as possible. As an example, some leases will provide that even if a tenant is current in its lease payments, the vacation or abandonment of the premises by the tenant is a terminable default under the lease, thereby accelerating the time period to take back the space. Leases should also provide for a short time period for a tenant to cure a payment default, failing which, the landlord can terminate the lease. These events are the typical prerequisites for the landlord to initiate a summary process eviction proceeding in a Massachusetts court. Last, but not least, the landlord should make sure that its lease provides for the recovery of attorney’s fees from a defaulting tenant.
Strengthening your lease agreements is not just a strategy for the down times. When the market rebounds and investors are looking for commercial properties to purchase, your leases become valuable assets. Certainly when it comes to office space, current and future occupancy rates, the strength of the tenant mix and the solidity of a landlord’s lease agreements will all be important factors in assessing the value of the property.
In a down real estate market, landlords may be driven to aggressively court potential occupants. However, they need to balance concern that space is occupied with the long-term protection of the space and value of asset by fortifying new lease agreements.
