Stuck Between a Lease and a Mortgage: Guidelines for Homeowners to Avoid Defaults in the Age of COVID

Even in normal times, risks abound for homeowners and tenants of real estate. But the risks have increased this year in the current COVID environment due to closures, travel restrictions, closures, work-from-home policies, supply chain disruptions, to name a few issues.

The general economic downturn that all of these issues have caused has created significant stress on the entire real estate industry. The looming second wave of COVID cases this winter now threatens to escalate these problems.

In today’s perilous environment, it is even more essential for landlords entering into rental and loan agreements to carefully consider the terms of each document against each other and coordinate the negotiation of the terms of the loan. each respective document. The aim is to avoid situations where an event of default by a tenant triggers a default under the landlord’s loan documents, but also where the landlord does not have sufficient rights under their tenancy agreement. to declare a defect and seek enforcement against the tenant. This is particularly problematic with single tenant properties since the rental income stream is entirely dependent on a single tenant. Here are some guidelines to avoid such a situation.

Default sections

Carefully review and compare the respective default sections in the leases and loan documents. Negotiate the longest possible term of cure in the loan documents and beware of lease cure periods that give the tenant an indefinite deadline. In all cases, the healing times in the loan documents must be as long or longer than the healing times in the tenants’ leases. It will be easier to incorporate all the desired provisions into the lease when the parties enter into the lease for the first time rather than attempting to add these provisions later via a rider, as lease changes, abstentions and reductions generally must be pre-approved by the lender.

Alliances

Landlords should understand the restrictive covenants in the loan documents that also apply to the tenant and ensure that these same covenants are also included in the leases with the appropriate performance rights from the landlord. Examples of commitments for which the landlord must also rely on the tenant for compliance include: (i) compliance with laws and regulations; (ii) maintenance of operating licenses and permits; (iii) not to allow any disputes or claims against the property, landlord or tenant; (iv) maintain the property in good repair and (v) not allow any liens on the property.

Outside of the circumstances

Homeowners can experience breaches of covenants on their loan documents due to matters beyond the owner’s control. Some examples include government-mandated closures, limitations on meetings and in-person transactions, and restrictions on accepting new residents to a skyscraper or senior citizen residence. These external circumstances can decrease a tenant’s ability to pay rent, or can reduce occupancy levels, and these rent and occupancy decreases can in turn result in violations of the service coverage ratio clauses. debt or occupancy level clauses under loan documents.

When negotiating loan documents, a landlord should look for express exceptions to these covenants that provide the landlord with a relaxation of the commitment requirements or an extended opportunity to remedy a breach, if it is due to a cause related to the loan. COVID. With no built-in exceptions, a homeowner who has violated these loan covenants will need to apply for a loan modification agreement or temporary waiver agreement from the lender.

Loan guarantees

If the owner’s loan documents include a borrower loan guarantee, insist on a non-recourse guarantee limited to “bad boy acts” such as fraud and embezzlement, and avoid accepting any collateral that might be triggered. by defaults on payments under the tenants’ leases.

Cessation of operations

Due to the risk of government-mandated closings, homeowners should review loan documents for any defaults triggered by an abandonment of the property (a.k.a. “extinction”) and incorporate an exception for abandonment. due to a government-mandated shutdown. . Additionally, avoid lease provisions that allow a tenant to reduce rent in the event of an accident that prevents them from occupying their premises, and make sure the definition of the accident is narrowly defined to exclude COVID. or other pandemics.

Loss of business and loss of rent insurance

Since the risks of government closings and eviction moratoriums are a constant concern, every landlord should require their major tenants to carry business interruption insurance and should carry rental loss insurance. for himself. These insurance policies generally cover operating losses and rental losses resulting from damage to the premises. However, policies do not always cover business interruptions and rental losses resulting from illnesses and pandemics like COVID, so homeowners should look for policies that expressly offer such coverage and should avoid any policies that contain exclusions for diseases and pandemics.

Construction

For properties under construction, the COVID environment has increased the risk that labor shortages, interruptions in material supply and slowdowns in the issuance of building permits and operating licenses could delay. considerably the completion of the property. It is important to incorporate sufficiently generous completion deadlines into rental and loan documents to protect against defaults due to such delays.

Responsibility of the premises

Lawsuits from employees and visitors who contract COVID while on premises are on the rise. Tenant leases must include indemnification clauses and tenant insurance requirements sufficient to protect the landlord in the event that a visitor or tenant employee contracts COVID and takes legal action naming the landlord as a defendant simply on the basis of the responsibility of the premises. Such clauses are particularly useful in single-tenant residences, senior residences and multi-family residences where the owner may not be the party who actively manages the day-to-day operations of the building, but is relying on it. rather to the tenant or to a property manager for such monitoring. .

Operating Expenses

To avoid budget deficits and their effect on the funds needed to service the landlord’s mortgage loan, tenant leases should allow the landlord to pass on the costs of any additional cleaning or structural changes to the building required by regulation for matters such as COVID, although these expenses were not expressly included in a specific annual operating expenses budget.

With due diligence devoted to the respective terms of the lease and loan documents at the document negotiation stage, and with close attention to the issues discussed above, landlords can significantly reduce the risks posed by the current COVID environment. , which, in turn, promote greater financial stability throughout the ownership of their properties.


About the Author

Thomas W. Slover is an attorney at law for Spencer Fane LLP at the company’s offices in Plano, Texas. He focuses his practice on commercial real estate, leasing, financing, corporate and partnership law.

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