On-Demand Webinar: Real Estate Market Update--Impact of the CARES Act and other Government Stimulus Programs (Part I)
April 01, 2020
The COVID-19 pandemic has had a dramatic and devastating impact on the economy, and making sense of the shifting impacts is crucial for navigating a path forward for the real estate industry. Our speakers discussed the industry impact, approaching negotiations with lenders, your rights and obligations under loan documents, potential lender remedies, negotiating deferments and extensions, and financial statement implications. We reviewed how to ensure cash flow from tenants, including understanding your rights under your leases, lease modifications, tenant communications, and tax implications.
- Stuart Ball, Partner, Westerman Ball Ederer Miller Zucker & Sharfstein LLP
- Eric Diamond, Partner, EisnerAmper LLP
- Robert Katz, Director, EisnerAmper LLP
- Lisa Knee, Partner, EisnerAmper LLP
- Philip Sharfstein, Partner, Westerman Ball Ederer Miller Zucker & Sharfstein LLP
- Greg Zucker, Partner, Westerman Ball Ederer Miller Zucker & Sharfstein LLP
There is help available now between this stimulus package, revised tax provisions and other government programs, the real estate business has more resources available to help them get through this tough situation. Today we will be drawing from our panelists real-world experience of working with numerous lenders, borrowers, landlords, and tenants over the past couple weeks as well as tackling negotiations. In Friday session, we'll dive into the specifics of the CARES Act, available SBA loans and deadlines deferrals you can use to your advantage. With that, let me welcome Greg Zucker to discuss more about the industry outlook.Greg Zucker:Thank you Lisa. My name is Greg Zucker. I'm a partner at Westerman Ball and on behalf my partners, I want to thank EisnerAmper and its real estate services group and its marketing arm for putting this together and allowing us to participate. We hope everyone that's listening is safe and healthy. Today is April 1st, April Fool's Day and if you watch Bloomberg this morning, 81 billion dollars of rent is due today. If you're a betting person, I'm sure you'd bet that the lion's share of that money is not going to be paid today, but what do you do? There's no playbook here. There's no script. Many businesses are in survival mode.
That's the honest truth and when just when this occurs, you need to be able to make game time decisions that strike the balance of reassuring your troops, your labor force that you're there for them, at the same time getting across the goal line which today means survival. It reminds me the famous story of Joe Montana, the legendary quarterback for the 49ers. He had this reputation for being cool, calm, and collected in the most difficult of circumstances. Legend has in the Superbowl 23, the 49ers were trailing 16-13 were 3:20 left in the game. They had the ball in their own eight yard line and they had to go the whole field. Montana went to the huddle and he saw the look on everyone's face.
They were nervous, they were concerned, they were looking for guidance, they were looking for dealership. He knew that he had to provide that leadership and he knew he had to calm them down, so he could focus on the task at hand which was to get him across the goal line. He didn't know what to do, so then he came up with an idea and he pointed to the stands and he saw John Candy there. He said, "Hey guys, isn't that John Candy, the comedian love? I that guy. He's so funny," and his teammates looked at him. They were perplexed, they were surprised, but they calmed down, they smiled, they relaxed. They concentrated on the job. They marched down the field and they won.
It's now time for you to be that general, to be the leader, to be the quarterback and people at my firm, Westerman Ball and EisnerAmper, professionals, we try to be the wartime lawyer and the wartime professional, the wartime accountant. As Lisa said, the practical matter is that real estate owners are caught in the middle. They're caught in the sandwich. On the one hand, they have debt service obligations of the lenders and at the same time, their tenants may not be in a position to pay. You need to focus on what we think three things to get your team across the field and into the goal line. First, know what's happening in the industry. Lenders are making deals.
We've been on the front lines non-stop for the last couple weeks making calls. They're expecting your call. The call don't wait. Ask for the ability to defer your payments, your mortgage payments for a few months, ask to extend your loan. Don't take no for an answer and be armed with what's happening with your tenants and their ability to pay. Have these bullet points ready. In a few moments my partner, Philip Sharfstein will walk you through the process of going through the loan modification process, but what's important is you have to be proactive. There's some nuances which we'll explain more on Friday when we go to the SBA loan process. For example, there's a period of time known as the covered period.
It's a 2-month period and if you spend on certain items during that covered period, it gets forgiven. One such item is mortgage interest. Strategically, if you got your loan on May 1st, you wouldn't want to pay principal interest on your mortgage for April, but starting May 1st and in June, you wouldn't want to pay mortgage interest because it goes towards the forgiven category. We're telling everybody that cash flow is king. Cash is king. It's very important that you hoard as much cash as possible right now. You want your tenants paying everything they constantly can right now.
In a few moments my partner, Stu Ball who's the head of our leasing department will go through knowing your lease, knowing your rights and your remedies under your leases because you want to be armed. The battle is won before it is fought. You want to know what your rights and remedies are before you have these difficult conversations, and the factual circumstances matter. For example, if you have a large tenant, a national chain that sends you a canned letter that basically says we're automatically not going to pay for the next few months, push back especially if you had adequate security such security deposits, letters of credit, guarantees from credit worthy tenants.
If you're in that position, push back. If it's a smaller tenant, know the facts and circumstances. Look, we know they're struggling, but you also have constraints and obligations including to your lender. We're human so we have to be practical and we also have to walk the fine line of making sure that your tenants have enough money to survive, but that you get the money that you need to survive as well. There's things that we're going to be talking about on Friday where we could educate you and you could deflect, but here's an example. Under the SBA loan process, under the CARES Act, one of the other items of forgiveness is paying rent.
Essentially you could have a conversation with your tenant if it's a small business and educate them and say, "Under the SBA loan process, if you apply, you'll get a loan. A certain amount will be forgiven and essentially if that occurs, the government's paying your rent, not you," and that's a good way to deflect things. The third thing is contact your SBA lenders now. If you're eligible for this loan which we'll go through on Friday, you must go for it. Get ready, get the documents that you need. On Friday, we're going to be going through a host of items such as the eligibility. There's a lot of rules that people are concerned about regarding affiliation and for example, if you have a management company and an SPE, do you qualify?
We'll go through the regs 13 CFR 121, 103 and the like, and explain those issues for you. We'll discuss how you maximize the amount of the loan and how you maximize the amounts of forgiveness. Now I hope you appreciate that when we go through this, we're going to be giving you a legal and accounting perspective, but we're also going to be practical. We're going to talk about what's happening on the frontlines and what you could do to help yourself. The folks at EisnerAmper have been terrific. The real estate services group is going to be talking about tax and accounting issues both as they relate to the loan modification process, the lease negotiation process and of course the CARES Act.
For example today, they'll be discussing among other things, the financial statement implications of the coronavirus, how that impacts your business, are you still within your loan covenants, things of that nature. In addition when we go through the leasing portion, they'll talk about renovate myths and concessions, and how that will impact the straight-line rent calculation for tax purposes. Without further ado, I'd like to turn this program over to my partner, Philip Sharfstein who's the co-head of our real estate group. Phi's an excellent lawyer. He's got a great background in lending and real estate. Phil.
Philip Sharfstein:Thank you Greg. Hello everyone. I'm Philip Sharfstein, co-chair of Westerman Ball's real estate practice. Today I will discuss commercial loan mortgage issues relating to loss of revenue. I will cover loan covenants and defaults, guarantees, negotiating with your lender and legislation. Before approaching your lender, you need to know your rights and obligations. Your loan documents contain various covenants and defaults many of which are financial in nature. They may include debt service coverage ratio, the ratio of net operating income to debt service payments, and debt yield covenants net operating income divided by the loan amount.
These covenants may decrease by lost income from the property. Your loan may have an ongoing loan to value ratio, the percentage of the amount of the loan over the value of the property. Again, lost revenue may decrease values of property tripping that covenant. Certain loans provide for a breach covenant if a key tenant goes dark, even if you're getting rent. That's frequent in projects with one or more major tenants, and then there are deposit requirements. Some lenders particularly banks want deposit relationships and have minimum deposit requirements. Others have automatic debit features which are fed by lockbox payments, tenants paying directly into the fund to cover debt service coverage.
Automatically on the day of payment, if that income isn't in the account, you will have triggered a day before. Then there maybe pledge requirements, additional collateral frequently in lines of credits and institutional loans. You may have pledged stock and that staff may have a requirement of a certain value. With markets being where they are, that covenant maybe breached and you need to know that. Then there are loans that don't have any of the foregoing, but have what's known as a material adverse change provision. If you have a material adverse change which cannot be affected by lost income or will be affected by lost income, that in itself creates a covenant breach which you need to know about.
Your SPE covenant, single purpose entity, most loans have them and you need to know what they say. Why is that? Because it's not just about separateness of entities which is what it's designed for, but there's also a capitalization requirement. Meaning that the entity has to be properly kept properly capitalized to pay its expenses. We negotiate for those to be limited to the extent of cash flow, but you need to know what your document says and if in fact, it's not limited to cash flow, not only may that be a breach at this level, it maybe covered by a guarantee which we'll get to in a moment. Stabilization requirement, many loans have deadlines by which a property needs to be stabilized.
Most frequently, that's construction lending environment or it's a situation for a major rehab where the time alone, the income wasn't in place. You need to understand the date by which you need to be stabilized and hopefully your documents have exceptions for force majeure which in this case, since it's not a payment obligation, hopefully the force majeure provision will cover and extend the date, but you certainly need to understand that. Then some loans are course defaulted. Your loan is fine. You're lucky you have a supermarket free standing tenant and they're paying rent. They're doing better than ever, but lo and behold, you look at your documents and it's course defaulted with another property that has a breached covenant.
Now you have a performing loan, a good property, but you had a loan that's in default. Work completion dates. Similar to stabilization, you close a loan that has worked. It may not be a construction loan. It could be just some element of work. Common is removing violations, could be minor, but yet you have a completion date and you have a date by which that needs to occur. Again hopefully, you have a force majeure provision that covers this, but in the event you don't, you need to understand what your rights are and whether you've tripped the covenant and it's a default. The last covenant I want to raise is an obligation to notify your lender.
Believe it or not, many loan documents have provisions, many lenders and we see it more in recent transactions, last few years is there's an affirmative obligation to reach out and notify your lender and tell them that you have a breached covenant or a default, so you need to understand. It's always interesting to me because once you're in default, you maybe in default for failing to say you're in default, but it's a little circular, but that's a little commentary by expecting it's a little humorous, but you need to understand that. When we represent clients in lending transactions, we see that the best time to address these covenants are in the term sheet stage.
They encourage our clients to speak with us early on and work these things through at a business level. They are business decisions. They are less legal, but we work with our clients in coaching them through and creating limitations, exceptions, and enhancements, and what do I mean by enhancements? We try to negotiate for what I refer to as credit enhancements which may provide for deposits of cash, postings of letter of credit or other collateral to cover income deficiency. That would cover things such as your debt service coverage ratio and debt yield covenants that maybe breached and certain other covenants. We also negotiate for the right to pay your loan down without a prepayment penalty to cause your loans to come into compliance with financial covenants.
Hopefully, your loans have that. We have had a lot of success with negotiating for these credit enhancements, and you need to see what your documents say. What happens if your covenants are breached? They don't all necessarily rise to an event of the fall providing for the lender with rights of loan acceleration, for interest, foreclosure, et cetera, but there were other remedies that certain covenants may trigger. The most common would be a cash sweep event. I gave an example of a cross defaulted loan. This loan is performing fine, has adequate cash, but you have a cross default. Maybe you were lucky enough to have negotiated that if a covenant default is breached that a lender simply sweeps the cash.
Meaning that the cash collected is retained by the lender in a cash collateral account, use the payment of debt service and property expenses, but any remainder has to stay with the lender and not distributed to the principals of the borrower. Then there are offset rights. I mentioned earlier that certain loans have deposit requirements, have additional collateral, whether it's cash, stock, et cetera and your lender if it does declare an event of default has the right to offset the amount held in its institution against the obligations that are then due. You need to understand what those deposit requirements are.
In the bank's situation that I alluded to earlier where banks simply want deposits, it is common that they have requirement for the borrower to maintain a certain amount in an account at their institution. Frequently however, there is not a default if that amount is not maintained, but an increase in the interest rate, but why is that important? Well, if you have property under water and you have a non-recourse loan, you have a decision to make. Your decision is to keep this property afloat or to let it go down. If your decision is to let it go down, we'll get your money out of that institution if the only remedy is an increase in the interest rate. Again, you need to understand your rights under your loan documents prior to speaking with your lender.
Next, we'll move to guarantees. Some of these obligations under loans are guaranteed. We all know that there's no such thing as zero anymore with recourse card outs and environmental being the minimum. Some loans having more. Well, if you have a full payment and performance guarantee, you're more limited in what your options are, and I think everyone understands that such a guarantee provides for the unlimited obligations under the loan documents to be guaranteed. More commonly, in income producing property, you have non-recourse loans which has what we refer to as a recourse carve-out guarantees. What is covered?
These traditionally or when they began, they started at the bad boy evidence, don't collect money and not pay me and put it in your pocket and think that I can't come after you for that. That was the genesis. Over time, that is evolved. These guarantees are much more widespread than they once were and they continue to grow, and so what's there? Does your guarantee provide that if an SPE covenant is breached, that's a recourse event? I alluded earlier to the fact that the SPE covenants require that the entity be capitalized. Well, if your covenant is not limited to the cash flow from your property and your SPE covenant is guaranteed which most are, then you're personally liable for payment of an amount to keep the property going, debt service and operating expenses.
I hope your documents don't have that. Of course, we're very careful when we negotiate to make sure they're not. In addition to SPE covenants, we course carve out guarantees may include among other things, payment of taxes, insurance, mechanic's liens, and other matters that are similar to the monetary obligations. Again, the key is to see whether you have the appropriate limitation such that your guarantees are limited to the cash flow of the property. Next, we'll move to carry guarantees. More common in turnaround type properties, properties that have a program to get them to stabilization which I mentioned earlier.
Carry guarantees are personal guarantees that the guarantor is responsible to pay debt service, somewhat debt service only. Others include real estate tax and insurance and operating expenses. You need to understand A, if you have it and B, what is the trigger to get off of that guarantee. Some of them if it's a turnaround property, stabilization will get you off. Others if it's a construction loan, it maybe completion of construction. Sometimes its completion of construction plus stabilization, but what do you do if you're stuck? Who does stuck mean? Stuck means you have a defaulted loan and you have a carry guarantee, and you don't have an exit.
Well, that's a problem so we negotiate for exits and what we negotiate for is the right to tender a deed in lieu of foreclosure to a lender. Lenders don't have to accept it. Some lenders don't want to accept it. It's a lenders choice and there are conditions and those conditions get negotiated, but it's important to have an exit if you have such guarantees. Hopefully, you have an exit for tender of a deed in lieu and you should make sure you understand what those provisions are. Your guarantees also have financial covenants or frequently may have financial covenants. They are net worth and liquidity. Well, they need to be looked at.
Post people's net worth and liquidity has been affected by recent changes in the markets, and you need to understand are you in breach of your covenants and if you are, how will you address them. May not be able to address them if you don't have the assets to address them, but you may need to address them in negotiating with your lender firm. Our firm has been looking at documents on behalf of our clients, people that are coming to us with loans that they've closed with other people, and we've been very active in reviewing these documents and discussing with people what their rights and obligations are and what covenants maybe breached. Then we go into the next step which is negotiating with the lender.
First, we need the knowledge, we need to understand our property, our obligations, and our rights, and now we speak with the lender. As Greg stated earlier, Gregg and I have been speaking with clients, with the lenders. Sometimes we're speaking to the lenses without our clients. Sometimes our clients in reaching out to the lenders first, but in any event, we've been proactive with our clients and reaching out to lenders. The lenders are receptive. They are not surprised, they are expecting it when we started because we were early in the game. We were relatively early and we broke some ice, but it was something that they expected and they are receptive.
Certain lenders will not speak in depth with you until they enter into a pre-negotiation agreement. A pre-negotiation agreement is lender's attempt to avoid a litigation by a borrower making a claim that discussions had during the negotiation process will bind the lender and therefore, the loan was already modified and modified in a way that ultimately didn't result in a final agreement. The pre-negotiation agreements contain waivers, many of which are appropriate waivers such as the deal is not final until its final and at the appropriate waiver. Some other waivers are appropriate, but as in most cases with lender loan documents they can be aggressive and they can be overbearing.
You need to watch what you're being asked to waive. You should consult with your professionals. You should have it looked at. We've looked at several of them already. They're common. The bigger the lender, the bigger the institution, the bigger the document and more they're going to ask you to wave. They may ask you to admit defaults. In some cases, it may be appropriate. In others, it may not, but understand what you're being asked to wave, and then be ready for lenders to ask for information. Lenders want to understand your problem. They need to understand there will be if you're asking for and to do that, they're going to ask you for rent roles. They may ask you for cash flow projections.
We have seen lenders ask to get copies of notices received by tenant and/or be informed what we were of our clients were verbally advised by tenants regarding the request to defer rent. The lenders are agreeing from what we've seen today to defer debt service payments. Some lenders have stated that they want the April 1st payment made. Well, why is that? Well, debt service payments are payments in arrears April 1's payment covers the month of March. Rent payments are made in advance, so you match the income to the expense and in a lender's mind, a borrower has money to pay April 1st debt service because they collected March 1st rent. Well, the reality is that's not how most borrowers operate.
Their real estate, they matched. Years ago when they put the mortgage in place, the money went into their pockets, they distribute it at the members and April 1 rent is the money being used for the April 1 debt service. It's a negotiation. We've seen it go both ways at this time, but Greg stated it earlier well is you have to stay strong with your position. If you don't have the money, if any of you doesn't have the money, if you made a proper distribution years ago with the first month's rent, you did nothing wrong. You have to stand your ground and do your best. Then lenders are understanding what the stimulus bill is provided, that there is relief interest as stated.
There will be relief for tenants to get rent. It won't be for April 1 rent, but it will be in the future and that leads to a lender's request for cash sweep. We talked about cash sweep in the context of a default earlier. Now we're talking about a cash sweep in the context of a loan deferral, and all that means is they want reporting. They want to know what you're receiving on a monthly basis. They want to see that the expenses of the property real estate tax and insurance are being paid, and they want to know that a borrower who's asking for a deferral is not putting money into their pocket. If there's excess cash after paying your operating expenses, they want to sweep that money and apply it to any deferred payments that were made.
Some lenders are extending maturity dates. How do you pay back deferred debt service payments? Well, they can be added to the balloon payment or the final payment of the loan if there is a balloon payment or the loan term to be extended, so a 3-month deferral, 3-month maturity extension. Again, it's a mix and match of what may go into the modification and that may include modification of covenants. I started with talking about the loan covenant that maybe tripped, completion date, stabilization dates, ratios, et cetera, and in negotiating for your modification, you should be negotiating to address any covenants that are breached. That's the negotiating process.
The last topic for me to hit on is a very brief topic which is legislation and at the moment, there is no legislation in effect for governmental relief for commercial mortgage loans. There maybe, there's a lot of talk about certain proposals as it relates to commercial mortgages, as it relates to commercial wrench, but to date, nothing exists. Stay tuned and if something happens, we'll get the word out to you. That's conclusion of my portion of the presentation. Everyone stay healthy. Hope your families are well and if you have any questions regarding these topics or any other matters, please send an email and I will promptly respond. With that said, I would like to introduce Eric Diamond who's going to discuss financial statement implication as it relates to debt.
Eric Diamond:Thank you Phil. This is Eric Diamond, partner from EisnerAmper. Phil just discussed debt covenants and loan modifications more from a legal and contractual perspective. I'm going to take a few minutes to discuss these from a financial statement and disclosure implication. Many companies may have annual or quarterly covenant compliance requirements and although they may have been in compliance for calendar year 2019 and possibly even first quarter 2020, companies should still be projecting out their covenant calculation for future periods. If there's any expectation or possibility of not being in compliance, companies should start having those discussions with lenders.
As Greg and Phil mentioned earlier, they started having those discussions immediately, and this is to determine any remediation which could be issuing waivers or amending or modifying the loan agreements. Some companies have been fortunate enough to already have completed and finalized their 2019 year-end financials. Others may be in the middle of that process and maybe even in the middle of their financial statement audits if they're required, which they're trying to complete by the end of this month.
Keep in mind that although the company may have been in compliance with financial covenants at year-end for 2019, if they're not in compliance or anticipate not being in compliance for any subsequent period in 2020 prior to finalizing and issuing the financial statements, there are certain disclosures in the footnotes for the financial statements that may be required. In addition, companies may need to also consider obtaining waivers for those future periods as well. I think Phil made a great point that as you're in those discussions with the lender and you're working up those waivers for having the attorney and the accountants review those drafts because it's very important for the company to understand what the lender is actually waiving.
Now in order to accommodate the borrowers, lenders may have to modify some of the terms of the loan agreements, granting concessions, reducing the interest rates, deferring payment. These modifications to the terms of the loan agreements may result in changes to the accounting that may include debt modification, debt extinguishment or troubled debt restructure, and this determination will impact how companies account for and record existing financing costs that were previously capitalized as well as how new financing costs are accounted for. I definitely recommend considering these financial statement implications early on in the process and having those discussions with your lenders and accountants.
I would like to now introduce Robert Katz who's going to further discuss lending considerations. Robert.
Robert Katz:Thank you Eric appreciate that. I hope everybody is staying very, very healthy. I will start about managing your lending relationship and my background and as much as its real estate, I deal with companies in restructuring the handled transitions when things aren't generally going well. Something that Phil stated is almost 100% going to apply for these in the next three months, and that is in just about every single loan agreement, there's something called a material adverse clause which general speaking if you've never had it, it means if there is a significant change in your normalized business, you're in default. By again having a month two or three with adjusted lower rents coming in in most cases, that would trigger that particular clause.
Five pointers and there is an article where you can go to the full article, but number one and I realize it's very hard in today's times, but try not to panic because you're not alone, right? Just about everybody is going through this, whether you're a lender or the tenant and as others have said, and this is more specifically, communicate early and often. It would be good if you haven't reached out to your lender now to reach out to them, so that you can touch base with them. In most cases, I have found that lenders have reached out the clients to get a feel for what's going on and in some cases, if you haven't heard, that could be good and bad.
It could be good because they have much bigger fish to fry and you're not on the radar, but you want to let them know what's going on being proactive, rather than reactive. The number three on slide 11 is when you're making an ask, know what you're asking for, right? When I was a much younger consultant and I am now, a lender said, "Always remember these five things. Let them know to your best ability and again everybody knows it's changing so it's subject for an update, but make sure how much do you need, how long will you need it, when will you pay it back, what if any additional collateral is available to shore things up, and are you willing to provide an equity infusion, and i.e., do you have money to put in?"
Again, those questions are going to be asked. What you say is certainly up to your strategy, but just be prepared to address those questions. Number four, at this point, don't be afraid or embarrassed to ask, and can you just drop back for a moment? Thank you. Don't be afraid or embarrassed to ask for anything and again, being proactive is much better than being reactive. As we go to slide 12, these are some of the things that again when I say looking inside the bank or the lender, again from the borrower standpoint as well as the lender, right? This is about a particular client where it went sideways very, very quickly and through communication in the plan, there was a substantial turnaround.
We gave the bank a plan. We had monthly meetings to make sure we were on track and again in today's world, and this is very important, right? Over the next 60, 90 days and hopefully not longer, lenders are generally not looking for new customers because they don't know anything about the new people. Their best borrower and their best chance could make additional loans right now to get outstandings are to their current customers that are good. They've had good long-term relationships with and even though you may have hit a bump, they know you, you're well-capitalized and it's another opportunity to shore up the position.
Then number four, again think of it that way, right? Sometimes special asset groups, they're like the reference of Hotel California. You can check out anytime, but you can never leave and that's why communication is so critical because on the second to last bullet, you want to be able to create a win-win to keep the loan, better position it. Again, if you make your lender look good to the extent you can, it's only going to help you to get back to whether it's performing or underperforming. Again, keeping a lender informed or meeting with the customer, laying out the plan to the best you can, executing on it and then finally, if you hit a bump along the way, just be prepared to address how you're going to bring it back to where you'd like to go.
With that, I'll turn it back over to my colleague Eric.
Eric Diamond:Thank you Robert. I'd like to now introduce Stuart who is going to talk about cash flows from a tenant perspective.
Stuart Ball:Thanks Eric. My name is Stuart Ball and I'm the co-chair of the real estate department at Westerman Ball and the head of the commercial leasing department. I represent many landlords and tenants in retail and restaurant leases for locations in shopping centers and street locations in urban areas and in office leases and industrial and warehouse places throughout the United States. Being on both sides of the table gives me perspective on how both the landlord and tenant are looking at the situation. Over the past few weeks, I've spoken with and advised many landlords and tenants on how to proceed in these unprecedented times.
Today I will discuss a few topics relating to the effects of the coronavirus pandemic on commercial leases. First, know your rights under existing leases. Second, know your remedies, which means reviewing the applicable leads to determine the party's rights and remedies under the lease, and the security the landlord holds under the lease, so the cash security deposit, letters of credit and/or guarantees. Third, know your tenant and who you're dealing with.
If your tenant is a creditworthy entity and you're holding a large security deposit and/or have a guarantee from a creditworthy entity, you can be more aggressive in your approach since you know ultimately you will be paid, as opposed to dealing with a smaller or mom-and-pop company which might not be in business on the other side of this pandemic, especially if the landlord pushes too hard with them. Also, as a practical matter, know what your tenant's views is and how they are affected by the coronavirus. Yesterday I received letters on behalf of a few different landlords I represented in leases with a well-known urgent care company.
The urgent care company was asking for a 3-months’ rent abatement, claiming their business has suffered dramatically due to the pandemic, but their business is open and operating. From the accounts I have read about, they have been very busy and are generating significant revenue. The response to this tenant's request should be treated differently than a response, for example, to a restaurant or a gym tenant who was forced to closed and has no revenue coming in. Fourth, educate and deflect and recommend to your tenants that they take advantage of the governmental programs that are now available. As most of you know how the lease provisions were negotiated and agreed to depends on the strength, sophistication, and leverage of the parties.
Once the commencement date or sometimes called the possession date has occurred under the lease, which is usually the date on which the landlord has satisfied its prepossession obligations and delivered possession of the premises to the tenant with the landlord's work substantially completed, most leases do not permit the tenant stop or delay the payment of rent, except under limited specific circumstances. Very few leases will provide the tenant with a rent abatement simply because business has deteriorated due to actions beyond the tenant's control.
Most leases contain a force majeure clause, which means superior force which is intended to permit a party to delay performance of its obligations when unusual or unforeseen circumstances beyond the party's control, such as natural disasters, acts of God and governmental restrictions or mandates interfere with the party's ability to perform within the required timeframe. However, most force majeure clauses drafted on behalf of more sophisticated landlords and/or landlords' attorneys contained a provision that the force majeure provisions will not excuse the timely payment of rent. Up until sometime last month, the force majeure clause and leases were usually just a boilerplate clause and at least it did not get much attention or negotiation by the attorneys.
However, the current situation has made this clause one of the most important clauses in the lease. During the past few weeks, I've reviewed many force majeure clauses on behalf of landlords and tenants and while the leases we are prepared on behalf of our landlord clients have this no excuse of rent provision in the lease, there are many variations of this language which many times are not clear and gives the tenant argument that rent can be excused for a force majeure event. Again, know your lease. We must review the actual force majeure clause in the lease.
As an example, I recently reviewed a force majeure clause on behalf of a tenant client which provided that under no circumstances shall the non-payment of money or a failure attributable to lack of funds be deemed an event to force majeure. Although I believe the landlord's intention was not to excuse the payment of rent, I do not believe this language says that. It says that non-payment of money is not the force majeure event itself, but does not say if there is another force majeure event, such as the governmental restrictions imposed in connection with the coronavirus, that rent is not excused.
It is very important review the actual language in the lease to know your rights under the lease and even more important, to have an experienced attorney to draft and negotiate this provision on your behalf. An important distinction to make to determine whether rent will be excused under the force majeure provision is whether or not the commencement date under the lease has occurred. Even if the notes used of payment of rent clause within the force majeure language, if the commencement date has not yet occurred under the lease, then the landlord's time for performance to deliver the premises and completed work will be delayed.
In that case, the rent commencement date will be delayed also because the free rent or construction period between the commencement date and the rent commencement date will not start until the commencement date occurs. If the commencement date has already occurred and there is just a time period for free rent to accrue with no other conditions, then pursuant to the lease terms, the free rent period will not be delayed and the right commencement date will occur when the free rent time period is over. Well, usually earlier if the tenant opens for business. This force majeure clause will be the subject of much discussion and negotiation going forward.
Some of my tenant clients have already been discussing how they're going to revise this force majeure clause going forward to eliminate the no excuse of rent provision or at least provide for an excuse of rent under certain limited circumstances, but just the current situation where businesses are required to close pursuant to governmental mandates. Some tenants are still signing new leases, but are revising the force majeure clause to make it clear that a situation like the current pandemic and governmental shutdowns will excuse the payment of rent. The situation gets a little more complicated with respect to, for example restaurants, which are still open for business but only for takeout and/or delivery.
In that case, I do not believe rent should be excused 100%, but instead, a good argument can be made that rent should be reduced based on the tenant's documented reduction in sales. Also when life gets back to normal and businesses resume operations, there will be a ramp up over time and many tenants such as, for example, gyms and other fitness facilities I expect we'll be asking for partial rent reduction until sales get back to normal. Going forward again, I expect the force majeure clause to be heavily negotiated now that there's so much attention has been drawn to it. In addition to force majeure, the lease may provide for rent abatement of certain circumstances occur.
Common clauses found in leases which may allow for rent abatement include one, a landlord's failure to provide access to the space and two, a landlord's failure to provide required utilities and/or services. However, in most cases, rent abatement clauses are extremely limited to a negligence or willful failure of the landlord. In limited cases where tenant has significant negotiating leverage prior to executing the lease, more tenant friendly abatement rights maybe included that are not fault based in which events a governmental closure or other events associated with the coronavirus may trigger the abatement, but that is unusual and if a landlord were to agree to this, I believe there would be strict time limitations attached to it.
Note that a lease may have other conditions, the failure of which may trigger a rent abatement such as a co-tenancy clause which are in many shopping-center leases, which may have now failed due to the impact of a coronavirus, therefore triggering a rent abatement. Again, know your lease and tenants may also make common law arguments to try to provide rent relief. For example, breach of the covenant of quiet enjoyment. However, this clause relates to the landlord breaching the covenant and not something outside the control of landlord. Another possible claim is constructive eviction, which typically requires the wrongful act of the landlord such that the tenant cannot use that space for the permitted use and as the result has in fact vacated.
In addition, doctrines such as impossibility and frustration of purpose maybe alleged by tenants. However, taking into account the potential long and expensive legal action that pursuing these rights would entail and the fact that the conditions necessary to support these arguments are difficult to establish is highly unlikely that pursuing such claims would provide an effective solution for most tenants. When landlords are determining how to respond to tenants' requests for rent abatements or deferment, again it is important to know the landlord's rights and remedies under the lease, which may include a security deposit which can be in the form of cash or a letter of credit.
Note that a landlord is better protected with a letter of credit because if the tenant files bankruptcy, a cash security deposit can be considered part of the debtor's property and might have to be returned, whereas the letter of credit is an instrument from a third party and it's been held to not be a part of the debtor's property. Unless the tenant is a creditworthy entity, the collateral usually will include a guarantee which can be a full guarantee of payment and performance or sometimes just of payment or a "good-guy guarantee," which means the guarantor will be a good guy and pay all rents and in many cases, for formal non-monetary obligations for so long as the tenant is in possession with an agreed upon notice period before the tenant can render possession.
Usually, a good guy guarantee is given when the tenant is single-purpose LLC with no other assets and the principle or principles of the tenant give this limited personal guarantee. If the landlord has a good guy guarantee and the tenant is less likely to default and be a "bad guy" by staying in possession of the space but not paying rent. Most good guy guarantees drafted by experienced landlords and their attorneys provide that the tenant must not be in default under the lease to be able to exercise the good guy clause. Most tenants are being careful these days to negotiate with landlords about how the rent will be excused or deferred, so that the tenant does not seem to be in default and lose their rights under the good guy guarantee.
Regarding communications with tenants, it has been my experience over the past few weeks that most tenants are reaching out to landlords as opposed to the landlord's initiating the discussion. Prior to entering the negotiations with tenant, I recommend that landlord's request that the tenant agree to a pre-negotiation agreement, which can be very simple and done by email. I'm seeing that even if the lease is 100% in landlord's favor with respect to no excuse of the payment of rent, tenant was still asking for release. Landlords are walking a very fine line in these negotiations and discussions. Again, know your tenant and your security under the lease.
If dealing with a creditworthy tenant who is likely to be able to withstand the lack of revenue for an extended period of time, you can be more aggressive, as opposed to dealing with a mom-and-pop type tenant or small company that may not survive if the landlord pushes too hard. Most landlords are sympathetic to tenants at this time, but of course have their own mortgage and expenses to pay. Here are a few alternative options the landlords can respond to tenants' letters. Landlords can respond with a general letter advising the tenants that they hope the tenant is safe and in good health through this unprecedented unfortunate time, and they will take their letter under advisement, but make no commitment to the tenant and reserve all rights and remedies under the lease.
This will kick the can down the road and decisions can be made at a later time after the full impact of the situation has evolved. In this case, the tenant must abate rent at its peril if accused to do so. I have some landlord clients who have offered to apply the tenant security deposit for the next few months' rent with tenant having the obligation to replenish the security deposit within agreed upon time period after business resumed.
This will maintain landlord's cash flow for a few months, but it's risky and that if the tenant does not replenish the security deposit, the landlord will not have the security deposit to resort to if tenants falls in the future, but the landlord can require that the amount of the security deposit applied to the rent be added to an existing guarantee, or make the obligation to replenish the security deposit the subject of a new guarantee from the principles of the tenant. Another option for landlords is to agree to a deferment of rent from an agreed upon period with the tenant's obligations to repay the amount deferred sometimes with interest over an agreed upon period after business resumes.
Alternatively, the term of the lease can also be expanded for the same time period as the deferment of rent. The landlord gets all the rent that was entitled to for the term of the lease. This does not help landlord's cash flow for the short term, but it is better than tenant getting a complete abatement of rent without payment to the landlord. As a practical matter, starting today as discussed earlier April 1st, many tenants are going to stop paying rent regardless of whether the landlord has agreed and deal with the consequences later.
Another approach I've seen some tenant's requests where a good guy guarantee is involved is that the tenant agrees to pay the rent currently, but the landlord agrees that during the next 12 months, the notice period under the good guy guarantee is reduced. For example, from 180 days to 120 days’ notice, in return for payments of rent for April and May. This way landlords maintain their cash flow and the tenant who maybe worried that they will be out of business and is thinking about the timing of possibly giving back possession of the space gets to defers its decision for a few months, but does not lose its good guy guarantee rights by the tenant being pulled under the lease.
There are many ways to handle the situation, some of which will maintain the landlord's cash flow. Landlord should also advise tenants that under the recently enacted CARES Act, the payment of rent in the eighth week covered period counts towards the forgiveness of the loan received by the tenant. Essentially, the government is making this payment for the tenant. This will be discussed in greater detail in the webinar this Friday. Thank you everybody for your time. I hope that everybody is well and safe and your families. I now like to turn over the podium back to Robert Katz of EisnerAmper who will further discuss cash flow implications in connection with commercial leases.
Robert Katz:Thank you very much for that tremendous summary. I guess in just trying to make sure we stay on the timeframe of it, I'll set suggest this with cash being king in these situations, as the tenant, make sure you're getting significant value for every dollar spent. When I talk about doing a workout, I ask the people making a request for funding knowing that funds are limited is what's the value I get in return for what I spend, and then is giving a limited pool of resources, is that value the maximum that I can get?
If you look at it that way to the best you can, you'll be best able to think about and address the most immediate needs to the extent to where if somebody, a lending institution is going to put you in default, there are a couple things to really consider, right? One in this environment, nobody wants to be on the front page. No large organization with any ties to the community wants to be on the front page of their local or national newspaper by putting somebody in default or the corona-related virus, and that should not be taken lightly.
Then the other thing from a practical standpoint, if somebody puts you in default, the time it's going to take to be able to execute on anything is significantly longer than it ever was, especially with the courts where they would ultimately have to go are closed. Again, like I talked about earlier, it's understanding the value proposition and looking at the whole chain of events from where it starts to where it ends, and how do you achieve the most value in between. That's my comment, and I will add just one last thing. Again, all of us on this call are happy and we'll be discussing it in further in depth Friday and be happy to follow up on any other questions that the audience may have. Eric.
Eric Diamond:Thank you Robert. As Stewart and Robert just went through the potential difficulty of collecting rent payments and how a landlord may need to consider modifications to lease agreements or rent abatements or rent concessions, now any deferral of forgiveness of rent could also be the result of certain future mandates issued by the government. Now for typical lease agreements that are in excess of one year, US GAAP standards required release order to straight-line rent, and this includes calculating rent escalations and any periods of rent abatement or concessions and in recognizing rental income evenly over the term of the lease.
With the increased potential of rent abatements and concessions being granted to tenants, whether they are new, renewed or existing leases in addition to any possible lease modifications, companies are going to need to assess the impact this may have on their straight-line rent calculation and depending on the specific property, landlords maybe cutting back on your various costs, whether including property management and common area maintenance or actually they may have increased certain costs due to additional cleaning services as a result of the outbreak.
For releases that contain clauses whereby the landlord is able to recover all or a portion of certain operating expenses, this pool of expenses to be allocated to the tenants for reimbursement may need to be analyzed much more carefully now and ensure it's in accordance with the terms of the lease agreements. Another financial statement implication topic is insurance recoveries and as a result of any potential reduction or loss rental income, companies may be able to claim business interruption losses under their insurance policy, which is going to be very specific based on the terms of the policy themselves. The accounting for the insurance claims will vary depending on the nature of the claim, the amount of proceeds, timing of the actual loss and potential recovery.
Any potential recovery for business interruption are considered gained contingencies under US GAAP and therefore, they're only recognized once the claim is resolved and finalized, which really means that either the proceeds have been received or confirmation of these proceeds has been received from the insurer. One of the biggest financial statement impacts right now from this outbreak is impairment consideration, specifically on long-lived assets and real estate properties. The impact of the outbreak has resulted in declines in occupancy and rent collections throughout many types of real estate asset classes.
Companies are going to need to assess these as well as other impairment indicators, but some of the more prevalent impairment indicators that we're really seeing right now would include a significant decrease in market value, a significant decline in revenue and cash flows, an adverse change in how a property is to be used or any significant change in the business environment. Keep in mind though that that impairment consideration is used to assess if the current carrying value of a property may not be recoverable. While short term periods of temporary declines may not necessarily indicate an impairment, the more long-term and permanent effects of the outbreak may result in impairment.
This is going to pose a challenge to many companies because the extent of the impact is uncertain and it's hard to quantify. Companies are going to have to do their best, come up with their best estimate of what the short-term and long-term effects will be on the company. Now for companies that have audit or review requirements on their financial statements and have yet to finalize and issue those financial statements, management will need to evaluate going concern. I do want to highlight though that the responsibility to assess going concern does not fall solely on the independent auditor. It is also the responsibility of management and the evaluation is more than merely an assessment if the company will continue to be in existence.
The assessment really includes an analysis to determine if the company has sufficient cash and liquidity to be able to pay its obligations and liabilities when they become due for a period of 12 months from the date of issuance of the financial statements. Now although the impact of the outbreak maybe hard to predict and difficult to quantify, companies need to carefully analyze their cash projections and budgets, and potentially even consider a few different projection scenarios. One a most likely scenario, a more conservative scenario and even a worst case scenario, and look at them in aggregate. The result of this going concern analysis will determine the extent of any required disclosures and the footnotes to the financial statements.
With no disclosures on the company's ability to continue as a going concern or deem necessary, there's still a very high likelihood that some disclosures maybe required on the potential impact of the outbreak on the company's performance and liquidity, and that would either be in a risk on uncertainty footnote or even possibly a subsequent event footnote to the financial statements. Lastly, I just want to comment real briefly on the impact that this may have on a company's internal controls, processes, and procedures considering how many companies are having employees working remotely, working from home as well as companies being put into position where they have to lay employees off or furlough employees.
Now the companies need to consider the challenges this poses to ensure that the accounting records are being updated accurately on a day to day basis, and living and adapting to this new remote virtual environment may result in the need to revise certain internal controls and procedures. May need to consider implementing additional layers of supervision, and really most importantly need to ensure that their IT systems are sufficient and secure to handle these remote capabilities. At this time, I'd like to turn it over to Lisa Knee who will wrap things up. Lisa.
Lisa Knee:Thanks Eric. Thank you everybody on this. I actually realized that we have some questions here, so I think we have some time to answer a few of these if I believe some of them are for either Greg or Phil or Stu if you guys want to start maybe answering one or two of the questions before our session runs. Some of the questions really might help some of our listeners today.
Greg Zucker:Sure. This is Greg. One question that was posed was, "Why should I pay mortgage interest after I received the SBA loan?" Under the CARES Act, once you received a loan, you have eight weeks which is a covered period. One of the items of forgiveness that's promulgated in the act is mortgage interest. The example I gave is that if you receive the loan on May 1st, you may want to pay your mortgage interest in May and June because it would count towards forgiveness. Another question that we've been getting a lot deals with force majeure and force majeure essentially deals with a situation in where you have the inability to do something because of an event.
Now if there's a contractual provision in either your loan or your lease that's on point, then the courts will look to that and say, "Hey two sophisticated parties agreed what they would do under these circumstances." However, as we all well know, most leases aren't going to provide that a tenant is excused for the payment of rent, and most loans aren't going to provide that a borrower doesn't have to pay the debt service. When the force majeure provision is not on point, people look to the common law doctrines of impossibility and frustration of purpose. They basically come down to the fact that there's an unforeseeable event and it's objectively impossible to perform.
Traditionally, these have been uphill battles, but in today's day and age, who knows and as one of the speakers said and he was right on point from a practical standpoint, the courts are closed now. There's not a lot of movement that are happening. There's not a lot of filings, unless it's emergencies. From that standpoint, there's nothing that's really going to be happening immediately with respect to evictions and foreclosures.
Robert Katz:By the way, this is Rob Katz just chiming in on one of the questions on why you should... I'm paraphrasing it, but why you should pay the interest or why should you not because the list of covered expenses is very, very, very specific and keeping in mind when you take funds in this program, you will be signing under penalty of perjury in jail time that you're going to use the funds for the intended and outline uses. In very new programs, one of the biggest red flags of the government is for recipients to potentially try end the runs, to try and fit the cliché square peg in a round hole. It's really critical to make sure that it is used for the very specific and intended consequences or uses of the loan and its proceeds.
Greg Zucker:Another question that we've been getting, "Is there any specific legislation that targets specifically for the landlord," and the answer is not as of yet. The relief that you're able to get is through the SBA loan process, the CARES Act but there is no specific legislation that says, "Hey landlord, this is what we're going to do when you don't get your rent paid."
Philip Sharfstein:This is Philip. There's a question asking whether force majeure can be used to cancel a contract even if that contract is out of the due diligence period. We have been asked this question before. We've actually looked into it and we're not seeing that there is any excuse for performance under contract generally due to the pandemic. Of course, every contract is different. You have to look at your particular contract and of course, we're happy to look at that for you, but what we're seeing today is we don't have a general relief from obligations due to the pandemic and that relates to your contractual obligation. Of course there are exceptions.
There's some relief for residential mortgages out there right now, and there are more proposals that are coming down, but the short answer is we haven't seen that yet.
Greg Zucker:Just to follow through with that, sometimes it's important to get your professionals involved as to how you shake the question, as to what caused the force majeure event. One way natural to look at it would be the coronavirus, the pandemic which wouldn't be one of the terms enumerated typically in that force majeure clause, but another way to look at it would be if there was an executive order, for example, from Governor Cuomo that required that non-essential people cannot go to work and those businesses were shut down. Another angle to look at it would be that it was that executive order that prevented me from doing whatever I had to do.
Philip Sharfstein:I see a question asked me about relief from payment of property taxes and again, consistent with the last question that I answered there is to date no such relief that I've been made aware of, but in the loan process, your expenses may include that and that will be on the next webinar or of course reach out to our office if you want more information prior to that. No, we're not seeing that taxing authorities are pushing back timeframes to pay taxes as of yet, but we believe or I believe and I'm not an expert in the stimulus package that people fry they are, that you'll be able to include that as part of your loan request.
Lisa Knee:Just want a caveat that's just real estate taxes. The income tax filings as we know have been extended in most state at that point. Today, New Jersey came in and extended that. Yup. I just want to make sure. We do have a number of questions coming in and I think what we'll do is we'll send out a Q and A afterwards, and we will respond to these questions to the best that we can without giving specific legal or accounting advice, but we will give to the ones that we can answer that aren't on specific circumstances, some guidelines to help and we will circulate that to the group. We'd like to thank everybody for attending today's webinar and to remind you that the Friday session again will be on the CARES Act specifically with respect to the SBA loans and the tax provisions under the CARES Act.
We're also going to be talking about the tax deadlines not from a property standpoint, but from an income tax point of view, and we'll be talking about some deadlines that haven't been extended yet the 1031s for section 1031 exchanges and for qualified opportunity funds. Please make sure that you log in and you register separately for part two of today's webinar. We wanted to thank everybody for attending today, and you can keep the questions coming. As I said before, we will answer all of them.
Moderator:We hope you enjoyed today's presentation. The recording of today's session will be available on demand later today and can be accessed using the same link you used to join. Please look out for a follow-up email with a link to our feedback survey and presentation. You can access the registration link for Friday's webinar within your resource list on the bottom of your screen. Thank you for joining our webcast today.