Category: Leasing

Commercial leases, COVID-19, and shutdowns: condemnation or casualty?

One effect of COVID-19 on the world of commercial real estate has been to move two lease clauses from the boring bits of boilerplate in the rearguard of the lease to be front and center in the minds of the negotiators.  These clauses are the provisions on damage and destruction and the provision on condemnation.

Until this year’s pandemic struck, when lease drafters considered damage and destruction they had in mind only physical damage or destruction.  The building burns down: can the tenant terminate the lease?  Must the landlord rebuild?  Must the tenant continue to pay rent?  If the building was not physically damaged, then the clauses on damage and destruction never came into play.

Similarly with the condemnation clause: if the government took a portion of the leased premises, or a portion of the project in which the leased premises were located, could the landlord or tenant terminate the lease?  Would rent be reduced?  If the government never took possession of part of the premises or of the larger project, then the condemnation clause did not come into play either.

This spring’s pandemic-related orders thread the gap between the Scylla of destruction and the Charybdis of condemnation.  First, Scylla:  if the government bars the tenant from doing business without regard to whether the property itself is an actual danger (think of the shuttered restaurants), then the property hasn’t been condemned – or has it?  An ingenious tenant might argue that the government has temporarily condemned its property for the public good, and a temporary taking entitles the property owner to compensation.  In the landmark case of First English Evangelical Lutheran Church v. County of  Los Angeles, 482 US 304 (1987), the United States Supreme Court held that a county that temporarily prohibited a landowner from all use of its property could be required to compensate the landowner for damages for the temporary taking of its property, even though the government itself never occupied the property.  Our enterprising tenant might continue the argument: if the government’s order to shut its business is a temporary taking under the United States constitution, and therefore a condemnation, the order should equally be a condemnation for purposes of the lease, and if the lease entitles the tenant to terminate the lease in response to a condemnation, then the tenant can terminate the lease.

The alert landlord might respond that the government never evicted the tenant – the tenant continued to possess the leased space, even if it couldn’t admit any customers or make any sales.  If the tenant never lost possession, then the tenant’s leasehold was not condemned, and the tenant can’t terminate the lease.

What would a court decide?  We’ll know the answer in a year or two when a case gets to a judge.

Let’s move on to Charybdis and the destruction clause.  What is “destruction”?  It includes physical destruction by fire or flood.  Sometimes (you may be reading your own lease now) it includes “or other physical event which makes the premises untenantable for the uses allowed under this lease.”

COVID-19 did not itself make any commercial space untenantable, but the pandemic did lead to state and local government orders that did make many commercial spaces untenantable.  Is the pandemic a “physical event”?  The viruses do have a physical existence.  If our ingenious tenant doesn’t succeed at arguing that the government shutdown orders are condemnations, it might win the argument that the virus itself is a physical event that caused the premises to become untenantable, entitling the tenant either to a rent abatement or to terminate the lease itself.

Tenants affected by the pandemic and the shutdown orders (which means nearly everyone) can’t renegotiate the destruction and condemnation clauses in their leases.  Prospective tenants, however, will want to pay close attention to these clauses in their new leases before they sign them.

Retail leasing after the COVID-19 pandemic

Most of the stories about how the COVID-19 pandemic is affecting real estate have focused on the short-term effects on rent payments and the indirect effects on landlords’ ability to make their mortgage payments.  The effects vary widely by area: the National Multifamily Housing Council (NMHC) reported that 88% of apartment tenants paid at least some rent in May.  The Community Housing Improvement Program (CHIP) found that 25% of apartment tenants paid no rent in May.  Why the difference?  NMHC surveys 11 million units across the country.  CHIP surveys 100,000 units, all in New York City, the urban area hit hardest by the pandemic.  By contrast, in San Francisco 96% of residential tenants paid rent in May.

The effects also vary by sector: CHIP reported that 64% of retail tenants in the New York apartment buildings it surveyed – nearly two-thirds — did not pay rent in May.  In San Francisco, 57% of commercial tenants did not pay rent in May.

Businesses will eventually reopen, but will their retail spaces be worth what they were before the pandemic?  It depends on the business.  At one extreme are the high-value, low-traffic retailers, who use their stores to display and sell merchandise and don’t need to accommodate many customers at one time – for example, Tiffany & Co., where customers rarely stood within 6 feet of one another.  Stores such as Tiffany can display the same amount of merchandise and welcome the same number of customers as before.  If their space is worth less than formerly, it will be because of general market conditions and not because of any change in their business practices.

At the other extreme are businesses that need space to hold customers.  Two good examples are exercise studios and sit-down restaurants.  If social distancing requirements cut in half the number of customers that they can serve at one time, then to them their space is worth half of what had been worth.  More crowded venues such as bars and nightclubs may lose more than half their customer capacity.

What does this mean for landlords?  If your existing leases to restaurants give you the right to monitor gross sales, ask for sales reports as your tenants reopen.  Be prepared to renegotiate the rest of the lease term – and check your loan documents to see if you need your lender’s permission to drop the rent.  If you’re considering a restaurant or bar as a new tenant, examine not just the restaurant’s concept and the owner’s operating history, but also the proposed seating plan and tenant improvements.  Can the tenant easily adapt the seating plan to comply with the social distancing requirements that a COVID-21 or COVID-22 pandemic would generate?  The provident landlord will test not just the financial strength of its prospective tenants, but also the resilience of their business model against the next pandemic.