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Managing Default Risk in a Crisis

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There is not a question of whether the CV virus and our government’s subsequent reaction has caused a negative effect on our economy. We can point the fingers later but right now we’re likely going to see trillions in stimulus get pumped into the economy, including bailouts for certain industries. The question for CRE stakeholders is, will we see any of that stimulus and if so, what are its effects?

Let’s review an industry that has been decimated by this public health emergency, dining. This week the NRA (National Restaurant association) asked the government to include a massive bailout for restaurants due to some starkly brutal predictions. They’re forecasting shortfalls of $225+ Billion for the industry, along with 5-7M jobs lost…That’s an enormous number. The real costs of this crisis will be tabulated much farther down the road but it’s safe to say the impact is staggering.

Dine-in services by most accounts averages 90% of a restaurants income, it’s highly unlikely that ordering/delivery/togo business can make up this gap in the current environment.  As such, they’ve asked for $145 Billion to help restaurants. What would that $145 Billion be used for? Well, a ton of that money (as it should) would go to keeping people employed and the businesses open. The next broad stroke would likely be efforts to help them pay their rent. Many other industries face these same pressures (like travel, retail and more…) which have an immediate effect on the CRE community, especially the ownership of assets who have affected tenancy. Of course, our business is (and always will be) unique, so solving this crisis is not likely to happen overnight.

The residential markets have lobbies and government organizations like the NHSC to issue orders, like stopping evictions and halting rentals for 30 days. However, no such regulatory body exists for commercial (at least directly). The federal government could try to step in to help businesses affected that cannot pay rents but I’m not sure how that would look or even work given the decentralized nature of commercial real estate. MANY many different owners with exponentially more tenants, lenders and situations make a broad brush stroke here difficult.

One solution we have heard floated is for the Landlords to anticipate these rental issues and contact their lenders now for some relief. Perhaps an otherwise cash-flowing and stable property can negotiate an interest-only period or even a deferral for a period of time. If such measures are implemented the Landlords may be able to provide their tenants with some relief, i.e. not paying base rent now, deferring payments for 90 days, mortgage relief pass-throughs. This does not make up for taxes and other operating expenses however, so I do think “some” rent will almost certainly be required. However, any relief would be welcome to these businesses affected by the crisis, not just restaurants of course. It’s in the interest of lenders to be creative right now and the banks are in far better shape than 2008.

 

Banks are in better shape this time around

Banks have more data than they have ever had before, frankly they know they can make it work. The idea of a 30-60-90 or longer deferral program where base rents are not collected make a huge difference when rent normally occupies the largest or second-largest expenses for most businesses.

We’ve seen some good hearted Landlords even tell their tenants NOT to pay rent, to prioritize employees which is beautiful. However, not every Landlord is in a position to do that.  The reality is the vast majority of commercial properties have debt on them and those bills are going to be due, now or later. Savvy Landlords will push lenders to be creative but if these debt-holders put their foot down we could see a cascading effect.

Tenants for their part should be talking seriously with attorneys about key terms in their leases, such as Force Majeure (AKA “Acts of God provisions). These are historically difficult to invoke but your attorney will know best. We’ve literally never faced a crisis like this though, so asking is a great place to start.

Tenants should also be discussing any options they may have for interruption insurance (although coverage is spotty at best for events like these).  In a general sense, Tenants who interact and communicate with their Landlords about their issues and intentions are going to do FAR better than those who do not. There is nothing wrong with picking up the phone and asking for help, DO IT NOW. It will serve you down the road, lean on your advisors and investors if available as well while communicating to customers your intention.

The only positive thing about this terrible terrible boat is that we are all in it together, so they will understand.

Monetary default is a serious provision in any lease and when Tenant’s cannot pay rent it has an enormous impact on the asset itself. We could see many tenants not make these payments, defaults occur for tenants and then even property defaults to lenders if enough of a building is affected by this crisis. It’s a real possibility, so how do we mitigate this?

Personally, I don’t think the practicality of defaulting tenants in this crisis is a good move. Not only is it going to be viewed as heartless to the business but it puts the property at greater risk. Deferring rents to a future date is the best thing Landlords can do for a Tenant, essentially setting up payment plans. As stimulus DOES come in, perhaps backed by loan guarantees tenants can start paying these things back. I think it is prudent for lenders to look at their portfolio in the same way. Is it a good move to call a loan as we recover from this crisis?

If we take lessons from 2008 we know that the lenders and banks that survived (and the landlords) should have learned a couple things. Number one being that defaults don’t really help anyone. Of course every situation is different but I would be picking up the phone right now if you own property and starting the process. Lenders are in a FAR better position cash-wise than they were in the previous crisis. We covered this in a previous post, but without this global crisis the CRE industry had a lot of room to grow debt.

As we start to climb out of this economic period of shock and negativity, the Landlords that have worked with their tenancy to survive will be viewed favorably, I also believe they will profit economically as well. Default is an expensive, last resort of an action for property owners and right now it’s inappropriate to use the heaviest-handed tool in the box. Property owners should be planning ahead, forecasting less rents and assuming they will deal with more vacancy going forward. This is reality.

So what happens when we do start to climb out? Well, a few things are likely to be true for businesses.

  • Businesses are extremely likely to have less cash on hand, even as we start to recover. Lost revenue, deferred debt and rent payments and other expenses will quickly add up. If Landlords want to encourage deal making they are going to need to get creative as things start to come back.
  • With slowing deal volumes and less cash, the likelihood of increased vacancy is incredibly high in a market like Houston (which also faces pressure from oil and gas price issues). Getting a deal done has to happen, this mean taking more risk as a Landlord.
  • Tenants may indicate they want less space now as they lay off employees, work with them to find a solution. Clever space planning, rent deferrals or increases in term can be ways to mitigate. Work with your leasing team for recommendations as well.
  • Prepare to write some bigger TI checks…tenants won’t be making up any gaps or overages right now.
  • Watch for rent negotiates and concessions like free rent. Using free rent as opposed to writing a check for TI might make more sense, allowing for deals to get done while we recover. For both Tenant and Landlord.

Look at strategies to reduce out of pocket costs, for you and the Tenant. It just so happens we have one as well.

Our AA-rated guarantee program can help you assess businesses fairly and in a matter of minutes while offering up to $50,000 in reduced capital needs from businesses.

We can get you setup in a matter of hours to provide assistance to both prospective and existing Tenants in these difficult situations.

We can even help set you up to return cash security deposits to help your Tenants. We can provide essential liquidity for your tenants.

If you’re trying to hammer down some renewals that makes total sense, as renewals are on average 66% cheaper to do than a new lease (which may be tough right now anyway).  Keeping vacancy to a minimum is huge.

Offer tenants a sweetened deal to sign longer terms to shore up your rent roll…or sweeten the pot by offering Tenants their cash deposits back. Yes, we can help you return deposits to Tenants in renewal situations helping you incentivize deal-making now while actually enhancing your coverage against default risk in these uncertain time.  We’re harping here, but we seriously are built to help businesses and landlords bridge these gaps. Let’s talk.

Let’s get creative folks

As the new reality of this shock sets in, we’re hoping that the creative and mindful cogs in our industry succeed here. Understand it’s not just all numbers, these are livelihoods being threatened. Please remember the human element in our business. While we all want to be economically successful there are many many people at risk right now, consider these resources to help out and learn more about what you can do in your local communities.

We know we can beat this crisis and come out stronger, but only if we stay resolute, patient and creative.  Stay healthy and safe folks, onwards and upwards 🙂

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