Surviving Volatility

The coronavirus pandemic turned the world upside down, so CRE professionals will need creative options when it comes to renegotiating leases.

Disruptions happen all the time. The next one is sure to come — what remains unknown is what form it will take and when. The COVID-19 pandemic, for instance, is a black swan event that could take a century of hindsight to put it into proper context by the type and scope of its impact. While this latest disruption is unlike previous systemic volatility, like the Great Recession, commercial real estate professionals need to adapt to the changes resulting from this most recent disruption.

One such change requires that industry pros hone their abilities to prepare for the widespread lease renegotiations in the coming months and years. Leases tend to be long-term contracts in CRE, extending three, five, 10, or 20 years into the future. In that time, businesses will change, and the economy will have its ups and downs. When a tenant and landlord sign a lease, there is typically an anticipation that the market and use of the space will continue uninterrupted throughout the term of the agreement. While early termination clauses are not uncommon in the office sector, the cancellation fees can be hefty.

In the wake of the pandemic, tenants and landlords/owners are renegotiating and modifying leases every day. Pinterest, as an example, recently cancelled a lease for 490,000 sf of office space in San Francisco that included total rent payments of $440 million. The cost to walk away from that deal was an astonishing $89.5 million. Why would a lessee pay that much to buy its way out of a deal? Risk.

Risk also explains why significant amounts of subleased office space has been hitting the market. Some tenants, seeing the volatility of 2020 and the near future, hope to minimize costs and recoup some revenue from their decreased need for real estate.

The commercial real estate market remains volatile, even if we all hope the worst of COVID-19 is behind us. Considering such uncertainty, plenty of tenants and landlord/owners will be faced with the prospect of subleases and buyouts in the coming months and years. Here’s a quick rundown of many of the considerations that go into lease modifications.

Seeking a Sublease

At its most basic, a sublease is an exit strategy for the tenant. By signing an agreement for another user to take their place in the premises, the original tenant becomes the primary tenant, and the new renter is the subtenant. The subtenant occupies the space and pays all or a portion of the rent owed under the original lease agreement, but the primary tenant is still on the hook financially and legally, with all rights flowing through the primary tenant.

Every situation is unique, but many tenants consider subleasing for a few common reasons:

• Need more space. If a client has outgrown their space, they will need to relocate to accommodate a growing business with greater needs. In this case, a sublease can cover all or a portion of the existing location.
• Need less space. A business headed in a smaller, leaner direction could also benefit from a sublease. Think of an office building in April 2020 — the business may have required every employee to work for home for months or longer, so 10,000 or 20,000 sf of office space is no longer a necessity.
• Things change. A tenant may look to sublease if their business model has changed significantly. Think of Walmart as an example. When these stores started to include groceries, their footprints greatly increased, leading to the spread of Supercenters. Walmart subleased many Division 1 stores to smaller retailers while they looked at larger facilities.
• Costs need to be cut. Some businesses may have to sublease some or all their space to stay afloat during difficult economic times.
• The space is obsolete. A tenant may look to sublease if a space or building is obsolete due to changing technology or business needs.

To pursue a sublease, a tenant must first make sure the landlord is properly notified. Language in the lease should detail what this entails — whether the landlord needs to give permission in writing or other parameters are established. The tenant or user of the space also needs to consider who profits from the lease in the event the sublease rent is above the contract rent. Will that go to the tenant or landlord? Conversely, if there is a reduction in rental income, how will the primary tenant account for the difference?

But other issues in the real estate market may complicate the subleasing process. You may not be able to find a new tenant for a space. Imagine if you were looking to sublease a boutique retail property in May 2020, for example, amid COVID-19 shutdowns.

To see how this plays out, let’s look at a case where a tenant was able to sublease a property for less than the existing lease. How would you determine the value of that sublease in today’s dollars?

In this case, there are eight years left on a lease that’s $50,000 per year. The sublease agreement is for $45,000 a year. Assuming the primary tenant’s discount rate is 10 percent, the difference in present value of the two leases equals negative $26,675. This total is crucial when considering if a sublease is the correct path forward.

Talking About a Buyout

If a sublease doesn’t make sense, a buyout could be another exit strategy for tenants. A more drastic move in some ways, a buyout can give a landlord/owner a chance to possibly lease at a higher rate, thereby increasing their building value, while tenants can exit leases that have become burdensome.

Prime candidates for buyouts include big-box stores that have closed permanently, such as JCPenney, Sears, and Kmart. Other situations could include a retailer moving from brick-and-mortar to online sales. H&M, for instance, has closed a significant number of stores as it emphasizes e-commerce.

Looking at a second case study, imagine the tenant owes the landlord $1 million over five years. From the perspective of the tenant, who desires to exit the property, if the landlord could lease the space to another occupant for $150,000 a year, that is a shortfall of $50,000 a year or $205,010 in today’s money when discounted at 7 percent. But from the landlord’s perspective, the tenant owes them $1 million. Even if the landlord agreed to discount the remaining rent owed at the same discount rate of 7 percent, they would be owed $820,039 today.

By comparing these two figures, you’ve established a negotiating range. In determining what to accept on a buyout, the landlord must consider multiple variables.

• What additional value might come from a stronger tenant?
• How long might the space be vacant?
• Can the property be repositioned with a different user?

Additionally, if the property is leased for $150,000 per year, instead of $200,000, the net operating income is reduced by $50,000 per year. This shortfall could cause problems if the landlord has a loan with a debt-service coverage ratio and loan-to-value ratio requirement. Most loans have covenants that require certain benchmarks throughout the term of the loan. If these aren’t met, a default or capital call may occur.

The volatility across commercial real estate markets doesn’t appear to be going away soon. Reworking leases, subleasing, and buyouts are skills that many CRE professionals need to have in their toolboxes. Knowing the goals of all involved parties — including tenants, landlords, owners, and other parties, including financing — will help you advise clients when deciding the best course of action as the industry enters a post-COVID world.

Source: “Surviving Volatility“