"Uncharted waters: The impact of the coronavirus crisis on commercial real estate — a US law perspective"

ABSTRACT

The COVID-19 pandemic dealt an unprecedented blow to businesses around the world and left CRE professionals struggling to keep up with rapid-fire changes in operations resulting from shelter-in-place orders and business shutdowns. This struggle can be seen in the urgent questions that CRE attorneys were hearing from their clients in the early days of the crisis and as it continued to grind along. This paper touches on many of these questions and reveals some of the hurdles faced when trying to find relief for a situation that few anticipated in real estate leases, purchase and sale contracts and other agreements. It also anticipates some of the challenges to be faced once businesses reopen and lists some of the important lessons learned.

INTRODUCTION

By the time the World Health Organization (WHO) officially declared COVID-19 to be a pandemic, many of the greatest fears of businesses around the world were realised. In the days and weeks that followed, the US federal government declared a national emergency and various states and localities began to announce stay-at-home orders, resulting in an unprecedented shuttering of most restaurants, shops, offices and other places of business. The stunning speed at which normal business operations came to a screeching halt, coupled with the lack of uniform nationwide rules, resulted in many CRE professionals desperately reaching out to their attorneys and other advisers to try to understand the immediate impacts and longer-term implications of a global pandemic on their operations.

In the early days of the coronavirus crisis, the telephones of attorneys across the US, and doubtless the world over, were ringing constantly as their clients struggled to stay in compliance with ever evolving laws, rules and requirements. This phenomenon was no different for CRE professionals, many of whom were charged with managing workplace closures and facilitating the transition to a remote work environment. For many of these professionals, the information they urgently sought in those initial calls was not only legal advice, but also an understanding of how other businesses were reacting. ‘What are others doing?’ was the most common question, and their attorneys, by virtue of interfacing with multiple clients, were uniquely situated to provide this valuable knowledge. Gradually, common themes began to emerge, and it became clear that seemingly straightforward questions often proved to have much more nuanced answers than might be expected.

CAN I GET RELIEF FROM PAYING RENT?

The widespread shelter-in-place orders and closure of non-essential businesses had a negative impact on the bottom line of virtually every company. With revenue plummeting, the focus quickly turned to finding ways to trim expenses. Unsurprisingly, given that rent is one of the largest expense items on the balance sheet, many CRE teams were asking their attorneys to scour their leases for provisions that might allow them to stop paying rent until their doors were open again or to otherwise reduce their rental obligations.

The logical first thing to check was whether the lease contained a force majeure provision, which excuses performance by a party when the failure to perform is caused by events outside of its control. After all, it is difficult to imagine a situation that is more outside the tenant’s control than having its business shut down by the state or municipal government due to a pandemic. But it is not that simple. For one thing, there is no uniform definition of a force majeure event, so the specific language of each force majeure clause needed to be reviewed. Very few leases that were signed before March 2020 made specific reference to pandemics or public health emergencies (although you can be sure this will change going forward). Many provisions list events such as governmental orders, national emergencies or acts of God as force majeure events, and it would be reasonable to consider the coronavirus crisis as fitting within this type of language. Most sophisticated leases, however, provide that a force majeure event does not excuse the tenant from purely monetary obligations such as the payment of rent, thus shutting the door on the use of this clause as an escape from rental obligations. If a lease does not contain a force majeure clause at all, the question of whether any relief is available will be dependent on the common law of the particular jurisdiction.

Attorneys also scrutinised the services provisions and casualty and condemnation clauses. Most leases include a list of services to be provided by the landlord and many of these lists include the provision of access to the premises on a 24/7 basis. This led some companies to ask if being shut out due to the pandemic constituted a breach of the land-lord’s obligation to provide access; however, landlords would almost certainly be excused from providing access by the force majeure provision, since building closures were not within their control. Attorneys also examined lease language addressing casualty and condemnation, which can allow a tenant to terminate its lease or receive an abatement of rent. Casualty provisions typically require physical loss or damage to the premises, but a few might be written broadly enough to support an argument that the coronavirus would qualify. Condemnation provisions might be read to apply, but it is unclear if a forced closure of a business would constitute a governmental ‘taking’ or, instead, a valid exercise of the government’s police power. The answer is dependent on state law and is far from a sure thing.

Another question asked by many CRE professionals was whether they could make a claim under their business interruption insurance to cover their rent and other expenses. Business interruption insurance is intended to protect businesses against lost income resulting from a covered peril, and the specific policy language should be examined closely. Unless the policy includes a special endorsement for communicable diseases, however, business interruption coverage generally requires that the interruption in the insured party’s operations was due to a ‘direct physical loss of or damage to’ property. Some courts interpreting this language have held that a loss of use alone is not sufficient to trigger coverage. In other jurisdictions, courts have interpreted the language more broadly. Given the uncertainty and hurdles faced by insured parties in obtaining coverage, several states, including New Jersey, Ohio, Massachusetts, New York, Louisiana, South Carolina and Pennsylvania, are considering legislation to help remove barriers to coverage for losses resulting from the COVID19 pandemic. At this time, it is unclear whether these legislative efforts will be successful or if they are even constitutional, but these developments will need to be closely watched. Businesses should strongly consider providing a notice of a claim or potential claim under their first-party property policy for their business interruption losses. The existence of coverage will ultimately depend on the particular policy language, the controlling law, and the underlying facts giving rise to the claim. Nonetheless, without a tender and timely notice to the carrier, potential coverage may forever be precluded.

Tenants who are unable to claim that they are excused by a force majeure event or unable to make a successful claim under their business interruption insurance may find themselves in default under their leases but nevertheless saved from eviction. Certain jurisdictions have enacted a moratorium on evictions in light of the coronavirus crisis. While most of these moratoriums apply to residential tenants, some have been expanded to cover commercial tenants as well. Generally, however, these protections are limited to small businesses such as those having fewer than 50 employees or worldwide gross receipts less than US$25m.

Without other available protections, many CRE tenants have no choice but to approach their landlords requesting rent relief. Some landlords are constrained by lender requirements or other limitations when it comes to negotiating rent relief, but those who are not so limited are often willing to make adjustments — but not for tenants who come forward with nothing but their hand out. The successful tenants are those who approach their landlords with not only a rent relief proposal, but also with a realistic plan for moving forward once the crisis is over and financial information (such as projected sales numbers or other recovering revenues) to back it up. Every rent relief arrangement is unique, but the typical agreement in the first weeks after the crisis began provided two to three months of deferred or reduced rent coupled with either an equal number of months added to the end of the lease term or an increase in the rent due over the next several months to cover the deferred amounts (so-called ‘blend and extend’ arrangements).

HOW CAN I MANAGE ONGOING PROJECTS AND TRANSACTIONS?

Of course, pandemics do not phone ahead to make sure it is a good time to stop by. Business shutdowns occurred in the midst of all manner of ongoing CRE transactions, leading to questions of how to move forward or how to back out. Even routine plans and projects have been affected.

Many facilities managers who were overseeing tenant improvement or other construction projects were relieved to learn that construction activities were usually designated as essential services and exempt from shelter-in-place orders, meaning that most ongoing construction projects could proceed. Because the rules vary from state to state, and in some cases from week to week, the ‘essential services’ rules for the location where the project is located should nevertheless be reviewed to confirm that the specific construction activities are permitted.

Determining whether a construction activity is allowed to proceed is only part of the equation. The onset of the corona-virus crisis created a myriad of potential project delays, ranging from an inability to obtain necessary permits and inspections from governmental agencies to safe-distance workplace practices that slowed down the contractor’s progress. Some subcontractors and tradesmen refused to go to job sites in locations they deemed to be too risky. Even in projects that were proceeding relatively smoothly, a report of a suspected or confirmed case of the virus could shut it down for a week or more to allow for appropriate disinfecting and other responses. While most construction materials seem to be readily available, certain speciality items, especially those coming from overseas, have been delayed or are unobtainable.

Delays in project completion result in problems beyond the delay in starting operations. If the project is part of a buildout under a lease where the tenant is performing the improvements, the rent commencement date is usually tied to a firm time period after the space is delivered to the tenant, regardless of whether the project is actually completed within that time period. Whether a tenant can push out the rent commencement date when construction has been delayed because of the pandemic will depend on the language of the lease. Here again, close attention needs to be given to force majeure language to see if it applies. Tenants facing the prospect of paying rent on unfinished space are also examining their construction contracts to see if delay claims can be made against their contractors. The language of the particular construction contract (including the wording of the force majeure clause) needs to be closely examined. In addition to claiming force majeure applies, contractors are seeking to avoid delay penalties by invoking other doctrines of contract law such as frustration of purpose or impossibility of performance. In effect, these contractors are arguing that governmental shutdown orders rendered their on-time performance impossible or that the governmental action frustrated the fundamental purpose of the contract. Whether these arguments are successful depends on the common law of the particular jurisdiction.

Some CRE professionals were in the midst of acquiring a new facility when the coronavirus crisis began to unfold. Almost every contract for the purchase of commercial real estate includes a due diligence contingency which allows the buyer to inspect and approve the legal and physical state of the property before it is contractually obligated to close. Many inspections and reviews typically conducted during the due diligence period, such as reviewing title, obtaining an American Land Title Association (ALTA) survey, performing an environmental assessment and preparing physical condition and zoning reports, have been delayed to some degree by the pandemic. Due diligence periods are generally strictly observed, and delays — even when caused by events outside of the buyer’s control — will not give the buyer additional time to conduct its reviews. Accordingly, a buyer in this situation will need to negotiate an extension with its seller in order to extend the due diligence period. If not, a buyer who fails to deliver a termination notice by the end of the due diligence period will likely find itself locked in and unable to get out of the deal without losing its earnest money deposit. Just a month into the crisis, lawsuits between transaction parties arguing over the applicability of force majeure to extend con-tract deadlines are already beginning to pop up, and more are sure to follow.

Some companies were in the midst of a like-kind exchange transaction, also referred to as a ‘1031 exchange’, when the crisis broke out. Section 1031 of the US Internal Revenue Code (IRC) allows a taxpayer to defer capital gains (and the associated income tax) from the sale of real estate if the proceeds of the sale are reinvested in another property identified by the taxpayer within 45 days of the relinquished property sale and acquired by the taxpayer within 180 days of the relinquished property sale. Those deadlines are traditionally rigidly enforced, leading many companies to wonder if they would lose the tax benefits if delays due to the crisis caused them to miss a deadline. Fortunately, that stress was alleviated some what when the Internal Revenue Service (IRS) announced on 9th April, 2020¹ that taxpayers could take advantage of relaxed deadlines in light of the pandemic. Under the new announcement, taxpayers who had either deadline falling within 1st April to 15th July, 2020 received an automatic extension of that deadline to 15th July, 2020.

For some companies, the economic uncertainty caused by the crisis meant that new acquisitions needed to be put on hold or cancelled entirely. As noted above, if the due diligence period under a purchase con-tract has not yet expired, then, depending on the specific contract language, a buyer often can terminate the contract without suffering any adverse consequences other than spent diligence costs. In situations where the due diligence period has expired, however, buyers will usually have a much harder time getting their earnest money deposit back² if they elect not to proceed with an acquisition under a purchase contract. The language of each contract will need to be carefully reviewed to see if any ‘outs’ may be avail-able. For example, commercial real estate contracts often contain a list of conditions that need to be satisfied before the closing can occur, and buyers are examining these conditions closely. Occasionally, a contract will include a condition that no material adverse change (MAC) has occurred. While this sounds helpful at first blush, the specific language of the clause is very important. The wording of MAC clauses varies widely from deal to deal, if one is available at all. Some clauses refer to a material adverse change to the physical condition of the property, others refer to changes in the ability to finance or develop the property, and still others refer to changes in the condition of the buyer. The existence of a pandemic may or may not fit within the type of change described in the contract condition. In addition, some MAC clauses contain carve outs for changes that affect entire industries or for changes in general economic conditions, which will arguably make it harder to claim that a material adverse change took place as a result of the pandemic. Other MAC clauses may expressly exclude pandemics from relief. It is also important to understand the con-sequences of an unsatisfied MAC or other condition. Some contracts provide that the closing is extended until the condition is satisfied, while others permit a buyer to terminate the contract and get back its deposit. With almost endless variations, CRE leaders who are looking to terminate a purchase contract are well advised to consult with their attorneys.

The coronavirus crisis is also affecting purchase and sale transactions where both sides want to proceed. Parties should anticipate that closings will take longer than normal and plan accordingly. For buyers who are obtaining outside financing, this will require coordination with lenders as well. Staying informed of closures or changes in procedure of recording offices and additional requirements that may be imposed by title insurance companies (which in the US assure title to the buyer and the buyer’s lenders) and lenders can head off potential hiccups or at least give the parties more time to address them. Even the simple act of getting closing documents executed and notarized often takes longer than normal with shelter-in-place orders in effect. Real estate transactions typically include deeds and other documents that need to be signed before a notary (who under state law in the US is required to authenticate the identity of the party signing a conveyance document), which creates unique logistical problems during the shutdown. In response to the crisis, many states have issued executive orders allowing remote online notarisation (RON) on an expanded or temporary basis.³ Typically, these orders permit a document to be signed during a video conference, then scanned and transmitted electronically to the notary. The notary then prints it, affixes his or her notary seal and sends it back to the signer. Some of these executive orders have defined end dates so caution should be observed.

WHAT HAPPENS NEXT?

Once the initial shock of the coronavirus crisis began to wear off, CRE professionals turned their attention to what will happen once restrictions on business operations are lifted. The prospect of returning to work is encouraging, but it is unlikely that any of us will return to a workplace that is the same as the one we left when the crisis started.

Employee density is one of the very first considerations under review by many CRE teams. One by-product of the pandemic is that it may have hastened the demise of the open-plan office. The trend of the open-plan office, with benching that put employees within a mere two to three feet of one another, was already being criticized for purportedly leading to lost productivity, increased stress and unacceptable noise levels, and now these types of arrangements are an obvious concern when companies are trying to comply with social distancing guidelines. Expanding employees’ work areas within a company’s existing footprint requires no small amount of creative planning by a company’s COVID-19 task force. Architects, engineers, furniture vendors and interior designers are working overtime to help companies create safer workspaces, even as some estimate that following social distancing guidelines could result in losses of up to 30 per cent of a formerly typical floorplan.

One way to solve the density problem is to bring back fewer employees at a time. In early April 2020, CORENET Global published the results of its survey of its members to gain insight into how, when and under what circumstances employees will begin to return to their offices.⁴ The majority of respondents (84 per cent) indicated that they planned to bring employees back in waves, rather than all at once. For some, this means returning critical teams first. Others intend to bring all teams back at the same time but will divide and rotate team members. Bringing employees back using a ‘hot desk’ or hoteling arrangement, where multiple workers use a single work station, is, however, likely to be resisted by most workers returning after the pandemic, at least until the fear of contagion begins to fade.

Some companies plan to have at least some employees continue to telecommute. If nothing else, the coronavirus crisis seems to have improved the perception of employee effectiveness while working remotely. The CORENET Global survey reported that 66 per cent of respondents had a more positive view of remote working than previously. The relatively positive experience that most companies had with workers logging in from home means that this practice will continue even after companies are given the all-clear to return to the office. Global Workplace Analytics estimates that 25–30 per cent of the workforce will be working from home more than one day per week by the end of 2021.⁵

Another option that companies are considering to solve the density problem is the use of co-working space. Many companies had already been relying on co-working firms as a source of flex space. This option may be less available than it once was, however, as the COVID19 crisis and the accompanying economic uncertainties have taken a heavy toll on coworking firms such as WeWork, Regus and Knotel. Those that remain once the crisis is over may find strong demand from corporate users, but they will need to reconfigure their space to include less collaboration space and fewer open work-spaces and more individual offices. They will also need to assure their corporate users that they are following appropriate cleaning and disinfecting protocols.

LESSONS LEARNED

The massive changes to which companies have had to react as a result of the coronavirus crisis have led more than a few commentators in the commercial real estate press to opine that the age of office space as we know it is over, or that real estate as a service, rather than an asset, is the wave of the future. While these pronouncements may be overstatements to a certain extent, it is clear that the pandemic has shaken up CRE as much as it has the rest of the world. Some of the early lessons include the following:

• Have a plan: For businesses seeking rent relief, a close review of lease provisions and business interruption insurance cov-erage is essential. Equally essential is the need to craft a compelling rent relief proposal for the landlord to consider. The proposal should contain both proof of how the crisis affected the bottom line and solid data on the company’s expecta-tions for recovery once the business can resume normal operations;
• Expect delays: For ongoing projects and transactions, delays should be expected and additional time should be built in to project deadlines. It is even more important than ever to track all project deadlines. If it appears that a deadline will be missed due to delays resulting from the crisis, reach out to the other side as early as possible to try to negotiate extensions;
• Require flexibility: Moving beyond the immediate crisis, the guiding principal for CRE professionals will be flexibility. Companies looking to lease new space will be seeking leases with shorter base terms, together with options to extend, or if a longer base term is unavoidable, then the option to terminate the lease early. They will be looking for options to add and/or contract space in order to adapt to unexpected changes in needs and workplace practices. Similarly, corporate users who are considering purchasing real estate will want to build flexibility into their purchase contracts by adding longer diligence periods and additional closing conditions to give them the ability to call off the deal if market conditions suddenly change;
• Keep your attorneys in the loop: Having a firm grasp of the provisions contained in its leases, construction contracts and purchase agreements can allow a company to position itself to maximum advantage when negotiating for extensions of dead-lines or monetary concessions or when looking to terminate a transaction. While the instinct of some companies may be pull back from using attorneys as a way to cut costs, keeping the company’s attorneys in the loop will allow them to anticipate issues and help craft solutions that will usually end up saving more money in the end.

REFERENCES AND NOTES

1. Internal Revenue Service (March 2020), ‘Update to Notice 2020-18, Additional Relief for Taxpayers Affected by Ongoing Coronavirus Disease 2019 Pandemic, Notice 2020-23’, available at https://www.irs.gov/pub/irs-drop/n-20-23.pdf (accessed 29th April, 2020).
2. In most purchase and sale agreements for commercial real estate in the US, a seller’s sole remedy if the buyer defaults is that the buyer forfeits its earnest money deposit.
3. National Notary Association (March 2020), ‘Notary Bulletin: States Take Emergency Action on Remote Notarization and Signers’ ID’, available at https://www.nationalnotary.org/notary-bulletin/blog/2020/03/states-emergency-action-remote-notarization (accessed 29th April, 2020).
4. CORENET Global (2020), ‘The How and When of Returning to the Office, Post-COVID-19: Key Findings from a Worldwide Member Survey’, available at https://cng.cms-plus.com/files/Coronavirus%20Return%20to%20 Office%20Survey%20Summary%20 Findings%2013%20April.pdf (accessed 29th April, 2020).
5. Global Workplace Analytics (n.d.), Work-At-Home After Covid-19—Our Forecast, https://globalworkplaceanalytics.com/work-at-home-after-covid-19-our-forecast (accessed 29th April, 2020).