Supporting Struggling Tenants

In the context of retail shopping center leases, these deal terms often include co-tenancy requirements, percentage rent, radius restrictions, and exclusive or prohibited use restrictions. Renegotiating these provisions into a landlord-favorable posture, or at least diluting their impact on the center, will make it easier for a landlord to lease other vacant space in the center.

A landlord will also want to take this opportunity to put specific monitoring rights in place to help it avoid being blindsided by the tenant's further economic distress. This will generally take the form of a gross sales reporting requirement or a requirement to provide tenant financial statements on a regular basis. While tenants that were not initially subject to such a requirement may balk, landlords would seem to have leverage in this discussion. A popular approach is frequent reporting during the deferral period (i.e., monthly), and less frequent reporting (i.e., quarterly or annually) once the entire deferred amount has been repaid in full. Again, any financial reports provided by the tenant should be certified by the chief financial officer or other appropriate corporate officer.

Getting a Clean Slate ' Estoppels and Releases

An important concession that landlords can seek in return for this rent relief is the elimination of the possibility that the tenant will bring a claim against the landlord for past transgressions. Desperate tenants may be reviewing their leases for any hook that they can find to justify rent offsets, and these often come in the form of disputes over whether the landlord has been improperly passing through common area expenses not allowed under the lease. Therefore, landlords should seek tenant estoppels similar to those obtained in favor of lenders or purchasers, and also full releases for any claims that arise from events that occurred prior to the effective date of the deferral agreement.

It's Our Little Secret ' Confidentiality

Although it is no secret to landlords that they are being approached by tenants who are in search of rent relief, many other tenants simply have not figured out that this is a possible alternative to continuing to struggle to make their rent payments, or worse, to closing down altogether. The landlord's rationale in seeking to keep the deal confidential, however, is obvious: If the word gets out that the landlord will defer rent obligations, then all tenants, regardless of need, will likely pursue a similar deal with the landlord. Also, if one tenant negotiates a particularly tenant-friendly deal, or a deep discount on rent in the short term, other tenants will use this as a barometer in negotiating their own deals.

The confidentiality provision should be absolute, and should survive the expiration or termination of the rent deferral period, and perhaps the full lease term. The teeth to this provision are tied to the acceleration provision discussed above. A violation of this provision should constitute a incurable event of default, which in turn accelerates all deferred amounts. Some landlords will even provide that a violation of this provision (or, any default under the deferral agreement) will constitute a default under the original lease, although this is less common.

Let's Call the Whole Thing Off ' Landlord Recapture Right

Almost certainly, a landlord's primary goal in granting rent deferral is not pure altruism. Instead, the landlord has made the business determination that keeping the current space open and operating benefits its asset, and the rent deferral is a means to that end. However, a landlord would undoubtedly want to kick itself if a new, more credit-worthy third party were to come along and be willing to lease the space for a rental value which exceeds the reduced rent amount and/or for a longer term. As a means of avoiding this unlucky result, landlords often demand a recapture right during the deferral period, which provides that if the tenant is unable to resume full rent payments (and fully repay any past due amounts) as required under the underlying lease, the landlord has a right to recapture the space.

Don't Forget About the Tax Man

One often overlooked aspect of rent deferral arrangements is the potential adverse tax implications for landlord. If the deal is not properly structured, the landlord may end up paying taxes on the deferred amount in the current year (i.e., on an accrual method), as opposed to when the rent is actually collected (i.e., on a cash basis). When this result is combined with the fact the landlord's own cash flow has been reduced by the rent deferrals, the impact to the landlord's bottom line in the current year is magnified.

The basis for this result is the application of ' 467 of the Internal Revenue Code. Section 467 was initially adopted in 1984 to address certain tax shelters that were designed to take advantage of cash basis tax reporting by accelerating depreciation deductions while delaying the payment of income taxes on the rental stream by pushing the rent payment obligations (and thus the collection such income) toward the end of the term. Thus, ' 467 was enacted to level such rent payments over the lease term for tax recognition purposes, thereby frustrating the taxpayer's attempt to defer taxes by recognizing the income at a later time.

To be sure, these tax shelters were the target of ' 467, not the current situation in which landlords intend to help their tenants through a rough economic patch. Nevertheless, the deferral of rent obligations until later in the lease term has a similar effect for landlords' accounting on a cash basis, and thus may trigger
' 467 treatment. The first step in determining whether ' 467 is a concern is to determine whether the lease is worth more than $250,000. If not,
' 467 does not apply at all. However, given that a lease with a 10-year term reaches this threshold if the average monthly rent obligation is in excess of $2,084, many leases will not be able to avoid ' 467 by reason of the $250,000 de minimus rule. Assuming the lease in question exceeds the $250,000 threshold, the next part of the analysis is to determine whether the deferred rent obligations are not required to be repaid until more than one calendar year after the year in which the obligation was originally intended to accrue under the original rent schedule. Under such circumstances, ' 467 becomes a concern, and it is advisable to include a provision in the deferral agreement coordinates the parties' tax reporting so as to minimize any adverse impact of ' 467.

Conclusion

In these trying economic times, landlords will undoubtedly be forced to make concessions in order to protect the value of their assets. In the face of “judgment-proof” tenants and low demand for vacant space, rent deferral agreements have become a popular vehicle for staving off financial collapse. Whether these deals pan out, and tenants rebound sufficiently to make good, remains to be seen, but the thoughtful landlords who are in a position to support these struggling tenants in the short term can offer a deferral arrangement which also protects landlord against some of the immediate down-side risk.

Kevin Corbett is a Partner in the California firm of Horner & Singer, LLP. Mr. Corbett Practices commercial real estate and corporate law. His commercial real estate practice includes representation of developers, owners, investors, and tenants in commercial transactions.

The first part of this article discussed four factors that a landlord should consider when negotiating rent deferral for a struggling tenant: verifying financial distress, lender requirements, short-term relief, and landlord acceleration rights. The conclusion herein addresses the remaining four points.

Improving the Original Deal

Since a landlord that is granting a rent deferral is relieving a tenant from its most fundamental lease obligation (i.e., timely rent payment), landlords often consider this an opportune time to revisit deal terms that they may not have been successful in obtaining during the initial negotiations. Thus, rent deferral agreements often revise other core deal terms.

In the context of retail shopping center leases, these deal terms often include co-tenancy requirements, percentage rent, radius restrictions, and exclusive or prohibited use restrictions. Renegotiating these provisions into a landlord-favorable posture, or at least diluting their impact on the center, will make it easier for a landlord to lease other vacant space in the center.

A landlord will also want to take this opportunity to put specific monitoring rights in place to help it avoid being blindsided by the tenant's further economic distress. This will generally take the form of a gross sales reporting requirement or a requirement to provide tenant financial statements on a regular basis. While tenants that were not initially subject to such a requirement may balk, landlords would seem to have leverage in this discussion. A popular approach is frequent reporting during the deferral period (i.e., monthly), and less frequent reporting (i.e., quarterly or annually) once the entire deferred amount has been repaid in full. Again, any financial reports provided by the tenant should be certified by the chief financial officer or other appropriate corporate officer.

Getting a Clean Slate ' Estoppels and Releases

An important concession that landlords can seek in return for this rent relief is the elimination of the possibility that the tenant will bring a claim against the landlord for past transgressions. Desperate tenants may be reviewing their leases for any hook that they can find to justify rent offsets, and these often come in the form of disputes over whether the landlord has been improperly passing through common area expenses not allowed under the lease. Therefore, landlords should seek tenant estoppels similar to those obtained in favor of lenders or purchasers, and also full releases for any claims that arise from events that occurred prior to the effective date of the deferral agreement.

It's Our Little Secret ' Confidentiality

Although it is no secret to landlords that they are being approached by tenants who are in search of rent relief, many other tenants simply have not figured out that this is a possible alternative to continuing to struggle to make their rent payments, or worse, to closing down altogether. The landlord's rationale in seeking to keep the deal confidential, however, is obvious: If the word gets out that the landlord will defer rent obligations, then all tenants, regardless of need, will likely pursue a similar deal with the landlord. Also, if one tenant negotiates a particularly tenant-friendly deal, or a deep discount on rent in the short term, other tenants will use this as a barometer in negotiating their own deals.

The confidentiality provision should be absolute, and should survive the expiration or termination of the rent deferral period, and perhaps the full lease term. The teeth to this provision are tied to the acceleration provision discussed above. A violation of this provision should constitute a incurable event of default, which in turn accelerates all deferred amounts. Some landlords will even provide that a violation of this provision (or, any default under the deferral agreement) will constitute a default under the original lease, although this is less common.

Let's Call the Whole Thing Off ' Landlord Recapture Right

Almost certainly, a landlord's primary goal in granting rent deferral is not pure altruism. Instead, the landlord has made the business determination that keeping the current space open and operating benefits its asset, and the rent deferral is a means to that end. However, a landlord would undoubtedly want to kick itself if a new, more credit-worthy third party were to come along and be willing to lease the space for a rental value which exceeds the reduced rent amount and/or for a longer term. As a means of avoiding this unlucky result, landlords often demand a recapture right during the deferral period, which provides that if the tenant is unable to resume full rent payments (and fully repay any past due amounts) as required under the underlying lease, the landlord has a right to recapture the space.

Don't Forget About the Tax Man

One often overlooked aspect of rent deferral arrangements is the potential adverse tax implications for landlord. If the deal is not properly structured, the landlord may end up paying taxes on the deferred amount in the current year (i.e., on an accrual method), as opposed to when the rent is actually collected (i.e., on a cash basis). When this result is combined with the fact the landlord's own cash flow has been reduced by the rent deferrals, the impact to the landlord's bottom line in the current year is magnified.

The basis for this result is the application of ' 467 of the Internal Revenue Code. Section 467 was initially adopted in 1984 to address certain tax shelters that were designed to take advantage of cash basis tax reporting by accelerating depreciation deductions while delaying the payment of income taxes on the rental stream by pushing the rent payment obligations (and thus the collection such income) toward the end of the term. Thus, ' 467 was enacted to level such rent payments over the lease term for tax recognition purposes, thereby frustrating the taxpayer's attempt to defer taxes by recognizing the income at a later time.

To be sure, these tax shelters were the target of ' 467, not the current situation in which landlords intend to help their tenants through a rough economic patch. Nevertheless, the deferral of rent obligations until later in the lease term has a similar effect for landlords' accounting on a cash basis, and thus may trigger
' 467 treatment. The first step in determining whether ' 467 is a concern is to determine whether the lease is worth more than $250,000. If not,
' 467 does not apply at all. However, given that a lease with a 10-year term reaches this threshold if the average monthly rent obligation is in excess of $2,084, many leases will not be able to avoid ' 467 by reason of the $250,000 de minimus rule. Assuming the lease in question exceeds the $250,000 threshold, the next part of the analysis is to determine whether the deferred rent obligations are not required to be repaid until more than one calendar year after the year in which the obligation was originally intended to accrue under the original rent schedule. Under such circumstances, ' 467 becomes a concern, and it is advisable to include a provision in the deferral agreement coordinates the parties' tax reporting so as to minimize any adverse impact of ' 467.

Conclusion

In these trying economic times, landlords will undoubtedly be forced to make concessions in order to protect the value of their assets. In the face of “judgment-proof” tenants and low demand for vacant space, rent deferral agreements have become a popular vehicle for staving off financial collapse. Whether these deals pan out, and tenants rebound sufficiently to make good, remains to be seen, but the thoughtful landlords who are in a position to support these struggling tenants in the short term can offer a deferral arrangement which also protects landlord against some of the immediate down-side risk.

Kevin Corbett is a Partner in the California firm of Horner & Singer, LLP. Mr. Corbett Practices commercial real estate and corporate law. His commercial real estate practice includes representation of developers, owners, investors, and tenants in commercial transactions.