By Ruth Colp-Haber

Law360 (July 9, 2020, 6:15 PM EDT) --

Ruth Colp-Haber

There have been many articles regarding the future of the office. Pundits are speculating about its new form and whether the office will even survive the coronavirus pandemic. We suspect the office will survive in an improved form, but these passing concerns may be missing the forest for the trees.

The real revolution that may be taking place is in the relationship between landlords and tenants. Virtually all of the legal commentators have opined that the tenants who have been unable to use their offices for months due to the pandemic are still liable for the rent under those leases.

Consider the absurdity of the present situation. In what other commercial transaction are people required to pay for services that are impossible due to government order or at the very least dangerous to use? Good luck getting paid in any other business for goods and services that are not provided. Accordingly, tenants are understandably enraged.

Landlords, faced with their own ongoing costs of operations, employees, taxes and debt service obligations are understandably worried and defensive. And as commercial and residential rent payments are missed, the risk to the banks and the collateralized mortgage-backed securities market will rise if present trends continue.

You have may have noticed a recent New York Times article,[1] which discussed a regional office leasing broker who was roundly criticized in the industry for offering assistance to tenants and attempting to renegotiate their leases. 

Due to the crisis, the real estate world has been turned upside down and the leverage has been totally flipped. Previously, New York City landlords in quality buildings were accustomed to sitting back and receiving over $100 per square foot for space as tenants bid up the price.

Today, no tenant wants to be the first to go back to the office and they are all rethinking their plans as they evaluate their options for working remotely while wrestling with safety and liability issues. This has put shocked landlords on the back foot. Businesses do want to get back to office work in some fashion, but the question is when and how.

Further, it is becoming increasingly clear that tenants are not going to be caught flat-footed again. As a result, the terms of office leases are changing as tenants are wising up and asserting their rights. Some of the potential changes to leases are the following.

1. Tenants are demanding shorter and more flexible leases with the right to cancel.

WeWork Co. Inc. started that trend, and it will accelerate. Understandably, tenants are balking at entering into five and even 10-year commitments when (1) the future of their businesses and (2) the value of their leases should they have to sublet the premises are so uncertain.

2. As a corollary, tenants do not want to be locked into unrealistically high future rents in the later years of their leases.

Accordingly, there is much discussion about pegging rents to a market basket of rents in comparable buildings via a formula such as an average.

For example, the landlord and tenant could select five buildings in the same market with similar characteristics as the space in question and take the average or median rent per square foot of those five buildings with consideration given to amenities and office floor for future rent years. In another example, many real estate investment trusts are now public, so their average or median rent per square foot for a city could be a reference point. Obviously, should rents rise that will be a function of a stronger economy, but with a formula tenants will be protected on the downside if the recession persists.

3. Percentage rent based upon transparent metrics (sometimes used in retail) may now be incorporated into office leases.

Of course, this would be dependent on a particular industry's norms as a percentage of (1) gross revenues or sales or (2) income. The percentage rent component could represent all or just part of the monthly rent.

This would require a deep dive into the tenant's financials by the landlord. However, different times require landlords to adapt. For example, Brookfield Properties Corp. has raised a $5 billion fund to invest in the equity of tenant businesses to keep them from going bankrupt. Landlords need to view their tenants as business partners, not just cash cows to be milked.

4. Reset provisions offering lower rents if the market changes after a fixed period of time.

This is a variation on the second change discussed above. If the recession persists, tenants should be able to pay lower rents. Landlords may view this as heretical, but tenants should not be locked into below market leases just because rents in future years almost go down.

 5. Protection or insurance for tenants in the event of a pandemic or other natural disaster so that they do not have to pay rent.

This is straightforward. In the event of a pandemic, tenants should be allowed to a pay either no rent or a reduced rent. As an alternative, insurance could be purchased to cover the rent under the lease in the event of a pandemic or disaster so tenants don't have to go out of pocket.

Conclusion

Renters of the world unite, you have nothing to lose but your gains.

Please forgive this uncharacteristic foray into revolutionary rhetoric. Perhaps it is a function of three months of inactivity in the office leasing market. But when James Gorman, CEO of Morgan Stanley & Co. LLC, says his company can make do with less of its very expensive office space, he means it. Make no mistake — the days of landlord hegemony are over.

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Ruth Colp-Haber is president and CEO at Warton Property Advisors Inc.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, Inc., or any of its or their respective affiliates. This article is for general informational purposes and is not intended to be and should not be taken as legal advice.

[1] https://www.nytimes.com/2020/06/05/business/economy/coronavirus-commercial-real-estate.html.

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