What’s the Risk?
COVID-19 has fundamentally impacted commercial leasing by changing the basic calculation behind pandemic risk allocation.
After more than a year since the world first learned of COVID-19, landlords and tenants, as well as their investors, managers, and lenders, are continuing to deal with the ravages of the pandemic on their assets and businesses. In commercial leasing, what began with short-term rent deferrals has given way to rent abatements and term extensions. Temporary shutdowns have led, in some cases, to shuttering, and bankruptcies abound. Now, with summer fast approaching, there is an expectation that vaccine supplies will surge as businesses start leasing new space in earnest again.
How will the pandemic alter commercial leasing from the standpoint of risk allocation? We are already hearing accusations during lease negotiations that one side or the other is engaging in “pre-pandemic” thinking. Leasing policies and forms of owners and occupiers alike are being reviewed and updated as decision-makers consider how best to approach pandemic-related risks — and other risks beyond their control, for that matter — in the future. Obviously, the development of widely available, affordable insurance or governmental safety nets to mitigate epidemic-related risks would impact lease negotiations in the long term, but that remains to be seen and new lease deals are happening now.
Fundamentally, a lease is a long-term agreement where the parties' interests are, for the most part, not aligned, so virtually every provision involves a risk allocation. The pandemic has forced the commercial real estate industry to take a deep dive into some of its lease boilerplates. The force majeure clause has been spotlighted during the pandemic. The most common iteration provides for an extension of the time periods for a party to perform its lease obligations if the party's ability to perform is impacted by certain causes beyond its control. The scope of force majeure clauses varies and often has exceptions. In addition, these clauses may do more than delay or suspend performance — they may relieve a party of its obligations where performance is prevented due to causes beyond its control.
In new leases, tenants will likely be unwilling to take the risk of pandemic-related delays.
From the landlord's perspective, the tenant should be allocated all property ownership risks with respect to its premises during the lease term. Landlords will likely continue to see pandemic-related types of risks as beyond the control of the parties and falling under force majeure clauses. Landlords will argue that these are risks of doing business, not risks of property ownership. Many landlords are updating their lease forms to place the risk of pandemics more directly on tenants. Moving forward, force majeure provisions will expressly include pandemics, illnesses of lesser proportions, governmental orders related to those situations, and other public emergencies — without relieving the tenant from its monetary obligations under the lease during pandemic-related impacts.
In addition, some landlords are broadening the releases and waivers in their lease forms to have tenants waive claims associated with the pandemic, such as those over a tenant's lack of access to its premises, an inability to operate due to pandemic-related governmental orders, and measures taken by the landlord during and in the aftermath of pandemics, such as shutdowns, safety protocols, and reopening restrictions.
From the tenant's perspective, risks should be adjusted on a cost-benefit basis to avoid inequitable allocations and to accord the landlord risks that the tenant views as inseparable from property ownership or as being included in the fixed rent. In new leases, tenants will likely be unwilling to take the risk of pandemic-related delays in the delivery of possession, construction, and the opening of their businesses in the leased space.
Tenants will argue that they should not bear 100 percent of the risk of future pandemics. They will not want to pay rent when they are unable to fully utilize their premises. Many tenants will propose lease provisions where pandemic-related interruptions in their use of the premises trigger rent abatement and, if interruptions are prolonged, allow the tenant to terminate the lease. Other tenants may address pandemic risks in a less direct way. They may seek greater flexibility in lease terms — shorter terms with more extension options or longer terms but with early termination options.
Generally speaking, the underpinning of risk allocations in a negotiated commercial lease is to create a fair allocation of anticipated risks among the parties. Casualty, condemnation, and service interruption provisions in a typical lease address the allocation of risks beyond the parties' control in a more balanced way than the “all or none” approach of the force majeure clause. Some landlords and tenants, especially in the sectors hardest hit by the pandemic, are negotiating to share pandemic-related risks.
Some landlords may decide to formalize a rent deferral right in leases that allow tenants an option to take rent deferral under certain circumstances.
Negotiations center on the scope of risks, as well how those risks will be shared. For example, the parties may agree to limit shared risks to governmentally imposed restrictions due to pandemics or public emergencies. On the allocation issue, the parties may agree that, in the case of a restaurant as an example, a required closure will afford a 50-percent rent abatement while density impacts might result in proportionally less abatement (measured either by the reduction in permitted density for in-person dining or by the impact of the restriction on the tenant's revenues or some combination of factors). Some parties are being more creative — or tortured, depending on your viewpoint — with the tenant taking closure risk for the first 30 days of impact during any given year (no fixed rent abatement), the landlord taking the next 30 days (100 percent fixed rent abatement), and the parties sharing that risk (50 percent fixed rent abatement) if closures run longer than 60 days during any year.
Some landlords may decide to formalize a rent deferral right in leases that allow tenants an option to take rent deferral under certain circumstances with the landlord's reasonable consent and after various submissions and required metrics are met, with preset repayment terms. Similarly, landlords also might consider having an early force majeure extension option with preset rent abatement that can be taken immediately if the tenant meets certain requirements. Having provisions that provide a roadmap for the type of abatement and deferral arrangements seen over the last year have the added advantage of creating more certainty among landlords and tenants. They can also help landlords and their lenders and servicers navigate how best to handle such situations in the future.
What is clear — it will be difficult for parties to come to any kind of industrywide consensus on the best way to address pandemic risk in a commercial lease in the near term. There are, and will be, lease negotiations over this risk allocation and, as with any other issue, its resolution will depend on the parties' leverage and what each side sees in the long-term economic and operational impact of the pandemic and the likelihood of facing similar challenges again. As parties debate whether and how to share future pandemic-related risks in commercial leases, everyone at the table will share the hope that we never see another pandemic like COVID-19 in our lifetimes.
(Disclaimer: This article provides a general summary and is for information/educational purposes only. It is not intended to be comprehensive, nor does it constitute legal advice. Specific legal advice should always be sought before taking or refraining from taking any action. The opinions of the author do not necessarily reflect those of Bryan Cave Leighton Paisner LLP or its members.)