As the end of 2022 approaches, market conditions are significantly different than they were a year ago. And while that may only stoke the urgency for some to wrap up deals, others are asking about their options. In Deloitte’s 2023 Commercial Real Estate Outlook, most respondents (40.7%) said they thought commercial real estate transaction activity would improve in 2023; however, a close 37.1% said they thought it would worsen with 22.2% anticipating no change. And no change isn’t necessarily a positive sentiment. Because at present and amid uncertainty, some parties are even inquiring about the b word: breach.
But before reaching the brink, it’s important to consider options aside from walking away and ways to avoid such ultimatums in future contracts.
When people do start looking for a way out, whether in a lease or purchase agreement, it’s typically due to three pain points, according to Joshua Gorsky, a partner in the real estate practice at Mandelbaum Barrett PC: inflation, rising interest rates and the remnants of the pandemic. “You’re having these supply chain issues, the unavailability of materials for development, the raw materials, the wood, the lumber, the cement, the steel, and the cost of the materials are going up as well” he told NJBIZ.
For leases, there are a handful of reasons why a tenant may try to walk away. For instance, skyrocketing rents along with higher overall costs. If a tenant’s rent increases are tied to upticks in the consumer price index (CPI) it could be enough to price them out of their space. Additionally, those pesky supply chain delays and higher materials costs could also be keeping properties from being built out in time. “So, when the parties enter into the agreement initially, they budget certain amounts of money and certain timeframes for when those improvements can be completed,” Gorsky said. “And there are consequences [varying from penalties to rent to payments commencing even if the tenant can’t occupy] if the improvements are not completed within those periods of time.”
Another complaint cropping up from tenants when it comes to leaving leases: “They’ve signed them and they haven’t occupied, and their business is no longer viable,” Gorsky said. “The market has changed. The demand for their business has changed.”
There are few easy answers to those issues – and a lot depends on a landlord’s cooperation, according to Gorsky. But a “break up” is possible if both parties agree to terminate the lease, though the surrender or early termination agreement will typically involve a payment from the tenant to the landlord. A tenant could also look to dump the landlord, so to speak, employing counsel to review a current contract for potential breaches.
“Another option is to try and renegotiate the lease,” Gorksy said. Again, this route takes a landlord being on board, however, it also presents an opportunity. Landlords are not immune to market shifts, and if rents have skyrocketed for a tenant that perhaps didn’t have a CPI cap negotiated into their contract prompting them to try to get a lower rate, it could be there’s something the other side wants, too. “Maybe we can extend the term, maybe we can move to a smaller space in the building or give up some of the space to lower the rent that maybe we don’t need anymore,” Gorsky suggested. “But try and work it out on amicable terms that doesn’t result in a termination per se, just in a change of the lease that is somehow mutually beneficial.”
Such a course also requires landlord consent, but tenants can try to assign the lease to someone else who does want – and can afford – the space, or sublease a portion to offset rental costs, Gorsky said.
If you are feeling the burn, it’s important to keep current conditions, and lessons learned, in mind for new negotiations. Like getting that rent cap. “Even if you have to tie it to CPI or tie it to inflation, make sure you have a cap that you could live with,” Gorsky said.
“Try and see if you could get a fair market value reset in the rent to … kind of rebalance things…. Just because the rates are going up and inflation is up and the CPI is up, doesn’t necessarily mean that that’s the market rent now,” he continued. “So, you know, the idea that you can reset and go back to market after certain intervals of the lease may be valuable in times of uncertainty.”
Another strategy is to strive for shorter term lengths. “Instead of negotiating a 10-year term, you negotiate a five-year term with a five-year option, and you try your best to break up the longer lease terms,” Gorsky said. There are no guarantees, however it could help to try to mitigate some of the factors that are hurting tenants today and to try to find flexibility when things are out of your control.
Lease agreements aren’t the only contracts being squeezed. When it comes to why someone may want to walk away from a purchase, more often than not it leads back to the fact that the numbers don’t make sense anymore, Gorsky said.
As interest rates rise, a deal that had been attractive to a buyer at the start of the process loses its luster because the money to purchase is now itself more expensive. Supply chain delays and rising costs are prompting reassessments at some development and redevelopment projects, Gorsky said. “The cost of materials is going up, the timing is going up, the unavailability of materials is going up and having to take down a rehabilitation project or a development project just doesn’t make sense from a financial standpoint anymore.”
And some people just get cold feet, particularly as recession worries hang in the air. “It’s more the inconsistency from the budget and how quickly things have moved from offer to closing,” Gorsky said. “Something changed in that month, two-month, three-month period that changed everything.”
The easy way out is offered during the due diligence period, which in most commercial contracts gives the buyer an opportunity to terminate the deal. “So, provided that the due diligence period is long enough to allow them to do their homework and to capture whatever the change in the market was that is causing them uncertainty, you either terminate … or you renegotiate,” Gorsky said.
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He added that in today’s market, that latter route isn’t uncommon. With market fluctuations changing costs for purchasers, sellers are also eager to see deals go through.
If the cost of debt is prohibitive, Gorsky suggests that a potential solution is for the seller to hold back some of the debt. “Perhaps the seller can finance this purchase and offer you terms for conditions that are better than the market in the spirit of getting the deal done,” he said, pointing out that it may not be a fit for every deal because the seller may also need that money to pay off their own debt.
If you do make it through due diligence but are still looking for an exit, Gorsky said that as in the leasing scenario, buyers and sellers can agree to break up. However, that route really doesn’t offer much leverage to the buyer. “And unless you’re looking for something in the deal of the property that could get complicated — you’re at the mercy of the seller coming to an agreement,” he said. “The only leverage the buyer has against the seller in that context is if it goes into litigation after a breach, then the seller for a period of time while the litigation is ongoing, won’t be able to sell it to anybody else because it’s trapped in litigation.
“So buyers with a strong appetite and a strong will and a strong stomach may have more leverage there than buyers that don’t have that,” he added.
Looking ahead to your next deal, you can try and extend the due diligence period, Gorsky said, or you can try to identify buyer-specific concerns: Are they really worried about the cost of debt? Are they really worried about the interest rates? If you know what those pain points are, you can try and insert targeted contingencies into the contract. As a buyer, it also helps to be aware of provisions in a contract that could be used against you if you think you may want to get out.
As the market continues to affect the velocity and volume of deals making it over the finish line, getting ahead of contract snafus could help ease the process for all parties, and work out a deal that better suits everyone amid that uncertainty.
“If you’re looking to default, you probably shouldn’t sign the contract in the first place,” Gorsky cautioned. “[B]ut if you want to try and mitigate certain damages … you can start to pay attention to these things and make it less painful on the way out if you think that’s a possibility.”