Southeast Real Estate Advisor : Atlanta Real Estate Lawyer & Attorney : Kevin Caiaccio Law Firm : Commercial Development, Retail Leasing : Buckhead, Sandy Springs, Georgia

This morning I attended a breakfast seminar sponsored by the Atlanta Bar Association entitled "Leasing Issues in Today's Economy."  The panelists were three prominent Atlanta leasing attorneys:  Jonathan Neville of Arnall Golden Gregory, Robert Stanley of Stanley, Esrey & Buckley, and David Kitchens of Kitchens Kelly Gaynes.

The discussion centered on current issues in retail leasing.  The panelists did an excellent job of highlighting issues from both the landlord and tenant perspective. 

Here are some of the takeaway bullet points from this informative seminar:

• For a tenant seeking rent relief in this market, short-term relief is often a more viable option.  Longer term rent relief is less palatable to the LL due to the detrimental effect it has on the shopping center's value.
• A tenant seeking rent relief should be current on its rent when approaching the LL.  Many institutional LLs have a policy against negotiating with tenants who are behind on rent.
• Tenant improvement allowances are a hot topic in lease negotiations.  Because so many LLs are struggling, the tenant must protect itself from a LL who is unable make a TI payment.  The tenant should insist on either having the TI dollars escrowed with a third party and/or the right to offset unpaid TI from future rent payments.
• Co-tenancy clauses continue to be a point of contention in negotiations and are frequently being litigated.  (See my recent post on this topic.)
• Due to the increasing number of foreclosures, it is more important than ever for tenants (even smaller tenants) to insist on a subordination, non disturbance and attornment agreement (SNDA) with the LL's lender.  This will protect the tenant's rights under the lease in the event the lender becomes the owner through foreclosure.

The current economic climate continues to drive lease negotiations in many ways.  Not only is the leverage shifting in favor of creditworthy tenants, but certain issues have become increasingly important as both landlords and many tenants continue to struggle financially.

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There seems to be conflicting reports concerning whether the proposed tax increase on carried interests remains alive in Washington.  The proposal passed the House in December, and its fate is now in the hands of the Senate.  According to reports last week, the proposal appeared to be dead for this session.  However, the Administration's budget released just this morning includes this tax increase.

The issue is whether carried interests should continue to be taxed at the lower capital gains rate (as they are under current law), or taxed at the higher rate for ordinary income.  If passed, the bill could more than double the tax liability for real estate professionals who are compensated with a promoted interest in a partnership or LLC.  

The proposal originally gained popularity after reports of hedge fund managers who made enormous sums of money and were being taxed at a lower rate than ordinary working Americans.  While most of us are unsympathetic to wealthy hedge fund managers, the problem is the unintended effect that this tax increase would have on the real estate industry.  Many real estate ventures, both large and small, are structured such that the promoters receive a carried interest in exchange for know-how and sweat equity.  

As noted in this ICSC report , compensation of real estate managers is fundamentally different from hedge funds and private equity.  In the case of RE promoters, the income from a carried interest is not guaranteed, and there is often a longer hold time before any profits are realized.  Moreover, the promoters are often required to incur contingent liabilities in the form of loan guarantees. 

As a matter of public policy, the proposed tax increase comes at a terrible time.  Commercial real estate is already struggling, and this bill would create a disincentive for further risk taking and could lower property values even further.

If policymakers intend to help stem the decline in CRE markets and the resulting damage to the overall economy, this bill should be voted down or amended to limit its applicability to fund managers.

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As I wrote back in November, the dramatic fall in real estate values is leading to litigation  involving confirmation proceedings after a non-judicial foreclosure.  Under Ga. law, a creditor is allowed to foreclose on real property without a court hearing or other judicial action.  However, if the lender claims that the foreclosure sale did not fully satisfy the debt obligation and seeks to recover the deficiency, the lender must file a confirmation action which requires a court hearing and testimony as to the fair market value of the property.

The Ga. Court of Appeals issued an opinion earlier this month in Statesboro Blues Development, LLC v. Farmers and Merchants Bank (PDF) which reiterates the deference given to the trial court in determining fair market value.  The case involves a very typical scenario in Georgia:  the borrower purchased a large acreage tract with the intention of developing the property for single-family home lots.  After the residential  market collapsed, the borrower defaulted.  At the time of default, the outstanding loan balance was over $3.5MM.  The bank was the sole bidder at the foreclosure sale (as is usually the case) and bid $2.915MM.  After the foreclosure, the bank sought to recover the deficiency from the borrower and guarantors.

At the hearing, the borrower contested the bank's appraiser's use of comparable sales and his estimate of development costs.  The trial court accepted the appraiser's calculations and found for the bank.  On appeal, the court reiterated Ga. law:  “The trial court is the trier of fact in a confirmation proceeding, and an appellate court will not disturb its findings if there is any evidence to support them.”  Because the trial court found in favor of the bank, the court of appeals held:  "it appears that the opinion is not based on sheer speculation, then this court cannot second guess the methodology utilized to reach the opinion.”

The upshot for future litigation is that the ruling of a trial court will not often be overturned.  The trial court judges are relying on appraisers who are often guessing at fair market value.  The result will be inconsistent rulings based on the leanings of the appraisers and the judges.  In other words, borrowers can only hope for friendly judges.

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A recent report in the WSJ details the FDIC's efforts to sell off real-estate loans acquired from failed banks.  This describes on a larger scale transactions which have become quite common in the Southeast as community banks and regional lenders unload unwanted assets.  

In fact, most CRE trading today involves distressed assets-either REO properties or note sales.  This trend will likely grow in 2010 as more lenders work through problem assets.  These transactions create opportunities for investors as properties trade at a fraction of the prices seen at peak levels, oftentimes at discounts up to 40 or even 60%. 

But these opportunities come with increased legal risks.  Because of the fire-sale prices, the sellers are demanding (and receiving) quick closings with very short due-diligence periods and few if any representations or warranties which survive closing.  As a result, buyers should take several steps to mitigate the increased risks:

• First, insist on certain basic reps and warranties:  disclosure of borrower defaults, loan balances, and at the most basic level, that the seller owns the note and has the authority to sell.  (See this Bryan Cave report for more detail on seller reps in a note sale.)
• Second, be prepared to move quickly on due diligence.  Buyers should make best efforts to perform the same level of due diligence as in a non-distressed transaction.  One potential advantage is access to the lender's due diligence files.  Insist on this access as early as possible.  But do not agree to a due diligence period that is unrealistically short.
• Third, due to the distressed nature of the asset, pay particular attention to the possibility of past-due taxes and utility bills.  These liabilities will become the responsibility of the buyer after closing.
• Fourth, review the lender's documents and files critically.  The stress in RE markets is revealing that many lenders were often sloppy in their underwriting and due diligence.  Do not assume that the documents are correct, enforceable, or free of defect.  Also, look for correspondence or documentation that could allow the borrower to claim that the loan terms have been modified.

From the seller's perspective, the timing with oftentimes be the primary motivation.  The lenders will generally want non-performing assets off the books by the end of a month or fiscal quarter.  In exchange for meeting these deadlines, a seller may make other concessions. 

Buyers with an understanding of the increased risks, along with the ability to mitigate these risks and close quickly, will find incredible opportunities to profit from the current downturn in CRE.

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As more retail tenants file for bankruptcy and close shop, surviving tenants in strip centers and malls are increasingly invoking co-tenancy provisions in their leases to pay reduced rent. 

Under a co-tenancy clause, which is a common provision found in many retail leases, a tenant is entitled to either pay reduced rent (typically based on gross receipts), or even terminate their lease, if an anchor tenant or a specified number of smaller tenants close for business and are not replaced by a comparable tenant or tenants within a specified cure period.

Co-tenancy clauses can create a domino effect in a retail center and are causing increased pain for landlords at a time when rents are continuing to fall. Savvy tenants are paying close attention to their co-tenancy clauses in an effort to cut fixed costs as sales continue to slide.  A website, www.co-tenancytrack.com, is assisting tenants in these efforts.  As a result, landlords must identify and work with tenants whose leases include a co-tenancy provision.

A recent Georgia Court of Appeals decision, Rainbow USA, Inc. v. Cumberland Mall, LLC (PDF),  highlights the complexity involved in drafting a co-tenancy clause for Georgia landlords.  In Rainbow, two department stores in Cumberland Mall closed, and the tenant invoked its right under the lease to pay 6% of gross sales in lieu of minimum rent.  The landlord subsequently demolished the JC Penny premises and later constructed a Costco warehouse in a free-standing one-level building adjacent to the mall.  The landlord then sought to return the tenant's rent to the pre-violation level.   On appeal, the court reversed the trial court and held in favor of the tenant .  The court reasoned that because the Costco was a free-standing building, it constituted an outparcel rather than a replacement tenant "in the shopping center."  Therefore, the construction of the Costco store did not remedy the co-tenancy violation created by the closing of the mall anchors.

As indicated by the court's analysis in Rainbow, co-tenancy clauses are often lengthy and complex, and the outcome in any given situation will depend on the specific wording found in the lease.  Because tenants have the leverage in the current economic climate, landlords in lease negotiations must attempt to limit their exposure in the event of a co-tenancy violation.  Specifically, there are several ways in which a landlord may accomplish this:

1. The landlord should have an adequate period of time (e.g., 90 days) to cure the violation before the tenant may invoke its remedies. 
2. There should be certain conditions that must remain satisfied while the tenant is paying reduced rent, such as the tenant remaining open for business (in order to mitigate further losses due to co-tenancy violations) and the tenant complying with the other terms of  the lease.
3. The lease should limit the length of time that the tenant may pay reduced rent.  A typical provision may require the tenant to either terminate the lease or resume paying full rent within 12 months of the violation.  (Although in the current environment, tenants may demand-and receive- longer periods of reduced rent.)
4. The right to pay reduced rent should be waived if the tenant exercises a right to extend the lease term while the violation exists.

In today's environment, co-tenancy clauses will continue to be put to the test.  Because numerous variables are involved in these provisions, each tenant will have varying rights and remedies depending on the specific wording of their leases.  Many landlords may find that the outcome of these co-tenancy negotiations will be the tipping point in determining whether the landlord survives the current downturn. 

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According to a recent article in the Atlanta Business Chronicle, "$3.7B in CMBS coming due from 2010 to 2012," approximately $3.7 billion in CMBS loans will mature in the Atlanta market alone between now and the end of 2012.  This provides a local perspective on a problem playing out nationwide.  The CMBS market is not functioning, and as the outstanding loans mature, financing is not currently available. 

The striking point about this problem is that there has been no concrete suggestions concerning where liquidity will be found.  According to William Boston's article in the Wall Street Journal, there is some indication that overseas investors will view depressed real estate prices and a weak dollar as an opportunity to purchase U.S. assets at bargain prices.  But so far, this hope seems to be based mostly on speculation and anecdotal evidence.  There has been much talk about the government’s proposed TALF program and whether it will help fill this void. Initial reports indicate that the program is off to slow start.

Unless liquidity returns to debt markets for CRE, it appears that many assets financed by CMBS loans will be turned over to special servicers.  And in fact, this is already occurring and accelerating at an alarming pace according to some reports.  (To see how this process plays out, see Joel Ross' article from hotelnewnow.com.)  What we will likely see is that special servicers will have to get creative in dealing with distressed assets.  Much remains unknown concerning how this process ultimately will play out . 

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Amongst the drumbeat of bad news and dire predictions, I enjoyed a recent article on Retail Traffic for its fresh perspective ("Commercial Real Estate Debt Won't Be the Next Shoe to Drop, Economists Say").  Many commentators have predicted that commercial real estate loan defaults will be the "next shoe to drop" on a economy struggling to find its footing in a fledgling recovery. 

The Retail Traffic article cites economists who predict that the impact of CRE loan defaults will not be as widespread as the fallout from residential mortgages.  Without a doubt, problems lie ahead in commercial real estate, principally from the lack of affordable debt financing at reasonable levels of leverage, but the fundamentals underlying CRE will ultimately be driven by the health of the economy.  As unemployment slowly moderates and consumer spending falls into a more normal and sustainable pattern, commercial properties, including multi-family and retail, as well as office, will gradually find their footing.

This report at least hold out some hope that the CRE issues should not have the same degree of impact as the residential crisis.

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Given the dramatic drop in commercial real estate values over the past two years, many borrowers are finding that their loan balances exceed the value of the property at the time of a default.  As a result, there has been an increase in litigation surrounding confirmation proceedings after a non-judicial foreclosure.

Under Georgia law, a creditor who forecloses on real property is barred from seeking a deficiency judgment against the borrower and guarantors unless the creditor files an application for confirmation within 30 days of the date of the foreclosure sale.  There are only two issues in a confirmation proceeding:  (1) whether the sale was properly conducted (i.e., in compliance with legal requirements concerning notice and conduct of sale), and (2) whether the property sold for fair market value.  Most of the cases which are litigated deal with the second issue.  Specifically,  the creditor must show in a confirmation proceeding that the property sold for fair market value.

Concerning the determination of fair market value, recent Georgia appellate cases have held as follows:

• The deduction of carrying costs and a bulk-sale valuation of multiple lots are permissible.  Trefren v. Freedom Bank of Ga (PDF)
  
• The deduction of completion costs and lost rents during construction are allowed.  Nash v. Compass Bank (PDF)
• A deduction due to the fact that the properties were in foreclosure is not permissible. Cartersville Developers, LLC v. Georgia Bank & Trust (PDF)

These recent cases reiterate that the appellate court will give great deference to the trial court in weighing the evidence of fair market value.  Borrowers defending a confirmation action must be prepared to submit evidence refuting the lender's calculation of fair market value.  The case law indicates that on appeal the court will not overrule the trial judge's ruling if decided on any rational basis. 

Because of the challenges in setting values and the broad discretion afforded to the trial courts, it will be interesting to follow the trends in the court rulings as more confirmation proceedings are contested in the current real estate market.

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