New Normal, New Challenges for Commercial Tenant Leases and Occupancy Cost

Editor’s note: Rick will be presenting a webinar on this content as part of NRTA’s “New Challenges, New Normal” curriculum webinar series. This webinar is scheduled for June 24, 2020, from Noon – 1:00 PM EDT. Please visit our Webinars page for forthcoming webinars and registration details.

Rick Burke, President
Lease Administration Solutions, LLC
www.LeaseAdminSolutions.com

As the nation slowly returns from shelter-in-place restrictions, many commercial tenants will find new challenges with the new normal. Prior to the pandemic, retail tenants were already under pressure from online shopping, and landlords had been experiencing increased vacancies in all areas including malls and strip centers. Landlords have been scrambling to fill those vacancies with tenants that are less affected by online competition such as restaurants, movie theaters, gyms, office space, and other destination venues. However, these are now the tenants most devastated by the pandemic.

In addition to competitive prices and a “unique” shopping experience, retailers will now need to make customers and employees feel safe. This includes requiring masks, widening aisles, using less sales floor, and a continuing cleansing and disinfecting protocol. Even small items like using the stylus to sign your credit card will have to change to hands-free. Restaurant space will need to accommodate fewer tables to promote distancing, utilize disposable menus, and expand the use of outside patios.

Commercial office tenants are also feeling a similar squeeze. Prior to the pandemic, the trend for commercial office tenants was to design open work areas that reduced individual cube space and private offices. With the new distancing, workstations, break rooms, and copy rooms will need to be reconfigured farther apart to promote distancing and safety for employees. Even elevators and bathrooms will need to be monitored for distancing.

Furthermore, in the last few years there has been a boom in office space construction. In almost every city, one could see giant cranes erecting office and mixed-use buildings. Now, office space may be facing a glut due to several reasons. The obvious one is the economic downturn from the pandemic that has sent the economy into a tailspin. But this is temporary, and in time the economy will bounce back. A far more concerning reason and daunting challenge for both retail and office space lies with people’s acceptance of change.

The pandemic has forced many of us to change our day-to-day habits, thus accelerating what was already happening prior to the pandemic. The concern is that these behavioral changes may not be temporary, but rather a permanent generational change—a lasting change in how we conduct ourselves and our business. For example, those who resisted online shopping have now been forced to use it and may continue to use it after the economy has opened back up. Employers who were against people working remotely may now be more accepting of it. New ideas and ways of doing things that take the place of human interaction such as telemedicine and artificial intelligent machines, may now get traction and become more accepted. These permanent behavioral changes will have far more impact than an economic slowdown, and they all have one thing in common: increased use of technology, and a decrease in physical real estate space.

Lease Modifications and CAM and Operating Expense Reviews

Aside from the challenges noted above, tenants will have to modify their leases to address the new normal and to protect themselves against future pandemics and other natural disasters. As vacancies increase, the lease language will need to better define what is allowed and disallowed in CAM and operating expenses. Lastly, it will be important for tenants to review their CAM and operating expenses to ensure they’re paying the allowable pass-through charges per their lease. The following is a list of lease clauses that may need modifications.

Lease Clause
Reason for Modification
Force Majeure Rent Protection against pandemics and other disasters
Ongoing Co-Tenancy Many retailers, including large retail anchors, are going bankrupt, and the increased vacancies are a concern for ongoing co-tenancy restrictions.
Outdoor Seating (Demised sf.) To promote safety, many restaurants are expanding to outdoor seating. This will require defining demised sf. and gross leasable area in the lease. In addition, who will be responsible for the increase in liability insurance?
Building and Specific Tenant Cost We have seen and will continue to see more landlords reconfiguring properties to convert to mixed-use. There may also be more building and capital costs from specific tenant buildouts that should be excluded from common area costs. Leases should exclude depreciation and amortization, and if capital is allowed, the tenant should have the right to verify the invoices and useful life of the assets.
Use Clause and Tenant Restrictions Many retailers may change products to survive, infringing on other tenants in the center. A well-defined use clause is needed.
Security Costs Security costs may increase due to the large number of vacancies that can attract crime. Who is responsible for this increase?
Sanitary, Cleanliness, and Common Area Upkeep Extra cleaning of the property will be needed to keep the property safe and germ-free. Who will be responsible for this cost? Who will be liable if it is not kept clean?
Insurance Requirements Additional insurance coverage will be needed for pandemics and other natural disasters. Much like terrorism insurance, who will be responsible for this extra cost?
Real Estate Tax Appeals The increase in vacancies will promote reductions in real estate tax assessed values. Tenants need to protect themselves to have the right to appeal and the right to receive refunds when received.
Documentation and Audit Rights The right to receive documentation and strong audit rights for both CAM and operating costs are critical. The tenant should detail its audit rights (without limitations) to protect itself from overcharges.

CAM and Operating Expense Reviews

As we look ahead at occupancy cost, there is a good possibility that tenants may find their future CAM and operating costs increasing considerably. Many tenants have negotiated with landlords to reduce their rent and in some cases, not pay rent at all due to the pandemic. With the increase in vacancies and the reduced rent, some landlords may be tight on cash but still need to pay their mortgages. The concern is that landlords may cut back by reducing some services to the property. In other cases, some landlords may want to reconfigure or add mixed-use to the property to attract other tenants. In both cases, it may result in an increase in CAM and operating expenses to the tenant.

Prior to the pandemic, we were already seeing an increase in retail overcharges and some bias allocations for CAM and operating costs resulting from the increase in vacancies. Bottom line, in the future, tenants will need to deepen their CAM and operating expense reconciliation reviews (desktop audits) to protect themselves from possible overcharges. The following are some CAM and operating expense items that will need to be reviewed in the future.

Expense Type
Reason for Review
Capital Cost, Building-related Expenses Look for large R&M expenses. Landlords may be forced to reconfigure their properties. Thus, CAM and operating expenses may see large expenses for buildings and landscaping. All depreciation and amortization will need to be verified. Request contracts.
Specific Tenant Expenses Look for increases in repair and maintenance expenses and electric usage related to specific tenant buildout costs.
Co-Tenancy Look for large amounts of vacancies, especially of large retailers and many smaller retailers that may be creating an ongoing co-tenancy violation.
Real Estate Taxes Look for reductions in assessed values for refunds, pro-rata share, and undeveloped land that aren’t part of the property that may be used for future development.
REA/OEA Allocations (Reciprocal and Operating Easement Agreements) Look for allocations between entities. REA/OEA will often detail the responsibilities of other entities such as retail and office in mixed-use. Is the allocation fair?
Insurance Look for increases in insurance to protect the landlord from pandemics. Much like terrorism insurance, this should be Landlord’s responsibility unless otherwise noted in lease.
Management Fees Look out for an increase in management fees. These are often a source of landlords’ revenue that goes directly into their pockets. When cash becomes tight for a landlord, management fees can increase. Make sure management fees are allowed vs. management salaries.

The new normal will present new challenges for all commercial tenants. As the economy slowly opens back up, shopping and work environments will be a different place from what they were two or three months ago. To be successful, commercial tenants must make both the customers and the employees feel safe. But just as importantly, tenants will need to modify their leases to protect themselves in the future, as well as expand their CAM and operating cost audits to avoid being overcharged.