25 January 2010

What Do Tenants Deserve When Landlords Fail?

In greater Los Angeles, office space vacancies are at 18.5%. This suggests all kinds of questions.

Why aren't commercial landlords there lowering rents in order to fill vacancies? Do they believe that rents will bounce back? Are they unwilling to offer rents so low that they are guaranteed to lose their properties, since the downside of a foreclosure to a landlord is so serious? Are banks that have made loans to commercial landlords unwilling to negotiate reasonably in a way that minimizes their long term losses for bureacratic/legal reasons? Is Chapter 11 of the bankruptcy code, which is supposed to prevent this kind of irrational behavior by lenders and landlords not up to the job?

It also brings to mind deeper and more general legal issues. Landlords all over are failing. The reasons are pretty clear, because property rentals have a quite simple business model. Rents can't support mortgage payments. When this happens, banks take possession of the properties. This gives the banks the power to void existing leases, even if the tenants aren't in default.

This is, of course, unjust for the tenant, who may lose a home or business location critical to that business for no fault of his own. Avianos coffee in Denver is one of many examples of this on the business side.

Does this make economic sense?

The formalist theory behind allowing banks this right is that tenant title derives from the landlord and that if the landlord loses title, that the tenant title dependent upon it is necessarily forfeit.

The economic theory behind allowing banks this right is that in ordinary times, landlord defaults on mortgages result from the landlord cutting too lenient deals with tenants, or being insufficiently aggressive in enforcing rent obligations, to cover the mortgage. Otherwise, a tenant and distressed landlord could collude to enter into a too low rent lease and deprive the bank of the full fair market value of its collateral.

But, what if the real problem behind a landlord failure is that the value of the property has declined, making it impossible for anyone acting as a landlord to collect enough rent to pay the mortgage? It still makes sense to wipe out the landlord's interest, to "punish" the landlord for having made a bad bet on the future value of the real estate purchased. But, in those cases, existing leases are likely to be at or above fair market value rents in light of the declining value of the properties, and tenants who are not in default on their leases are not themselves the source of the economic distress that causes the landlord to fail.

Of course, bank could simply reaffirm the old leases, and sometimes they do. But, the tenants, once they have settled into their properties, often have a vested interest in staying where they are, so it may be in their interests, after a foreclosure, to pay a greater than fair market value rent which they would not have agreed to prior to moving in and being locked into their location for business reasons. The foreclosed upon landlord prior to foreclosure, wouldn't have had a right to increase the rent, however, until the lease was over.

Why, economically, should a foreclosing bank be able to deny a tenant the benefit of an already better than fair market value bargain? After all, ordinarily, landlord solvency isn't a major concern of a tenant, and ordinarily, a lease is not so long that making a foreclosing bank wait until the end of the lease for a renegotiation of the rent term. In this situation, the bank is basically trying to shift the burden of its bad bet on the value of the property it took as collateral onto a an innocent third party.

Allowing tenants of foreclosed landlords to keep their existing leases in force for a considerable length of time (perhaps something on the order of a year to three years, or until the end of their leases, whichever comes first), could mitigate the unfair bargaining advantage of the bank.


Michael Malak said...

I have a "non-disturbance" clause in my lease as a business tenant. I don't know how common that is. I wasn't familiar with such clauses until I saw it in my lease, but I'm glad it's there.

Andrew Oh-Willeke said...

Not very common. (Also, FWIW, such a clause needs to have the lender as a party to be enforceable against the lender.)