The Impact of Strategic Defaults

The Wall Street Journal reported that commercial property owners are intentionally defaulting on mortgages. Companies of various sizes have chosen to utilize “strategic defaults” on properties where the value of their property has plummeted to levels far lower than their outstanding debt. The total value of these defaults has already reached billions of dollars. As a side note, many of the defaulting owners are being “rewarded” in the public markets because the strategic defaults allows the company to direct money toward shareholders or into other more profitable projects. There are many ethical and business questions surrounding this topic. While we feel that there is a slippery slope that companies often step onto with the intentional breach of a contract, that discussion is outside the scope of this article. (Feel free to discuss by posting your comments on the topic though!) The question we are interested in is how do strategic defaults, particularly in multi-tenant office towers and large shopping centers, affect the tenants?

Let us relay a first hand experience. One of our national corporate clients has been a long time tenant in 2600 Michaelson in Irvine, CA. For years this property had been the trophy of Maguire (MPG) an LA based Real Estate Investment Trust (REIT). For several months we assisted our client in negotiations and space planning to reduce the square footage they occupied, improve the space with additional build-out and also drop the per square footage price significantly.

After the lease was reviewed and prepared for signature, Maguire announced that they would be turning the building over to its lenders among whom were Bank of America and a large group of CMBS holders. Once this change of active ownership occurred, there was an extended period of time where the new special servicers would not fund the tenant improvements or permit our client to downsize…in their opinion, we had agreed to those terms with a different owner. We were able to quickly coordinate the acceptance of the terms by the new owners and lobby for improvement work to begin on time; we helped our client avoid the pain of the ownership transition, however, in many situations the transition is neither seamless nor painless for corporate tenants. A strategic default is usually the last action for an owner, however, it is not uncommon for a struggling property owner to have exhausted their cash reserves months or years before the default. This means the owner cannot afford to provide promised Tenant Improvements or to properly maintain the property and common areas. The result is that the new lease that you have signed binds your company to a deteriorating space.  When it comes to your facilities and locations, the only thing worse than your company running out of money is your landlord running out of money.

What can be done:

1)   Regardless of whether you are considering a new lease or signing a renewal, we recommend that you review the financial statements of the building owner as well as their levels of debt and equity in the property. As a commercial tenant you may be accustomed to providing your financial statements to prove that you are credit worthy and will uphold your end of a lease contract. Why should a landlord be exempt from the same type of analysis?

2)   The distress amongst property owners brings a unique opportunity for large tenants who may consider purchasing their corporate headquarters or any space they plan to occupy for more than ten years. With new accounting standards in the pipeline  leases will soon be accounted as long term liabilities (and accordingly show up on a balance sheet). While private investors are hesitant to purchase new properties because of the risk of rising vacancy rates, a business that occupies a space it owns has mitigated its vacancy risk and can sometimes capitalize on the current fear and opportunity in the markets. This may be particularly appealing to businesses with plans to have a consistent headquarters presence in one area—Of course, many municipalities are offering incredible economic incentives to corporations that will relocate their headquarters.

Author: Liam Murphy

Liam Murphy is a partner at Hayes Commercial Real Estate and supports many national clients in their commercial real estate needs. He holds the distinguished Certified Commercial Investment Member (CCIM) designation as a recognized expert in the disciplines of commercial and investment real estate. Less than 6 percent of the commercial real estate practitioners nationwide have earned the CCIM designation.

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