By Fernando Landa, Partner, and Lee Kaplan, Associate
While economists and pundits may disagree about the likelihood of a recession in 2023, it is important for real estate investors to take steps now to prepare their portfolios for a potential economic slowdown given the stark rise in interest rates over the last ten months. From a legal standpoint, landlords should consider the following preventative measures:
1. Shore Up Your NOI. During times of economic uncertainty, landlords should invest time in analyzing the health of their tenants’ finances. To the extent leases permit a landlord to solicit gross sales statements and/or tenant and guarantor financial information, landlords should make such requests and stress test the viability of their tenant bases. For leases that do not include landlord rights to access tenant financial data, landlords should push to include such rights in any upcoming renewal or extension amendments. Tenants in weak financial condition should be closely monitored and any lease defaults should be quickly prosecuted. Landlords should also consider approaching tenants in distress about buttressing lease security by taking steps such as adding (another) guaranty or an (additional) security deposit.
Landlords should also ensure tenants, particularly those in dire financial straits, are maintaining adequate insurance and have paid all insurance premiums. The last thing a landlord needs in a recession is to incur an uninsured casualty that could have been avoided with proper oversight of lease insurance requirements. In short, landlords should require updated certificates of insurance from all tenants.
Additionally, landlords should review property expenses to ensure they are not being overcharged by vendors. Expenses that can be passed through to tenants should be to avoid expense leakage, and like for tenants, landlords should ensure all of their vendors are maintaining adequate insurance.
2. Understand Your Loan Documents. Loan documents typically offer lenders numerous options to protect themselves during a recession, so it is critical for real estate investors to understand how these lender protections could impact their business if exercised and take steps to avoid negative outcomes. For example, investors should be acutely aware of any debt coverage ratios or vacancy requirements in loan documents to try to avoid lender cash sweeps and/or re-margin payments.
Similarly, borrowers should check their loan documents to see if and when a lender can reappraise the property and require the borrower to paydown the loan to meet loan-to-value requirements in debt instruments.
Often the deadlines for any such re-margin payments are very short, so prudent investors will reserve cash and engage in discussions with their lenders early in the event a property faces distress.
3. Understand Your Guaranties. In a distressed property situation, it is important for borrowers to remember that lenders prefer not to take ownership of their property, but negotiating leverage is critical in any workout discussion. Unfortunately, personal guaranties tip the leverage scale significantly in favor of the lender.
That being the case, guarantors should be keenly aware of their guaranty obligations. Even non-recourse carveouts, or “bad boy” carveout guaranties can impose personal liability far beyond what most individual guarantors realize when executing such guaranties. Most guarantors who sign “bad boy” carveout guaranties think they are only guarantying a lender’s losses arising from the gross negligence or willful misconduct of the borrower.
However, most such non-recourse carveout guaranty obligations extend well beyond such “bad boy” conduct and often create personal recourse for more trivial matters, particularly when an experienced attorney was not engaged to negotiate the carveout language. That being the case, guarantors should be aware of what borrower conduct could trigger personal recourse to them, and retain experienced counsel to negotiate the details of any future “bad boy” guaranty carveouts.
In conclusion, preparing your real estate portfolio for a recession takes careful planning and a diligent follow through. By following the above tips, landlords can increase their chances of weathering an economic downturn and protect the value of their investments.