The global pandemic could have a drastic effect on the commercial real estate market
The coronavirus outbreak, which began in China at the beginning of 2020 and has been declared a global pandemic by the World Health Organization as of March 11, 2020, has had a drastic effect on both the US and global economy. With a potential recession on the horizon, many are wondering if the US will see a meltdown similar to the 2008 financial crisis, which was precipitated by a crash in the subprime mortgage market. While the human health and well-being of people across the world should be of primary concern, the potential economic impact of the outbreak should not be ignored. The long-term effects of the coronavirus on the economy remain unknown, but we can predict some acute short-term effects on the commercial real estate market in general, and in particular on contractual relationships in this arena. The ability of parties to perform their obligations under a variety of contracts, from athlete contracts to distribution agreements, and loan agreements and completion guaranties to purchase and sale agreements, just to name a few, is likely to be challenged in the coming weeks and months.
Force Majeure
A force majeure clause is a contractual provision that excuses the performance of a party’s obligations if circumstances beyond the party’s control frustrate or interfere with its ability to satisfy its obligations. Here is a sample force majeure clause:
“The performance of the parties under this Agreement is subject to earthquake, hurricane, tsunami, tornado, war, government regulation, terrorism, disaster, civil disorder, curtailment of transportation facilities, failure of utility services, acts of God, or any other emergency beyond the parties’ control, making it impossible to perform their obligations under this Agreement. Either party may cancel this Agreement for any one or more of such reasons upon providing written notice thereof to the other.”
If a force majeure clause applies, a party will not be liable for its failure to complete its obligations. While force majeure clauses are often included in various contracts, the specific wording of these clauses may differ significantly. Some such clauses list out the specific events that allow a party to declare force majeure, while other clauses may be more generally written to encompass the concept of events that are outside the reasonable control of the parties to the contract. Most force majeure clauses will state (i) which events constitute force majeure, (ii) how a party should inform the other party to an agreement that a force majeure event has occurred, and (iii) the consequences that arise from the occurrence of a force majeure event.
As is often the case, courts have articulated different interpretations of force majeure clauses in the past. Some courts have narrowly interpreted these clauses, arguing that the event must have been one of the specific events delineated in the contract and that such event must have prevented performance by making it impossible. On the other hand, other courts have applied a broader interpretation, asserting that an event need only hinder or delay performance in order to qualify as a force majeure event. Regardless of the legal analysis applied, the first step is to look at the contract in question to determine whether there is in fact a force majeure provision. If there is, the next step is to assess whether the event in question (the outbreak of the coronavirus, or some type of response to the outbreak, like a government curfew or private shutdown of operations) satisfies the required criteria of force majeure in the contract. If this hurdle is cleared, then it is critical to comply with the notice procedures that most contracts include, so that you properly provide notice to your counterparty. Prior to asserting force majeure, it is important to understand the contractual consequences of a force majeure event, because certain obligations or liability may be excused, but others may not.
Implications
There are many different implications of the force majeure concept described above for the commercial real estate world, but here we will describe just a few of them.
- Construction Contracts: The coronavirus outbreak has already had an impact on the supply chain for various materials required for construction. Similarly, government restrictions, such as curfews or lockdowns, could interfere with the ability of contractors to have the labor needed for construction, and there may also be delays in the issuance of construction approvals and permits. Suspension of or delays in the ability of contractors to complete construction could be covered by force majeure provisions in construction agreements.
- Completion Guaranties: Many construction loans require completion guaranties, which essentially serve as a promise from a borrower and/or guarantor to a lender to complete a project within a specified timeframe in accordance with approved plans and budgets. If construction is delayed, for one or more of the reasons described above, guarantors may increasingly be facing defaults under completion guaranties, which could trigger different types of lender remedies as laid out in the guaranty itself. Borrowers and guarantors would be wise to look to the force majeure language in their guaranties to determine if the performance of their completion obligations could be suspended due to the coronavirus outbreak.
- Loan Agreements: Many loan agreements require borrowers to keep their lender apprised of developments at the property and/or business operations. The cessation of activities of a tenant or a building as a whole, could trigger disclosure obligations. Borrowers are encouraged to review their loan documents to ensure that they are complying with all of their disclosure requirements to their lender in light of recent events. Additionally, it is likely that many tenants, particularly those in the hospitality industry, may face difficulties paying rent in the coming months, which in turn may dramatically reduce the income generated from various properties. Many loan agreements include ongoing performance covenants from borrowers regarding cash flow. For example, borrowers may covenant to maintain a certain debt yield (net operating income/loan amount) and debt service coverage ratio (net operating income/annual debt service). Failure to satisfy these tests on a monthly or quarterly basis can result in some type of cash trap event, where the lender will assume control over the flow and distribution of income. Borrowers should look to their loan documents to understand their potential performance covenants, and whether their failure to satisfy such tests may be excused by the coronavirus outbreak. It remains to be seen what concessions lenders may provide borrowers, but there are early signs that banks may be willing provide some relief given the unprecedented nature of the pandemic.
- Purchase and Sale Agreements: It may be wise to include new language relating to the coronavirus outbreak in all purchase and sale agreements, as well as any new agreements that are being entered into in the commercial real estate space. Both buyers and sellers should consider inserting language referencing Covid-19 or pandemics generally into their purchase and sale agreements, as the future impact of recent events on the ability of buyers to conduct due diligence, and of both buyers and sellers to close transactions remains uncertain.
Conclusion
The world is still in the midst of the coronavirus pandemic, but it has already left an indelible mark on society and the economy. We will be following the effects of the coronavirus pandemic on the real estate market, and will post updates as and when available.
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