For Tenants, Distress is a Minefield

NEW YORK CITY-Although distressed properties still account for only a tiny fraction of the Manhattan office market, the number is expected to keep growing. For tenants, this poses both opportunities and hazards, says tenant-rep firm CresaPartners.

“Properly analyzed, the risks can be mitigated through carefully designed lease negotiations,” the firm says in a recent report. “It could actually be advantageous to take space in a distressed building that is facing an orderly resolution,” such as a sale to a financially sound owner. Under those circumstances, “the tenant should be able to negotiate a fair rent with good concessions simply because the new owner will not be obligated to cover an unrealistic debt.”

Going into distress is not a one-way trip, CresaPartners points out in its report. For example, of the 28 Manhattan office properties that were categorized as distressed in 2009, 10 have reclaimed a positive position. Eight of the 21 office towers that entered the ranks of troubled properties in the first half of this year have also landed on their feet, so to speak. But it doesn’t take a mathematical wizard to see that, with the year-to-date number of troubled properties not far behind the full-year total for ’09, distress is on the rise.

“We’re just starting to see it become more of an issue,” Robert Stella, EVP and principal at CresaPartners, tells GlobeSt.com. “As each quarter passes, we see more buildings come onto that list.” With properties purchased during the highly leveraged go-go years of 2005 to 2007 now potentially facing the challenge of meeting debt service, “we think that’s going to be a continuing issue for the next 12 to 24 months.”

With that in mind, there’s “a significant burden” on tenants to perform in-depth due diligence, CresaPartners says in its report. They need to consider, among other things, the property’s current debt situation, the ownership’s levels of capitalization and experience and the quality of the tenant roster.

“You have to understand the basic financial position of the ownership,” Stella says. “You have to do your homework: know when the loan matures, understand the basic loan-to-value of the building, know whether the current mortgage is higher than the current market value, which sends a signal that the loan is coming up.” Having that knowledge, he adds, “allows the tenant to be in a very strong bargaining position.”

In negotiating a deal where distress may be a factor, a tenant should make sure the lease contains a provision requiring the landlord to deliver a subordination, non-disturbance and attornment agreement. An SNDA, says CresaPartners, can help prevent tenant eviction in the event of a lender takeover.

Leases should also incorporate “appropriate remedies” for the owner’s or lender’s failure to deliver tenant improvement, such as placing a cash allowance in escrow or receiving rent breaks. A self-provision that allows a tenant to perform its own TI obligations, and set off the costs against rent, is another must, CresaPartners advises.

Stella says the tenant going into a distressed property needs to perform a balancing act between the perils and opportunities. “The good thing is that in this kind of market, the landlord is going to be aggressive in offering a lot of concessions because there aren’t that many tenants that are willing to move,” he says. “If you follow the steps that we have to protect you, you’re going to be able to take advantage of the market and have the comfort of knowing that the risk is mitigated.”