Caroline Harcourt joins host Joel Simon to discuss the impact of COVID-19 across the real estate sector, including forbearance requests to lenders, the impact on leasing and the opportunities and challenges down the road.

(Editor’s note: transcript edited for clarity.)

Welcome to Pillsbury Industry Insight’s podcast where we discuss current legal and practical issues in finance and related sectors. I’m Joel Simon, a finance partner at the international law firm of Pillsbury Winthrop Shaw Pittman. We hope from wherever you are listening, you are safe and healthy. Today, I’ll be speaking with Caroline Harcourt, a partner in Pillsbury’s real estate practice. Caroline represents owners, lenders, investors, developers and tenants in all aspects of commercial real estate.

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Caroline Harcourt: Hi, Joel. It’s great to be here, and thank you for inviting me to join you.

Joel Simon: Caroline, just thinking about what’s happening in real estate these days makes my head spin. What can you tell us about the impact COVID 19 has had on real estate activity.

Harcourt: During this reality of stay-at-home orders started to sink in, transactional bill borrowing dropped precipitously, whether it was loan originations, purchases, sales or leasing. As we all know, hotels and retails have been especially hard hit, devastated really with thousands of hotels shuttered or operating at historically low levels; malls, retail centers, movies and entertainment centers are shuttered; and retail and restaurant bankruptcies are on their way starting in early 2020 with what we can only expect is going to be a tidal wave of insolvencies. Office product has been the least hit so far, although we’ve seen a rising number of claims by tenants that they shouldn’t have to pay rent because they’re unable to access their estate. And who know what else it’s going to look like when the crisis is over. Clearly, users of office space are likely teleworking, meaning they will need less office space and also determining that some of the furloughed employees don’t really need to return. All of this is going to put a lot of pressure on the office sector in the long term. As this drags on, as payments become harder and harder to make, we’re going to continue to see a huge number of requests for relief, whether its tenants, [landlords] or borrowers asking their lenders to forebear on collecting debt service payments. On the flip side, it’s a good time to have a lot of cash on hand. We’re seeing various [groups] being formed to “swoop in.” They’re swooping in on bad or preferred equity, obviously at distressed prices. So the bottom line for those of us who practiced real estate in the early ’90s and through the ’08-’09 crisis is that though this crisis is eerily different given this human cost and tragedy and with possibly of more than 33 million Americans having lost jobs—maybe more like the Great Depression—it is very familiar in terms of cycles and in terms of the real estate legal work that we’re seeing with forbearances, loan and lease amendments and waves of insolvencies.

Simon: That’s quite a picture you’ve painted for us, Caroline. Let’s get a little more granular now. What are some of the issues you’re helping clients with right now?

Harcourt: As mentioned, borrowers are asking lenders for temporary forbearance until normal operations can resume. This can be tricky for several reasons. If the loan is secured, for example—a request for forbearance can cause the loan to be transferred to special servicing. We’re helping borrowers draft request letters that wouldn’t cause a transfer to special servicing. Another issue that we are contending with is that a poorly worded request for forbearance can trigger a personal recourse under a bad boy guaranty. It’s interpreted as an admission of the inability to pay debt as they become due.

That said, in the real estate world, many requests for forbearance start with a short negotiation agreement. This allows the parties to freely engage in discussions and not be bound into a final, formal agreement that’s signed, and we’re just seeing a lot of, and continue to expect to continue to see a lot of temporary forbearance. I think we can also expect that these are going to evolve over time. If things turn into workouts, lenders are going to start to ask for more collateral or guarantees maybe. They’re going to start in the second round to make requests like putting in place hard cash management or increasing reserves. They’re certainly going to ask for enhanced financial reporting in many cases. Our advice to most real estate lenders and borrowers alike is to start the process now and not to wait. For borrowers, this is especially true, since waiting until resources have been depleted is going to give a borrower very little leverage in the negotiation and less flexibility in the long run.

Simon: Acting now and not waiting is definitely a mantra we’ve been hearing a lot lately. It’s another way of saying be proactive rather than reactive, which is an important transition for companies and lenders to make in times of crisis.

Harcourt: I could not agree more. We’ve seen this time and time again. One thing I wanted to mention is we’re also representing lenders in structured debt stacks or securitized loan situations, including many mezzanine lenders who come behind securitized loans in order of payment of security. We’ve been reviewing a lot of intercreditor, co-lender and participation agreements just to confirm who in the debt stack is between senior, subordinate lenders, loan participants, etc. Services can actually make the decision to forbear or extend and also who’s consent is required in connection with entering into a loan amendment.

Simon: That’s a good point—I remember those were crippling issues in the mortgage-backed securities crisis because all the parties to a transaction seemed to be frozen. Deal documents were often inconsistent on those points, and everyone thought someone else was in the driver’s seat on those issues and decisions.

Harcourt: Exactly right. It would be great if we could afford that this time around, and certainly improvements have been made to the structured pooling servicing agreements in that regard. But as far as the relations we are seeing, I would mention for mezzanine lenders, we’re reviewing loan agreements carefully with respect to cure rights—also foreclosure provisions and purchase option provisions. Of course, there are some mezzanine lenders under water. Many mezzanine lenders will just choose to walk away essentially from the deal. We’re also dealing in the day-to-day with many questions regarding the CARES Act, SBA and UVP loans, and now of course the Main Street Lending Program. We are also advising regarding state and local stay-at-home orders, which we’ve been cataloguing across the country. We’ve been very busy indeed.

Simon: Thanks for that view from the trenches Caroline. Could you give us a quick rundown on what’s happening with the world of leasing?

Harcourt: It’s somewhat of a similar story. Not surprisingly, tenants are taking rent deferments, reductions or they’re looking to get out of leases altogether. The flip side is that landlords have debt service payments they have to meet or they have returns to investors that they have promised, and often in order to agree to the tenant’s request for deferral or amendment, they have to obtain their lender’s or maybe even their investor’s consent for lease modifications. We’re seeing tenants making all kinds of claims right now. They’re looking at their leases and wondering about or writing about force majeure causes of course. Those are the first that pop into people’s minds. But they’re also saying condemnation or casualty—do those bear on the analysis? Can I get out of my lease or rental obligations because of those causes or constructive eviction or frustration of purpose or impossibility of performing? These are sometimes difficult arguments, generally, for a tenant to make, but that won’t stop them from trying given the amount of money at stake. Interestingly, the legal scholars have all been rereading cases from World War II and also from Hurricane Sandy as precedent. I’d advocate then the courts are going to have to weigh in. One note for landlords and tenants alike though—there may be coverage under business interruption insurance, and it’s really worth looking at those policies right now.

Simon: Looking into your crystal ball, what legal issues do you expect will come up in the next few months?

Harcourt: Unfortunately—or not depending on your perspective I guess—it looks to be a big opportunity for those on the sidelines with cash and a willingness to jump in. But of course what I think we’re going to see is workout, mortgage foreclosures, UCC foreclosures, court appointments and procedures. It’s actually already all begun. We’re going see deeds or assignments and more, and borrowers handing their keys over to their lenders starting with hotels. We’re going to see tenants walking away from the lease obligations leaving their security deposits behind. As a practical matter, we’re going to see businesses unable to reopen and bankruptcies in every area with litigation around bad boy guaranty. Basically, there’s going to be a tremendous amount of pain to go around in the commercial real estate world in every sector.

Simon: Caroline, you’ve given us a lot of food for thought today. Thank you so much for joining me.