In A Lease, If I Didn’t Do It And You Didn’t Do It: Who Should Suffer The Loss?

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Stuff happens. Ask Bill Nye or David Hare.

And, in modern America, it seems as if someone else is always at fault, not me. [If you take no blame, it must be them; Who must then pay my fines. It's really is quite the cleverest ploy; By which illogic shines. – Gary Bachlund.]

Actually, there are times when bad things happen and the landlord and its tenant are each “good people.” Here are some examples:

Access is lost because the road serving the property (call it a shopping center) is temporarily or permanently closed by the government

A nearby bridge leading to the shopping center is closed and the alternative access route is undesirable to customers

A fuel delivery truck spills its load when parked on the shopping center so that its driver could run across the street (meaning that the driver wasn’t using or serving the shopping center)

The entire area is closed for a week as a crime scene

The arena across the street from the shopping center has been closed and the businesses at the shopping center relied on business from the arena

Power from the utility company directly to the tenant is interrupted

Power from the utility company directly to the landlord is interrupted and the tenant gets its power through a submeter

The shopping center is closed by reason of flood, famine, locusts, etc.

Make up your own examples

In each case, neither the landlord nor the tenant can point its finger at the other. They may be able to find someone else at fault, but it won’t be either of the two of them. In some cases, the risk of loss can be placed on an insurance company, if that were thought-of, and the premium charged made sense. But, again, that doesn’t tell us who, as between a landlord and its tenant, “should” bear the risk of loss (and, therefore, which one of them should bear the expense of an insurance premium where that is an option).

Well, there is no answer other than: “it depends.” And, what does it depend upon? Answer: mostly, it depends on two factors, the relative bargaining power of the parties (a recurrent Ruminations theme), and whether any party thought of the issue in the first place.

To us, those are both “practical” responses, but not very satisfying on an intellectual plane. So, we began to Ruminate, and thought this would be a good time in our relationship with our pretty impressive collection of loyal followers, to start a discussion.

The main approach coming to mind is to ask yourself: to what degree does the disabling event affect the value of the property and to what degree does it affect the value of the tenant’s business” Here, the key word is “value.”

After struggling with a simple way to explain this “thought,” and finding our skills inadequate to the task, we decided to do so by way of an example. Here we go. We think the value of a shopping center is a function of how much money its owner can make. For a shopping center (or any other income generating property), that depends on “how much rent can be charged and what the occupancy rate will be at that amount.” Yes, property prices are based on the present value of the projected stream of net income. [We know there are some situations where factors beyond rent for the existing configuration are in play, such as for a property with additional development potential, but that still goes to working with the “projected stream of net income."]

So, how does this apply to the “harm without fault scenario”? Ask yourself, given two otherwise identical shopping centers (as we say in Latin, ceteris paribus), one with direct, all-direction access to an interstate highway intersection, and the other visible from the same highway, but four miles in either direction from two such interchanges, which property will garner higher rents? We think placing a shopping center at an interstate highway exit is the better bet.

Now, if you have a shopping center at such an interchange and the interchange is permanently closed, the shopping center becomes less valuable because the rents obtainable will be less after the closing than beforehand. We also think that the landlord impliedly promised its tenants that they would enjoy (and be paying for) a shopping center with the higher level of customer traffic expected from an easily reachable shopping center. Our conclusion – if a critical highway exit is permanently closed such that the fair market value of the rent chargeable (and, by extension, the price of the property) were to fall, then, as between a landlord and its tenant, the landlord should take the risk. If the rent would not fall (say, the closing was temporary – whatever that means in the context of our example), the tenant should bear the loss. How that translates into “dollars” doesn’t lead to a fixed answer. Perhaps it means that the rent should be reset to the “new” market, but if the rent would then fall by more than a certain percentage (implying that the location would not have been considered by the tenant in the first place), the tenant should have the right to terminate the lease.

“Wait a minute, you say” – “why shouldn’t the chips fall where they landed?” Why is the landlord taking the hose in such a situation?” Our admittedly less that powerful response comes in the form of another example. What would the rent have been had the parties known, at the time of lease negotiation, of a 50-50 chance the exit would be permanently closed? If the tenant was still willing to take the space, would it have paid the same rent as if there was no chance of closure? Could the landlord have gotten the same rent? In each case, we think not.

What event, occurring without fault, would be a business risk for the tenant and not its landlord? How about its strongest competitor opening a superstore directly across the street? That could certainly have a negative impact on the tenant’s location, but wouldn’t reduce the value of the shopping center, only the value of the tenant’s business there.

What about the crime scene, a temporary situation having no measurable effect on the “value” of the property or the prospective rents for space there? By extension, our thinking is that the tenant should bear that risk. That’s the same as an interruption in electric service (without landlord’s or tenant’s fault), whether the power comes directly to the tenant or if passes through the landlord’s meter. We know that’s a departure from the common negotiated outcome, but that’s the way the our analysis comes out.

We invite, indeed encourage, our readers to play with this question and our approach in their heads. Apply this approach and your own approach to various examples. Tell us, the other (about) fifteen hundred other weekly Ruminators, what you think. Just click on some form of the word “comment” just below the headline to this posting and join the conversation.

What about events for which insurance can offer protection? Yes, some of these “no fault” events can trigger insurance coverage (such as the closing of the sports arena – look at contingent business interruption coverage). As an extension of our working theory, we think that the party who should take the hit should bear the expense of the insurance coverage, but we also understand that the market might price that premium cost into the rent or otherwise into a tenant’s occupancy cost.

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Comments

  1. A recurring theme forwarded by Ruminations is that landlords “sell their space” to tenants – a “rent for possession” relationship. Given that assertion, it is difficult to argue that rental rates should be affected one way or another by the actions or omissions of a party unrelated to landlord or tenant unless either party specifically warranted or represented such in the lease in the first place. After all, if a real estate transaction were in fact a sale rather than a lease, would the buyer be able to seek a refund years after the fact because of such an event. If a business across the street closes, a highway interchange closes, etc., and assuming these specific circumstances were not addressed in the lease, why would should a tenant receive an adjustment in rental? Is the mortgagee going to permit a reduction in landlord’s mortgage payments? Doubtful. How about if a new interchange is constructed or a new business opens across the street? Should tenants be obligated to increase their rentals mid term by a certain percentage because a positive event occurred (absent landlord’s participation by virtue of a percentage rental provision in the lease)? From my viewpoint, neither scenario is fair. Too often tenants and landlords want the other to absorb the other’s inherent business risks. Concepts such as co-tenancy, sales thresholds, etc. are a variation of this common theme that taken to the extreme, doesn’t just hurt landlords, but also can lead to the exponential implosion of a shopping center and impact remaining tenants. A business windfall during good times as well as the losses as a result of negative events or circumstances, should be shared. Again, it’s called ‘business risk’. There are no guaranties in retail shopping centers. Landlords are already being asked to be the so-called lender for for their tenants by funding large construction allowances; they shouldn’t now be asked to also be their insurance policy.

    • Readers will know that we rarely respond to comments. That’s because we don’t want to dominate the discussion by “holding the switch.” So, this is a rare exception.

      You are entirely correct in that your approach has equal merit. We would have adopted your approach if the lease, a “temporary” sale of the premises, allowed the tenant unrestricted use of the property as would be the case if it were the fee simple owner. That’s why we went the “economic bargain” route we are suggesting. If a major competitor moved in across the street, that risk would affect the tenant’s business and how much the space is worth to the tenant, but it still isn’t the landlord’s risk. But, when a landlord says to the tenant that the tenant has to sell widgets and rents the space as one where it is worthwhile to sell widgets, we’re thinking that loss of access to the property should hurt the landlord more than the tenant.

      But, despite the balance we’re striking, your approach is also a valid one.

  2. Alan Betus says:

    Ira, as always another post that caused me to slow down and think things through more thoroughly. I love your “economic bargain” approach. I think all too often tenants and landlord ask the other party to bear the risk that should be their own to bear. However, I think sometimes reality gets in the way and there does have to be some sharing of the other’s burden so that both the Center and Tenant’s business can be sustained.

    I agree that Rent shouldn’t decrease or stop if the power goes out, unless the Landlord caused it. Similarly, if something happens to change the value of the property (the closing of a critcial highway exit), then Landlord should feel some pain in the form of reduced rents (or maybe even the loss of a tenant who was savvy enough to have the forethought to negotiate for a termination right).

    However, one thing that I think your analysis omits is the reality of most of situations. It is easy for a Landlord to say that rents will reduce if if the highway exit closes. HOWEVER, most of the times the Landlord is beholden to a lender that doesn’t allow many exceptions to withholding or reducing mortgage payments, or shareholders that are seeking strong returns – or both. In that case, what are the Landlord and Tenant to do?

    And, it is also relatively easy for a Tenant to say “ok, sometimes the power goes out and it’s not the Landlord’s fault; I’ll deal with it.” This is a fine thought for a short period of time. But, what happens if the power goes out for more than a few hours or days (and such failure doesn’t arise to the damage/destruction level)? Eventually, the hit will be big enough that unless Landlord is willing to share the pain, they could risk losing the Tenant because it isn’t making any money.

  3. David Huprich says:

    I’ll pick at one thing you said. You said that the strongest competitor of one of the tenants opening a superstore across the street would hurt the tenant but not the center. I respectfully disagree. The center’s value can be hurt any time the business of one of its tenant’s is hurt. The hurt may not be immediately reflected in the rent roll, but any potential buyer or lender properly doing its due diligence will recognize the negative impact of the competitor opening across the street.and should discount or at least seriously question the rent stream from the “hurt” tenant. In fact, if the “hurt” tenant is an anchor and the competitor across the street is a signifcant customer magnet, the discounting may not be limited to the rent stream of the “hurt” tenant.

  4. Fascinating scenarios with interesting implications for tenants and landlords. Mr. Cafaro brings up a good point in my mind about business risk and sharing the impacts of good and bad developments in the rental situation. The economic bargain approach is certainly one I’m mulling over… very thought-provoking, mind-twisting post here, with lots to consider, and my expertise in this specific area (retail real estate) is less strong, thus my enjoyment learning from your blog.

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