Had A Fire? Enough About The Money: What About Reopening?

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Had a fire? Sometimes, the damage done is just too much to bear. It could be that it is so extensive that governmental requirements won’t let a previously permitted use to resume at the property. That can happen if zoning ordinances permitted retail use of the property when the building was erected, but the law was later changed such that retail use was no longer permitted. “Grandfathering” goes only so far; most ordinances “revoke” the “grandfathered” status when half or more of a building is destroyed. Ordinances vary as to how “half” is calculated, some basing it on floor area destroyed; some on the cost to restore; and still others using specialized formulas.

[As a step toward “full disclosure,” today’s blog posting is adapted from presentation materials we’ll be using at the Shopping Center Law Conference on October 17 in San Diego. Learn more at the end of this posting. Yes, another shameless plug.]

It could be that a building was shaped or sized pursuant to a dimensional or setback variance, and with a major loss, so goes the variance without any guaranty that it can again be obtained.

Perhaps the building code has changed and, even with funds from the Ordinance Or Law insurance coverage, the required “new” space just doesn’t work for the former tenant.

Lastly, even if a landlord could restore a damaged building to exactly its pre-damage dimensions and location, there are times when that just doesn’t make sense. Maybe the damaged building was always “in the way.” It could be blocking the visibility of important other parts of a shopping center. It could be crippling access or traffic flow. It could have had a degree of ceiling clearance no longer desirable in today’s market. It could have been a multi-story building (e.g., an old department store) where that configuration makes no sense in today’s market.

Time Is A Factor

Time is also a factor. Leases commonly draw a dividing line when it comes to any rebuilding obligation at the “two years to go” point, but buildings last 30 or more years; why rebuild the “old” building for a tenant who will be around for only five of those years? If the demand for “brick and mortar” stores is declining in the market area, why restore a retail building when office or dwelling space is what would be built if there were no obligation to restore a retail building?

Yes, when it comes to the “time factor,” there is a disconnect between the interests of a landlord and those of its tenant – landlords are invested for the long term, whether they like it or not (because buildings, like diamonds, are forever – or it seems so), but tenants commit themselves in short bursts, five years at a time being common. Translated, that means when a seriously damaged building is restored, the landlord is locked in for 30 or more years whereas its tenant will generally remain obligated for five years or less. So, a tenant has a lot less to lose than a landlord has to lose if the market for retail sales turns south.

What If It Takes Too Long To Complete The Restoration?

Leo Tolstoy, in War and Peace, tells us that “the strongest of all warriors are these two − Time and Patience.” While, “time brings all things to pass,” (Aeschylus, The Libation Bearers), a tenant’s patience may not survive the wait. At one level, we recognize the three cardinal rules of real estate, “location, location, and location,” but do we ask, “Why are those are the rules?” They are such because the three rules of real estate are a subcategory of what makes a business valuable – its good will. Tenants also have a “good will” interest in their “location.” In other than monopolistic situations, a great deal of business comes to a particular store in a particular location because of “momentum” – “that’s the supermarket (or home improvement center, or …) I always go to.” Most consumers don’t “try another place out” unless they have a reason. That reason could be a fire that “forced” the consumer to shop down the block. Sometimes, that shopper-store relationship is so strong that the store’s competitors would rather open their own stores in another neighborhood. But, along comes the fire. If someone can open a competing store across the street in three months from start to finish, the operator of a “damaged” store (by fire or other peril) can be hurt very badly if restoration takes six months and it has to wait that long. Basically, it could lose its good will. Interestingly, there is insurance coverage designed for tenants to take into account the period of time it might take for the tenant to “get back up to pre-damage levels,” but it doesn’t last forever.

Time can also tax a landlord’s patience, though not as often as it would that of its tenants. While twelve months’ coverage is the most commonly sought, Landlords can get a readily available eighteen months’ Business Income coverage form added to their commercial property insurance policy. Of course, with the passage of time, pre-damage tenants will leave for one reason or another and a landlord might find itself in a receding, downward-pointing rental market. If “forced” to rebuild because a single tenant of a damaged building had negotiated for that outcome, a landlord could find itself with a single-tenant building, unfortunately not one entirely occupied by that tenant.

The Interplay Between “How Bad” and “How Long”

Now, we get to a key question: “Will The Lease Be Terminated?” We’ve introduced the consequence of the quantum of damage creating a situation where it is just plain impracticable, if not impossible, to restore a building for the benefit of an existing tenant even if the parties are willing to wait until the work is done. We’ve also exposed the issue of “what happens when it takes too long” to restore the building. What is the interplay between “quantum of damage” and “time needed to restore”?

If a lease is to have a “circuit breaker,” a switch that click off and ends the lease term, it needs to cover both quantum and time. The quantum it needs to address is the amount that would make the project unworkable for either party even if some form of restoration were to take place. When thinking that through, the parties should avoid tests like “if the entire premises is damaged,” unless they agree-upon, and then explain, what they mean by “damage.” Will one inch of water covering the entire premises constitute damage to an entire store? Is that the “quantum” the parties had in mind when they were contemplating “marriage” to each other, but not when one party or the other wants to initiate a “divorce”? What about smoke damage to the entire premises?

When it comes to “quantum,” it might be wise, in the ordinary circumstance, for the parties to measure the “amount of damage” in terms of the amount of money it would take to repair or restore the space in question. Other “extent of damage” situations can be handled when addressing the “time to restore” factor. There is a relationship, though not a truly tight one, between how bad the damage was and how long it will take to restore the space. One should think about the restoration task as constituting two phases. One phase is what needs to be done before the hammer hits the nail; and the other is how long it takes from the first time a worker strikes a blow and when the certificates of occupancy are issued.

One of the amazing things about Food Network’s Restaurant Impossible is how “Tom” can redo any restaurant in just two days, limited budget aside. One can speculate that the construction crew is much larger than what is seen on the screen. But, how do they get the permits in so short a time? Yes, every restoration project of the scope we are talking about will require plans and permits before the construction work can even begin. If that takes a minimum of two months (by example) in a particular jurisdiction, how long thereafter will the second phase, reconstruction, then take?

This means that, regardless of how extensive the physical damage might be, there is a minimum period of time that must be allotted for getting permits for the restoration. That amount depends on the jurisdiction and its reputation for “promptness.” Beyond that, time is needed to rebuild. Assuming that a tenant isn’t looking for a trap door to sneak out of its lease, so long as the total time to restore the premises is less than the time it would take, starting from scratch, to get new, nearby space, there won’t be a problem. By way of example, if the very common six month limit is less time than it would take the displaced tenant to locate alternate space, execute a lease, and build-out the new store, then being “stuck” for six months is “no problem.” This is very tenant specific. Following the destruction of the World Trade Center’s towers in 2001, some large office tenants had to scramble very quickly. Some found alternate office space, 300,000 contiguous square feet or more, within days, and actually completed the find, sign, and move-in process in a week. [With our help, of course.] If a particular retailer has such a “rushed” need for replacement space, then a six month restoration provision in its lease would not work for that tenant.

In practice, very few landlords and tenants think about the “micro” reasoning behind the restoration time period for either party to “bail out.” In the abstract, and that’s what is most commonly used in practice, landlords would like to imprison their tenants (i.e., not let them go) for as long as possible. Tenants want the flexibility to get out of the lease in case “things change in the marketplace.” Each is justified in taking its respective approach because each party’s approach best serves that party’s own business interests. The problem is that the parties need to agree.

There are a couple of somewhat “boilerplate” approaches found in retail leases. Often, and logically so, the bigger the space, the longer the permissible restoration time will be. Also, it is common for landlords to insist on relatively long thresholds for lease termination in order to avoid a domino effect. Losing one tenant may lead to loss of another tenant, and so on. Landlords rightly fear that if they allow one tenant to leave if restoration can’t be accomplished in three months, which will weaken the resolve of the tenant with a four month “kick out” to wait beyond the four months. Eventually, the landlord’s lender would get cold feet because the debt service ratio doesn’t work any longer. Consequently, even if a tenant thought it could move across the street or down the block and reopen there within two months after a fire, it would be unreasonable for that tenant to expect the landlord to accede to a two month restoration deadline.

Another “boilerplate” approach appears to vary depending on the overall scope of the project. Small shopping center projects commonly use “six” months. Larger ones commonly use twelve months. Compromises often result in “nine months.” Is there any logic? Assuming the answer is, “barely,” then: “what drives this result?” More than likely, this use of “standard” solutions results from the way most leases are negotiated. In an overwhelming number of situations, the “business” people mark the “damage and destruction” provisions (among others, such as the eminent domain and indemnification provisions) as “legal” items, deferring to attorneys who don’t know the “business” anywhere as well as do those very businesspersons. The result is that every lease looks the same depending on what the attorneys or other non-business person lease negotiators think it should look like in the “abstract.”

Less common, but often seen nonetheless, are provisions setting one time period after which the landlord can “kick out” and another, usually shorter one, after which the tenant can do the same. There is some inherent logic to such a bifurcation. Landlords, generally, have less to lose than tenants have to lose while waiting for the property to be restored.

As a practical matter, the parties would like to know, shortly after the damage occurs, “will the lease be terminated by reason of the damage?” So, typically, the time period that is inscribed in a lease as the “kick out” threshold is described as follows: “If restoration is reasonably estimated by landlord’s architect to take more than [number] months, then either party, by notice to the other, given within [number] days [after something] may terminate this lease.” That serves a good purpose – why wait the entire “six” months when you know that restoration won’t be accomplished in that period of time?

Finding agreement on paper as to “how long do I have to wait” (“before a girl like me can move on” – from a Sharon Jones song) isn’t the end of the story. As the hymn lyricist and poet James Vila Blake wrote in an essay: “It seems to be not the vast things, but the immense multitude of little, like insects in a forest, which eat up the fruit of time.” What happens if six months was a reasonable estimate at the time of the “fire,” but it just isn’t happening? Leases need a second “kick out” date, one that allows the parties to terminate the lease if, despite diligent reconstruction efforts, it is now taking too long. For a tenant, this isn’t a matter of “should I wait at this point or will I be back in business sooner if I negotiate for replacement space elsewhere”? It is a matter of “market risk.” It may no longer make sense to return to the same property. The reason may arise out of general economic conditions, factors unique to the particular tenant, or because a lot of other tenants have bailed out in the meantime and the property’s synergy is gone. Landlords face the same “market risk” as time marches on and, if they have been working diligently but factors beyond their control (such as moratoriums) delay reconstruction for too, too long, they may need to “bail,” go in a different direction, or go under.

To cover the possibility that reconstruction reasonably looked like it could be completed within the estimated “six,” “nine,” “twelve” or “whatever” month time period, but is actually taking much longer, the parties may take one or more of the following approaches. One way to deal with the possibility of project “creep” is to give the parties (or more commonly, only the tenant) the right to terminate the lease if meaningful work is not begun within an agreed-upon time period. “Meaningful” could be defined to be the point at which all pre-construction permits are obtained or could mean when the entire building envelope (walls, floors, and roof) is complete or whatever else might be appropriate for the project. Another way to deal with the time line is to require, by a date that is halfway through the originally “bail-out time,” a certification from the project architect or engineer that it is reasonable to believe that substantial completion will occur before the “bail-out time.” Yet another device to deal with time overruns is to require a termination-desiring party (usually the tenant) to give at least sixty days’ notice of termination and not allowing that notice to be sent unless there are less than 60 days to go in the “six,” “nine,” “twelve,” or whatever period that is set forth in the lease. That will give the delayed party sufficient notice to enhance the restoration labor force or buy more expensive, but more readily available materials, or call for overtime.

WARNING: Shameless Plug Ahead

Well, you’ve now gotten a flavor of what our entire presentation materials look like. Oh, you forgot we had mentioned “presentation materials” earlier on? Shame. Anyway, here’s the scoop: If you are coming to the ICSC Shopping Center Law Conference in San Diego (October 16 through 19, 2013), please say hello. After all, we’re always looking for fresh ideas for Ruminations. One sure place to find us is by coming to our Thursday, October 17 program from 12:45 – 2:00 pm. What’s it called? – “Will Your Lease Stand Up To A Real Fire, Or Will It Be Collateral Damage? Reflections From After The Fact.” John Kim (of Westfield, the shopping center folks) and I look forward to seeing you there. There are a number of other programs connecting with the same range of issues, but we promise to be the most entertaining and that we’ll strive to be the most valuable one.

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