Borrowers in the already volatile commercial mortgage-backed securities space should brace themselves for a significant bout of difficulty due to the COVID-19 pandemic, says a new report from Kroll Bond Rating Agency.
With commercial tenants facing unprecedented disruptions to their day-to-day operations and declining demand as a result of mandatory social distancing measures across the country, KBRA foresees several potential legal problems on the horizon for CMBS borrowers.
CMBS loans rarely include force majeure provisions. Commercial tenants, however, often enter into agreements, such as construction contracts or leases, that are subject to force majeure defences. CMBS trusts can find themselves exposed obliquely to risks associated with those agreements.
As the report explains, pandemics are not considered legitimate triggers for force majeure clauses, but acts of government, such as the mandated shutdown of businesses, can be, giving some tenants the impression that their rents may not need to be paid during the COVID-19 crisis.
The situation gets thornier, particularly for retail centres. Co-tenancy provisions for these properties sometimes allow for rent reductions if certain anchor tenants or a certain percentage of other businesses close. That is certainly the case in most US plazas and mall properties today.
The problem is that co-tenancy provisions have rarely, if ever, been tested by a situation anything like COVID-19. A lack of customer traffic at this time is hardly the fault of landlords, who may use that argument when explaining to tenants that rent relief is unwarranted.
Commercial rent relief
KBRA’s feeling is that reductions in the rents paid by commercial tenants are “inevitable”. Some of the country’s most recognizable national chains – Cheesecake Factory, Nike, and Subway, among others – are already at different stages in rent relief negotiations. What form that relief will take is unknown, but deferred rent or rent reductions in exchange for lease extensions are considered two prime possibilities.
Business interruption insurance and litigation
CMBS borrowers are often required to carry 12 months of business interruption insurance or more, but standard policies typically kick in when physical damage to a property occurs, not loss of use, and standard policies rarely include pandemic coverage.
The report theorizes that a confirmed COVID-19 case on a property’s premises could be spun as “physical contamination”, thereby constituting the kind of physical damage needed to trigger a business interruption claim. Such claims could come down to semantics, as policies with ambiguous language are hardly in short supply.
Courts are already hearing cases between retail owners and insurance carriers over business interruption cases, and their number is expected to swell.
The report highlights a case involving Oceana Grill. The New Orleans-based restaurant is arguing that its business interruption policy covers losses related to COVID-19 because they are the direct result of an order from state and local officials. Oceana’s policy specifically contains language around business closure by a civil authority.
This case, and many others like it, will hinge on whether or not the coronavirus constitutes direct physical loss or damage. Prior cases determined that a pathogen or airborne substance’s presence in a property can be considered damage worthy of business interruption coverage.
One hopes that commercial landlords aren’t rooting for COVID-19 to be found in their properties. But if it is, and such an occurrence means tenants’ rents might be covered by business interruption insurance, you could forgive a few of them for breathing a little easier.