Commercial Real Estate Liabilities Are Amplifying. How COVID’s Playing a Key Role

Historically, external shocks like epidemics or pandemics followed by economic downturns have had an immediate to short-term effect on investment activity in commercial real estate (CRE), says Jim Berry for Deloitte. While event-oriented downturns rebounded quicker, longer-term downturns, such as the 2008 recession, took longer to recover. The industry, on average, experiences the effects of recession six months after the broader economy. However, this pandemic has started to affect CRE businesses much sooner due to its expansiveness, depth, and unprecedented reach.

Unlike the 2008 economic downturn, the CRE industry was in a strong position before the onset of COVID-19. Balance sheets, capital availability, and liquidity were healthy; companies could manage their debt maturities to longer positions 

Unlike past economic challenges, such as the 2008 economic downturn, COVID-19 had an immediate and widespread impact on the CRE industry. And, this really stung considering how strongly the CRE industry was positioned prior to the onset of COVID-19. Financial statements, capital availability, and liquidity were strong; companies could manage their debt maturities to longer periods. 

Across the board, the pandemic impacted CRE sub-sectors including REITs, developers and homebuilders, Private Equity Real Estate (PERE), and proptechs. 

Government Intervention

A number of steps were taken by the governments to mitigate the impact on tenants, not the least of which was stopping evictions and halting foreclosures. A portion of borrowers has also temporarily been relieved of their payments obligations under forbearance measures.

Other measures that the US government and Federal Reserve took to respond to the impact of COVID-19, some of which affected the CRE industry, included short-term financing to investors and cash flows and liquidity from the CARES Act. The act contains a number of tax provisions that can be leveraged by CRE companies, such as allowing shareholders to carry forward their minimum tax credits for a cash refund, increasing bonus depreciation, and using previous net operating losses, adds Berry.

In the meantime, real estate investment managers, corporations managing real estate investments for third parties may still not fully understand the full impact of the pandemic.

However, investors, tenants, and lenders have historically sued real estate, asset managers. The firms and the assets they are managing are typically insured by financial institutions’ management liability insurance policies. Further details regarding the COVID-19 have been provided below. The three types of plaintiffs have filed different types of claims against real estate asset managers.

Investor Claims

The underlying real estate investment is typically accused of improper handling in these claims. In some cases, investors have been unable to realize their investment returns due to hiring a subpar property manager or failing to accurately monitor investment performance.

As a result of the pandemic and its accompanying economic disruptions, investor claims have increased. Rent revenue and performance of real estate investments have both declined as a result of the aforementioned evictions and forbearance actions.

In order to maintain capital, some real estate asset managers have eliminated or adjusted distributions to investors. Investors are asserting claims against real estate asset managers for making these decisions, despite the fact that asset managers claim that the adjustments are in the investors’ best interest to protect and preserve their investment.

Moreover, the pandemic’s impact on real estate values has led to an increase in claims in the wake of the sale of properties for less than their true value or at a loss.

Observers may question the wisdom of the sale given the current COVID-19 market conditions or may take issue with the price obtained in these situations. A real estate asset manager is typically sued for breach of its contractual obligations under the applicable operating agreement and/or alleged to have breached its fiduciary duties for taking actions contrary to investors’ best interests.

A disgruntled investor cannot be prevented from filing a claim, but steps can be taken to help mitigate the exposure.

In terms of risk management, real estate asset managers need to stay in touch with their investors as early as possible. Sending regular updates to investors about the impact of the pandemic on their investments and addressing any inconsistencies with distributions can be helpful. Also, it would be a good idea to review investment memoranda and operating agreements for information related to the pandemic and its potential impact on investments and distributions.

Lender Claims

The pandemic has made it difficult for some to repay their loans, including landlords who have financed a significant part of their real estate investment due in large part to the declining ability of tenants, including commercial lessees, to pay rent.

As reported by Moody’s Investor Service, the delinquency rate for real estate-related loan portfolios grew almost threefold to 7.54% in December 2020 from February 2020. It noted that 82% of delinquent loans in the hospitality and retail industries were serious, a “huge spike.”

There has been some welcome news since then, however. As of June 2021, MBA and NCUA data have shown a consistent drop since December.

While large banks and hedge funds that provided billions of dollars of high-interest financing are waiting for commercial tenants to increase their lease terms to stabilize cash flow, other funds, such as hedge funds and private equity funds, forced the foreclosure and sold properties at auction to stabilize cash flow.

As a result of the pandemic’s severe effects, some judges delayed taking action and advised lenders to forbear. There is an influx of judicial foreclosure lawsuits anticipatable as courts reopen to hear these backlogs. The asset manager may find it easier to avoid contentious outcomes by keeping communication lines open with lenders when an asset can no longer service its debt.

Tenant Claims

Both residential and commercial tenants have filed numerous claims during the pandemic.

In the commercial sector, tenants often claim that the pandemic has affected the value of their leases, disengaging them. Among the most high-profile cases is that of Valentino S.p.A., a fashion company from Italy with its flagship store in New York City on Fifth Avenue. According to its complaint, the closure of COVID-19 “massively disrupted” the company’s sales, voiding the lease, the company sued the property owner in state court. Valentino U.S.A., Inc. v. 693 Fifth Owner LLC, Sup. Ct. N.Y. (June 21, 2020). 

According to the complaint, Valentino has been hampered from conducting high-end retail business at the premises because the “social and economic landscapes [of Fifth Avenue] have changed drastically, if not irreparably.” 

Among the other lawsuits filed by tenants in relation to COVID-19: 

• The lease agreement may be rescinded, reformed, terminated, or terminated due to circumstances beyond our control; and 
• Expulsion threats despite a government ban on evictions and wrongful rent demands.

In the face of rapidly changing legal and regulatory environments, property managers and real estate asset managers need to closely monitor and respond to jurisdictional changes related to COVID-19.

Liability Insurance Ramifications 

Currently, the federal government, as well as state governments, are discussing additional programs to mitigate the impact of interruptions in rental revenue. For example, on March 11, 2021, President Biden signed into law the American Rescue Plan Act. This was meant to provide additional relief for the nation’s small businesses and hard-hit industries. In states like California, Governor Newsom issued directives to provide relief for small businesses and workers displaced by COVID-19 in April 2021. The plan includes deferring up to $50,000 in sales and uses taxes for small businesses.

Regardless, a comprehensive and specialized insurance plan for financial institutions should be available to real estate asset managers to protect investments. The lifting of the eviction moratorium and suspension of foreclosures will most likely lead to more lawsuits from investors, lenders, and tenants. Those actions are likely to target asset managers in the real estate industry.

Real estate asset managers should take steps to mitigate their exposure to these risks by contacting their risk management partners (insurance brokers, lawyers, compliance officers, etc.).

As part of their due diligence, real estate asset managers should examine their insurance policies to make sure they are adequately covered with comprehensive liability insurance, including directors and officers, asset management, and possibly miscellaneous professional liability, with adequate financial limits.