By now every commercial landlord in the country has likely had an uncomfortable conversation with at least one of their tenants about rent that was due on the first. Businesses around the country are asking for payment terms for this month’s lease payment, some like The Cheesecake Factory have even made public statements about their inability to pay. The company’s CEO David Overton explained, “Please understand that we do not take this action or make this decision lightly, and while we hope to resume our rent payments as soon as reasonably possible, we simply cannot predict the extent or the duration of the current crisis.”
One study reported that 30-percent of small businesses haven’t paid their rent and another 20 percent have only made a partial payment. Many were hopeful that a small business loan program set up in the CARES act would help the situation but it has already experienced some delays. Although most landlords want to help tenants that are struggling, if rent concessions are given en masse, it could create a cash shortfall that could devalue buildings and trigger widespread defaults.
So, in order to keep tenants who can pay from breaking their leases and to help preserve property value tenants and landlords have agreed to a change in lease terms called “blend and extend.” This technique waives a period of rent and then amortizes it out over the life of the lease. In many instances, in order for the payback period to be more manageable, leases will also be extended past their original expiration date.
I spoke with Michael J. Ostermeyer, real estate partner at the law firm Ballard Spahr about this. “Since commercial properties are valued on a cash flow basis, similar to how a bond is valued. One way to preserve the present value of the asset when there is no current cash flow is to create back end value over time,” he said. He also explained that since the main terms of the lease don’t change, this can be done with a simple, if modified, forbearance agreement, and often doesn’t need a complete rewrite of the lease. This is the part where I tell you that this is not legal advice and to consult a lawyer for any questions you have about lease law because I am not a lawyer and this is just a (particularly informative) article on the internet.
Even if the renter and the property owner agree on this type of extension, there is still the question of the payment schedule. As Mr. Ostermeyer, Esq. explained, what matters to the property owner is that the present value of their leases stays the same. This is similar to an annuity and requires a net present value calculation that so many of you are likely familiar with. When I learned about this technique I understood in theory that making payment terms for a temporarily lost cash flow could be calculated to give the same present value. But, I had no idea how to do it.
I knew from researching a previous article, Have Real Estate Investors Been Calculating IRR Incorrectly All This Time?, that calculating net present values wasn’t as an exact of science as I had taken it to be. The person who helped me understand this was John Cona, founder of F9 Analytics, a financial calculator for the commercial real estate industry. He reminded me that, to solve for a rate of return in a net present value calculation you have to work with two unknowns, time and money. Basic algebra doesn’t give us a precise way to solve these kinds of equations. So, getting to the correct rate of return historically required a bit of guess and check. When it came to buildings worth billions with incredibly complicated cash flows of dozens of leases, this approximation wasn’t good enough for John. To call him particular is a bit of an understatement. “I’m the guy that has to find a way to explain everything,” he once told me. His quest to calculate the value of a cash flow precisely led him to study mathematics, eventually discovering a new mathematical way to use matrix functions to find an exact answer, a method now called The Cona Inverse Rotation.
So when I heard about this blend and extend lease and the need to calculate the value of an irregular cash flow, I knew Cona would have some opinions. Turns out, he had already been working on this. “For people like me that need replication and accuracy, we need to tie it to a financial variable. Cona showed me how a lease with 80 months remaining could be extended to 90 months and have an entire six-month rent break annuitized over the rest of the term. The calculation factored in rent escalations, leasing commissions and tenant improvement allowances but, more importantly, was able to solve for the present value in a way that made them match entirely.
This effectively preserves the value of the building. It also gives a lot of transparency during what could be contemptuous negotiations. “Most operators calculate the value of their leases in a non-mathematical way,” Cona said. “They just try to make it close enough. But by using a precise calculation you can explain to renters how you came to the new terms.” Most of the landlords and occupiers I have talked to say that they would agree to new terms to help alleviate this natural disaster-induced crisis. But, as anyone who has ever been involved in a lease negotiation knows, the dispute is in the details.
Being able to calculate the net present value of a lease, and therefore the perceived value of a building is important for lenders as well. “By preserving the collateral value, you create a better story to tell a lender,” Ostermeyer, told me. The global lockdown has put commercial landlords in a tough position. At the same time, they are having rent concession talks with renters, they are also having to find new terms with lenders. While commercial mortgages backed Fannie Mae and Freddie Mac have been granted temporary payment forbearance, many commercial buildings have debt with private lending institutions, each with their own investor mandates. One thing that they all have in common, though, is the need to keep the loan to value ratio under a certain threshold to prevent losses in case they have to foreclose on a property, making the net present value of leases an important metric especially when there are almost no new property sales to use to gauge market prices.
We are in uncharted territory. Disasters are often focused on one geography and have never prompted the kind of economic shutdown we are seeing right now. This unparalleled, unfortunate series of events has required compassion, compromise and creativity. No one is responsible for the emotional and economic blow we are all suffering but we all have a responsibility to help mitigate our losses. The better we are at social distancing the less damage the virus will do. The better we are at reconfiguring our property industry, the less damage the shutdown will do. All of this #inthistogether attitude is easy to talk about but in the zero-sum world of business, it is naive to assume that we will all be able to agree on terms. “Blend and extend” leases will not solve the cash crunch that we are in now but they are a way to allow landlords to help their tenants without devaluing their assets and threatening their livelihoods. By understanding ways to amend leases that are fair for the parties on both sides of the table we could help prevent losses that would become catastrophic for the entire economy.