Money & the Law: Pandemic Creates Chaos for Commercial Real Estate Investors | Business
In normal times (which is not the case), investing in commercial real estate is an attractive proposition.
The investor buys or constructs a building intended for commercial activities – stores, restaurants, offices – using, in large part, borrowed money. The investor then puts tenants in the building who pay rent and an additional amount to cover operating costs – insurance, maintenance, repairs, property taxes, utilities. The investor uses the rent to make the mortgage payments and withholds what is left as a return on the investment.
From an investor’s perspective, the transaction is tax-efficient as the depreciation can be used as a tax deduction, even if it is not an actual expense. And, when the value of the property increases in value, the investor can sell the property and pay income taxes at lower capital gains rates or defer income tax indefinitely by swapping the property for a other similar property.
But what happens when a pandemic strikes? The short answer is: legal chaos. Tenants cannot pay their rent because their businesses have been closed. The investor could sue tenants for unpaid rent, but since they are now bloodless turnips, this strategy goes nowhere and only generates legal fees. Eviction is of no use as there are no new tenants who wish to move into the property. In addition, the courts are stuck and unable to deal with a sudden increase in debt collection and / or eviction lawsuits.
Now the investor must try to cover the operating expenses previously paid by the tenants. Maintenance is postponed, repairs are no longer made as needed and the landscaping is neglected and dies. In the absence of rental income, the investor defaults on the mortgage.
Then, the mortgagee, no longer receiving payments from his borrower, defaults on his obligations and finds himself pushing back several creditors. The mortgagee could, in theory, seize the property, but this would amount to repossessing a property without rental income and in poor condition. Or the mortgage holder could sue his defaulting borrower for the outstanding loan balance, but since the borrower is now insolvent and threatening bankruptcy, that would be another exercise in throwing money at the bad one.
What ultimately results from this chaos is a complex set of negotiations driven by necessity. Investors and their tenants negotiate rent deferrals and changes in rental conditions. Mortgage holders and their borrowers negotiate forbearance – interest rate cuts and the postponement or cancellation of accrued payments. Other creditors and debtors negotiate accommodations on the assumption that something is better than nothing.
To complicate matters further, in the mix comes government help to save the economy. This generates further negotiations on how the government money will be used. Renters, for example, want the money to cover their unpaid rent obligation. Real estate investors want the money to cover their delinquent loan payments.
These negotiations are motivated by the fact that trying to enforce legal obligations against parties unable to pay is a waste of resources and waiting for the storm to end is the only viable option.
This is the situation commercial real estate investors find themselves in right now, and it will likely take years for anything to come close to normal to return. Along the way, there will continue to be casualties and the survivors will have deep wounds.
Jim Flynn works for Flynn & Wright LLC of Colorado Springs. You can contact him at [email protected]