The governmental response to the COVID-19 virus escalates daily, resulting in government mandated and elective closures of retail, dining and other businesses and governmental offices, as well as eviction moratoriums and other government regulations on landlord activities and property operations. Clients on both sides of real estate transactions fear that the current crisis may impede their ability to fully evaluate and close deals. Buyers who have entered purchase agreements for property are re-evaluating their ability to complete due diligence, and are wary of putting their money at risk in light of practical roadblocks that may impede completion of due diligence and closing. Buyers are also seeking to protect themselves against potentially slipping values as tenants request rent relief, close their doors, or default. Sellers are similarly concerned with practical roadblocks to closing, including their own ability to fulfill closing conditions, but are also focused on maintaining certainty of sale, and retaining their ability to effectively manage their assets through this crisis while under contract. This alert outlines certain broad concerns of buyers and sellers of real estate that parties should bear in mind as they navigate through the practical disruptions and shifting risk created by the current COVID-19 outbreak. Of course, it is important for both buyers and sellers to review their form of purchase and sale agreements, because it is likely that many customary provisions need to be clarified or adjusted in response to
Due Diligence and Closing Impediments
For purchase and sale agreements that have been executed but that are still within the due diligence period, or new deals that have just been awarded, buyers are becoming increasingly concerned about their ability to properly evaluate and diligence the real estate. Travel bans may prevent the potential buyer or its consultants from physically visiting the target asset. Stay-at-home or social distancing orders may prevent surveyors and physical, environmental and zoning consultants from visiting the property or accessing public records to complete their evaluation and reports. At a minimum, diligence may take longer, but in some cases it may not be able to be legally conducted at all while restrictions are in place. As a result, buyers may be looking for longer due diligence periods, or pre-negotiated, unilateral options to extend due diligence periods as a result of COVID-19-related disruptions, before investing significant due diligence dollars into a transaction. Sellers will be incentivized to agree to some timing concessions to get deals done in this challenging environment; however, given the quickly shifting market, sellers will still be focused on transacting quickly, and will want to minimize the “free look” period to the maximum extent practicable to avoid a lengthy due diligence period that only ends in termination. In exchange for timing risk, sellers may ask for an increase in earnest money. To successfully transact, buyers and sellers will need to balance these competing concerns, likely resulting in loosening of the very tight timeframes for diligence that have become customary in recent years, with the understanding, however, that extensions should be reasonable and that sellers as well as buyers will want the right to terminate the purchase agreement if the impediments to due diligence are not removed by an agreed upon outside date.
Because real estate closings are typically run through a third party escrow, and require original, notarized signatures (or remotely notarized, in certain jurisdictions)1 and physical recording of documents, buyers and sellers of real estate have been uniquely affected by the physical closure of many businesses and governmental office closures, particularly title companies and recorders’ offices. Absent express provisions in purchase agreements addressing these potential impediments to closing, buyers and sellers may have to rely on arguments based on common law contract standards for excuse of performance, such as frustration of purpose, intervening government conduct, or impracticability, all of which may be difficult to assert and have unpredictable outcomes.2 As such, buyers are looking for express rights to extend closing for myriad COVID-19-related disruptions, including closure of title companies, recorder’s offices, and inability to send or receive wires, with an eye to keeping the list as broad as possible and the available extension as long as possible, to protect their right to acquire the real estate, and to protect their deposit in the event that something outside of their control prevents their performance at closing. Sellers have many of the same practical concerns with respect to fulfilling their own obligations at closing, and may be amenable to some extension right for a defined period of time. In fact, with respect to certain seller obligations, like completing repairs or obtaining estoppels that may be a condition to a buyer’s obligation to close, sellers may similarly request an extension right.3 However, sellers will seek to limit the universe of disruptions that would entitle the buyer to extend, or ultimately terminate, in order to encourage an expedient closing, maintain certainty of closing, and prevent broader market disruptions, like unavailability of financing, from becoming an excuse for buyer’s failure to perform.
When negotiating such closing extension rights, buyers and sellers will need to address ancillary issues such as whether the estoppels need to be “refreshed” to satisfy the closing condition on the extended closing date, and whether sellers will require that the earnest money be increased in exchange for the extension. Buyers and sellers also need to address mutual termination rights if the impediments to closing are not removed by an agreed upon outside date, as well as the question of whether any of the earnest money is at risk if such impediments are not removed by such outside date. Finally, while usually a minor contract point, all parties should double-check the notice provisions to make sure they permit for email delivery without the need to follow up using a traditional mail or courier service, particularly with respect to extension and termination rights exercisable during the COVID-19 outbreak.
In addition to extensions to due diligence periods and closing dates, buyers may also seek to negotiate an expanded set of closing conditions in their favor, including:
- Financing Contingency. While financing contingencies have not been typical in commercial real estate transactions for many years, buyers may begin to request limited financing contingencies crafted to address issues with capital markets generally (as opposed to being specific to the buyer/borrower or the property), such as availability of financing in the CMBS market generally. Sellers are likely to resist even narrowly crafted financing contingencies, but sellers may be amenable to an extension of the scheduled closing date if, for example, there is a temporary inability across the financial system to wire closing funds.
- Rent Relief. Buyers may insist upon a cap on rent relief granted prior to closing or, if the asset is a single tenant property, a buyer may want to condition closing on there being no lease modifications or rent relief granted to such tenant without the buyer’s consent.
- Title Policy. While the issuance of the title policy is a fairly standard closing condition, buyers may seek to specify and confirm that the title policy covers the so-called “gap” period between the date of its last title search and the recordation of the deed. Such a gap period may be extended beyond normal periods if a county recorders’ office is closed, making it temporarily impossible for the title company to update its title search or record the deed. For now, title companies are continuing to issue “gap” policies; however, expanded gap indemnities are being required from sellers and, if there is mortgage financing, buyers, at closing. If county recorders’ offices remain closed for extended periods, the title companies’ willingness to cover the “gap” may change. For example, certain title companies have introduced a “COVID-19” exception to title policies to carve out the risk to the title company created by delayed recording and lack of access to public records. In jurisdictions where records can be searched electronically and e-recording is available, the exception should be deleted, but buyers and sellers should be aware that this exception could become more prevalent, and address it upfront in the purchase agreement and with the title company based on the facts, on the ground, in the subject jurisdiction.
- Government Order/Notices. Buyers may push to include conditions that no COVID-19 government notices or orders have been issued that adversely affect the operation of the property, and that necessary operating permits must be transferred. This would be particularly relevant in the context of nursing homes and assisted living facilities. Note, however, that given the prevalence of stay-at-home orders and mandatory business closures, while buyers may request a closing condition related to the absence of such legislation, sellers are likely to vigorously resist such a condition.
- Casualty/Condemnation. As would be typical in a purchase and sale agreement, casualty and/or condemnation of a certain magnitude will provide the buyer with a termination right. In light of COVID-19, certain forms of casualty and condemnation provisions could be interpreted broadly to include contamination as physical damage or a government-mandated closure as a non-physical taking. To restore initially intended meaning to these provisions, it may be necessary for sellers to clarify that such provisions relate only to physical destruction and not temporary surface contamination and actual physical taking versus an alleged regulatory taking. Sellers may even wish to specifically carve out COVID-19 from being construed as contamination.
Operating Covenants during COVID-19 Crisis
As a result of the COVID-19 response, landlords are seeing a high volume of requests for rent relief from retail tenants and are beginning to see limited requests from office tenants. In some jurisdictions, landlords are temporarily restricted from exercising eviction remedies against defaulted tenants, despite monetary defaults. In the coming weeks, it is likely that the pace of such requests should diminish now that the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) has been passed and signed into law. Under the CARES Act, many of the retail tenants that have been requesting rent relief from their landlords will instead be able to obtain an SBA loan that can be used for their rental obligations. Until these loans are available, however, buyers and sellers will need to meaningfully address approval rights over lease amendments and modifications, particularly rent relief and deferral, while under contract.
Under normal circumstances, a buyer might typically expect to have reasonable approval rights over lease modifications prior to the expiration of the due diligence period, and sole discretion over such modifications following the expiration of the due diligence period. However, in the current environment where facts on the ground are shifting so quickly, sellers will likely require the unilateral right to offer rent deferral (rather than abatement) during the due diligence period. After the due diligence period, sellers will likely want to retain a significant level of control to offer rent deferral prior to closing (as it may be extended). Such control is crucial for sellers to move quickly in managing their tenants through the economic impact of the COVID-19 crisis, but buyers will also want some control. One option may be for sellers and buyers to agree on pre-arranged circumstances under which sellers can provide rent deferral as well as the terms of such deferral. If the terms of the offered deferral do not fit within the agreed upon parameters, then the seller would need to obtain buyer’s approval before proceeding with such deferral. Any such parameters should be sure to address the following: (a) minimum tenant evidence to support the need for the rent deferral (after taking into account funds available to the tenant under the tenant’s insurance policies and/or the CARES Act); (b) the scope (e.g. base rent plus CAM or just base rent) and length of any rent deferral; (c) the required amortization or pay-back period, and interest accrual during such period, if any; and (d) confirmation of no waiver of landlord rights. Both buyers and sellers have a vested interest in clear and consistent communications on these issues with the tenants to avoid future disputes.
In the event deferrals are permitted during the contract period, buyers and sellers will need to address proration of any deferrals at closing. Sellers may request a credit for base rent and CAM deferrals relating to their period of ownership, given that buyers will likely have the exclusive right to pursue tenants for repayment of deferrals after closing. Buyers may object to such credits as too speculative, similar to delinquent rent. As buyers and sellers seek a middle ground, sellers may negotiate for expanded rights to pursue tenants on a post-closing basis for deferral repayment relating to seller’s period of ownership.
In addition to increased focus on negotiations with tenants, buyers may also focus on expanding typical basic operating covenants (that is, the seller’s covenant to operate in accordance with “current practices”) to address specific COVID-19-related issues. Such additional covenants might include: (a) a seller covenant not to engage in voluntary closure (which could potentially support a tenant rent abatement claim); (b) a seller covenant to provide notice of tenants whose employees have or are suspected of having COVID-19 (a heightened issue in senior housing and multifamily); (c) a seller covenant to engage an industrial hygienist in the event a person in the building tests positive and the corresponding obligation to perform a “deep cleaning” per CDC guidelines; and (d) a seller covenant to provide notice of tenants asserting lease defenses based on COVID-19 matters, as well as all requests for rent relief. Sellers, of course, will want the flexibility to modify their “current practices” to the extent required pursuant to applicable legal requirements and/or CDC or WHO guidelines, including restrictions on the use of common areas, as well as restricting elevator access to a limited number of people in order to preserve “social distancing.”
COVID-19 Due Diligence and Representations
In this environment, buyers will be conducting heightened diligence with respect to leases and tenant files to try to anticipate tenant COVID-19-related issues, including review of leases to identify provisions that may permit a tenant to: (a) assert a force majeure or material adverse change defense to rent payments or other obligations; (b) assert abatement rights on account of the failure to have access to the building; and (c) avoid increased CAM charges attributable to COVID-19 cleaning and related costs. To complement this heightened diligence, buyers may ask for an expanded set of representations and warranties from the seller for COVID-19-related matters. For example, buyers may ask the seller to represent that it has delivered all notices related to rent relief or deferral, force majeure claims, and any other notices regarding potential rent offsets or defenses received from tenants. In addition to expanded representations, buyers may also request the “tolling” of a survival period in cases where a property is not operational at closing and a longer survival period where a property is partially, but not fully, operational at closing. Buyers may argue that they need sufficient time to operate the asset after closing to discover any breaches, and make claims.
With such heightened buyer diligence and expanded representations in mind, sellers should carefully review their standard set of seller representations in light of COVID-19-related matters. Representations that previously seemed straight forward and easy to give may assume new meaning in light of the COVID-19 outbreak. For example, a knowledge-based no hazardous materials representation may take on new meaning if the definition of hazardous materials is broad enough to include bacteria, viruses or pathogens. Leasing representations, including no default and notice representations, may be harder to confirm, as communications with tenants and negotiation of lease modifications accelerates, and may change quickly. If representations are remade at closing, sellers need to be careful to retain the right-to-update representations until closing (as extended), without jeopardizing closing.
Often, buyers and sellers agree to a mutual “my watch, your watch” indemnity in purchase agreements. Each party gets comfortable that liabilities for which an indemnity may be sought are either (i) breach of contract claims, for which it is appropriate for the party that committed the breach to retain liability, or (ii) tort claims, for which each party should have insurance. COVID-19 responses and operating procedures create the potential for an expansion of such indemnity provisions beyond that for which they were initially intended, and for which no insurance may be available. Buyers and sellers will be looking for a fair middle ground here, where neither party is unfairly burdened with liability to third parties. Given the uncertainty regarding the scope and nature of COVID-19-related claims, both parties may forego the mutual indemnity, in favor of an affirmative statement that neither party is assuming liability or waving the right to make counter-claims with respect to such COVID-19-related claims
1 Currently, while there are many jurisdictions that have fully implemented remote online notarization statutes, there are also many that have not done so, and as a result, parties should consult with escrow agents on a case-by-case basis.
2 See https://www.mayerbrown.com/en/perspectives events/publications/2020/03/impact-of-covid-19-on-real-estate-contracts-force-majeure-mac-clauses-impossibility-of-performance-and-other-considerations