Renting rights of the tenant in the case of commercial retail real estate!

When a business goes bankrupt, the key to value is often owned by the commercial real estate lease. Here's what the assessor needs to know.

Retail Center

The elaboration of a conclusion on the value of the right to real estate is a territory familiar to most assessors. Difficulties arise in assessing the rights resulting from renting or in assessing a long-term rented property, as the rental guarantees the right to use the property and creates a number of personal obligations. Unlike the absolute ownership of real estate, representing a durable right which normally survives the bankruptcy of the owner, the rights resulting from the rental are more 'sensitive' and their existence may depend on the continuation of the contract or the solvency of the tenant.

In the context of this article we use the term tenant's right of use in its usual legal sense: the right of a party (i.e. tenant or lessee) to occupy the property owned by the other party in exchange for a rent paid regularly over a certain period of time.

Thus, insolvency and bankruptcy proceedings come with unique challenges in assessing the right to use the tenant of a commercial real estate property, especially when it comes to retail premises. In the context of this article we use the term tenant's right of use in its usual legal sense: the right of a party (i.e. tenant or lessee) to occupy the property owned by the other party in exchange for a rent paid regularly over a certain period of time. In other words, the tenant's right of use is the right of ownership enjoyed by the tenant, as is apparent from a lease.

The assessment of the tenant's right of use is less common than the assessment of the property right affected by the tenancy, since the first of these cannot be traded in the same way that the landlord can sell his property affected by the tenancy. The tenant's right to use may be easily traded because of the limited duration of the related lease or the constraints laid down in the lease, or because this right is not attractive from an economic perspective, such as where the contractual rent is higher than the market rent. The lease often prohibits or restricts the tenant's ability to transfer ownership of property affected by the tenancy to another party. Apart from the bankruptcy situation, the clauses prohibiting subletting may convert the tenant's right to use into a right of no value in terms of his ability to be traded; the right of use may have a value of use for the tenant, but this value usually contributes to the value of the enterprise and is not normally dealt with in the assessment of property rights. Bankruptcy can completely change the situation, as the procedure allows the tenant to sell and transfer his right of use to another party when they would not be allowed under the lease. Of course, a lease, otherwise impossible to transfer, does not turn into something of great value if its main clauses (economic, use, duration and relating to the right of renewal) are unattractive to other potential tenants. The terms of the lease cannot change with the entry into bankruptcy, so that the owner is obliged to accept other than those negotiated in the first place. Why does the bankruptcy law prohibit the change of economic and use clauses, but allow the transfer of the tenant's right of use, even when the terms negotiated by the landlord prevent this? In the end, the landlord negotiated the right to terminate the lease if the rent fails to fulfil its obligations. The termination clause allows the landlord to regain the full market value of the property and to avoid waking up to a new tenant, chosen by the old tenant, who is unable to fulfil his contractual obligations. When conceived, the bankruptcy law balanced the rights of the owners and the rights of their tenants' creditors. This law does not create an advantage for tenants when it allows them to transfer their right to use the property, but provides the tenants' creditors with a potential source of debt recovery, i.e. on the basis of the value of the tenant's right of use created by the contractual rent lower than the market rent.

Almost all retail traders liquidate their assets through bankruptcy proceedings. In January 2009, with the approval of the Syndic Judge, Circuit City was able to move from one bankruptcy proceedings to another (from Chapter 11 to Chapter 7) and sent "close the business" advertising messages, after which it began to close its stores.

As long as the new tenant can demonstrate before the trade union judge that he has the resources and desire to carry out his activity under the terms of the lease to be entrusted to him, the landlord does not suffer as a result of the termination of the contract, as he will continue to receive the benefits of the contract he has negotiated. What is the effect of transferring the tenant's right of use in the event of bankruptcy? This possibility may create a value of the tenant's right to use (and, indirectly, also for his creditors) where the terms of the lease would not allow that value to be created. However, in order to achieve this value, the tenant must declare bankruptcy. If solvent, the tenant will be retained by the terms of the lease and has no legal instrument at his disposal to enable him to realise the value of a contractual rent below market level if the lease prohibits him from transferring the tenant's right of use.

When conceived, the bankruptcy law balanced the rights of the owners and the rights of their tenants' creditors.

In the bankruptcy reorganization procedure (Chapter 11), Kmart requested the court's approval to terminate the leases of hundreds of stores already closed.

What effect does all this have on the evaluator? Let's think of a retail business that operates in multiple leased spaces. Any lender will grant a loan on the basis of two elements:

1. The lender will have to determine whether that activity can generate a cash flow large enough to cover the debt service. For the purposes of this analysis, the creditor will probably not consider RadioShack electronic equipment stores, where the auction attracted several bidders who offered millions in sums for a large portfolio of stores leased by RadioShack. Any potential lender of a retail firm will want to know which of the leases offers more advantageous economic clauses than current market conditions. In the case of contractual rents below the market rent level, creditors will also want to know the value given by the difference between the two types of rents, which depends on the actual annual rent, the number of years remaining from the lease and the discount rate used in the calculation. This type of analysis is carried out by real estate appraisers. The assessment of the tenant's right of use may be of interest to other parties, not only credit institutions. In all cases of bankruptcy of a retail business, the court appoints a committee of creditors to determine how the assets of the undertaking are to be converted into liquidity. A significant task of the creditors' committee is to determine (or to ensure that the bankrupt retailer has already determined this, in its capacity as 'debtor in possession') which premises are leased on the basis of a contractual rent below the level of market rent and which could be sold.

In 2010, when it filed for bankruptcy, Blockbuster closed thousands of retail spaces. Following the acquisition of the company by Dish Network the following year, only 500 of the leased premises were retained, but they were eventually closed.

Where it is established that a rent is paid for a given space under no circumstances is the possibility that the applicant for the loan obtains the amount of the tenant's right of use for a lease with a rent below the level of the market rent.

Moreover, in the event of the bankruptcy of retail businesses, the transfer of the tenant's right of use may be the most important source of recovery of the amounts owed to creditors.

2. If the retailer's situation deteriorates, the lender will want to determine whether the company's assets have a liquidation value high enough to cover the loan. Almost all retailers facing difficulties liquidate their assets through bankruptcy proceedings, which allows them to sell their otherwise untrading right of use below market value. Moreover, in the event of the bankruptcy of retail businesses, the transfer of the tenant's right of use may be the most important source of recovery of the amounts owed to creditors. A recent example is the bankruptcy of the market rent chain, the creditors' committee aims for the bankrupt retailer to keep that space long enough (continuing to pay rent) to attract the best bids at auction. The Committee of Lenders wishes to quickly terminate leases in which the contractual rent exceeds the level of the market rent, so as to cease payment of sums for a tenant's right of use which has no value for sale (in the event of bankruptcy, the tenant may terminate a lease and return the property to its landlord. The landlord may also terminate the lease, but this does not lead to the cancellation of the tenant's right of use as long as he pays the rent). The assessment of the tenant's right of use in the retailer's portfolio is necessary for the accuracy of the determinations made by the creditors' committee. Consider what happened in recent bankruptcy cases of major retail firms such as Kmart, Cache, RadioShack, Circuit City and Blockbuster. All situations involved the sale of the tenant's right of use for which the contractual rent was below the market rent, a non-transferable right under other conditions. In order to determine which commercial premises were below market level and where the tenant's right of use could therefore be sold, the assessors had to analyse the market rent case by case.

The flip side of the coin: Assessment of ownership affected by the tenancy resulting from a long-term lease

The discussion in this article is not complete without taking into account the way in which the same rules – and other rules in bankruptcy proceedings – influence the assessment of a property right affected by the tenancy, when the lease ends in the long term. The valuation of a rented real estate is usually a simple process, if it is based on the assumption that for the entire duration of the lease the tenant will fulfil his obligations. The conclusion on value could indicate a value greater or lesser than the property would be worth if it were not rented, in particular according to the economic terms of the lease, i.e. whether the contractual rent is below or above the market rent level. If it is allowed that the tenant will fulfil his contractual obligations during the valuation of a rented property, such a hypothesis would eliminate the need to take into account what might happen in the event of the tenant's bankruptcy. However, if the assessment includes an analysis of the probability and impact of the tenant's insolvency, then, for a contractual rent below the market rent, the appraiser might wish to take into account the very high probability that the lease would continue for its entire duration, including the renewal period, be it the original tenant or another tenant to whom the lease was transferred , after approval of this transfer by the competent court in bankruptcy cases.

Where the contractual rent is above the market level, the evaluator could consider terminating the contract in bankruptcy proceedings. There is no question of a tenant going bankrupt just to terminate a lease, but many retail firms fail to stay on the surface and it is not unreasonable to think that a major retailer, which pays a significant number of rents above the level of market rent and already face financial difficulties, will not take advantage of the bankruptcy law in order to create value for a fundamental category of assets (market-level leases), which would otherwise not present value or would have a small value under conditions other than those provided for in the bankruptcy proceedings.

In order to determine which commercial premises were below market level and where the tenant's right of use could therefore be sold, the assessors had to analyse the market rent case by case.

A useful advice for evaluators.

If we were to draw practical advice from this presentation, it would be that when the evaluator had to draw a conclusion on the value of the tenant's right of use or a long-term rented real estate, it should be the terms of reference of the assessment to what extent the assumption that the lessee will be paid to his obligations under the lease for the entire duration of the assessment. The user of the assessment report may wish to apply the assumption of the continuation of contractual relations in the case of contractual rents below the level of market rent (in order to reflect that the lessee will never give up the rent below the market level), but not in the case of contract rents above the level of market rent (in order to reflect the inherent risk that the retailer will go into insolvency and the likelihood that, under insolvency proceedings, the termination of leases in which the rent is above the market level).

If the assumption is accepted in the assessment of a rented property that the lessee will pay the obligations arising from the lease for the entire period of the lease, such a hypothesis eliminates the need to take into account what might happen if the tenant goes bankrupt.

Source: value magazine no 13/2016