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Overview.
Since the outset of the COVID-19
pandemic, various aspects of our lives have, for better or for
worse, changed. Some of these changes had already been occurring at
a slower pace pre-pandemic, but are now rapidly accelerating and
becoming the norm in a post-pandemic world. These changes to
lifestyle and work habits affect not only the work force, but also
the utilization of commercial properties across all sectors. Some
sectors – notably hospitality, office and retail – are
among those hit hardest by these forced changes. The question now
becomes: how do developers, landlords, managers, lenders, tenants
and consumers maximize existing and future real estate projects in
a post-pandemic world?
Market Trends.
In many respects, the COVID-19
pandemic expedited existing trends relating to online retail and
telecommuting. Pre-pandemic, online retailers such as Amazon were
already experiencing rapid growth. Unsurprisingly, with many
in-person retail outfits forced to close during the first months of
the pandemic, online retail services exploded further in 2020,
expediting the closures of many in-person retail stores. With
respect to office leasing, many companies already permitted limited
work from home options. However, the widespread pandemic
“shelter in place” rules adopted by many states and
municipalities forced a significant change whereby nearly all
companies were required to permit remote working. Consequently,
members of the workforce who once believed that consistently
working from home led to inefficiencies and an inability to unplug
from business related needs were forced to adapt for the better
part of 2020. In many cases, companies even found that workers
could be as (or almost as) productive as they were when physically
working in the office. These forced adaptations led many executives
and leaders, particularly in white collar industries, to rethink
their current space footprint and question the long term viability
of physical offices. If even a portion of their employees could be
as productive working remotely as in the office, why not take the
opportunity to reduce mortgage, rent and/or operating expenses,
which often constitute some of the biggest line items in a
company’s budget? As a result of this shift, office
availability in New York City hit 16.1 percent in the first quarter
of 2021, the highest number on record, according to Colliers
International’s latest quarterly report. With this backdrop in
mind, we are now left to ponder how best to utilize spaces that
will likely be subject to a limited percentage of workers being
permitted to work in-person at one time and flex scheduling.
Similar to the office and retail sectors, the hotel and
restaurant industries took a beating as a result of the pandemic.
In fact, no industry was hit harder during the pandemic than the
hospitality sector. New York City, for example, saw more than
42,000 hotel rooms (representing about one third of the hotel rooms
available in the city) wiped out, with nearly 200 hotels closing
permanently, to say nothing of the many restaurants that were
forced to close up shop. While trends regarding online retail and
telecommuting have been on developer radars for quite some time,
the shock to the hospitality sector brought about by the pandemic
was unexpected. Most in the industry suspect that it will take
several years (even into 2024) for the hospitality sector to fully
recover. In order to ride out the expected long recovery, many
hotels are now seeking short and long term options to maximize
revenue.
Third Space and Suburban Revitalization.
These industry woes have forced tenants, landlords, property
managers and lenders to pivot temporarily or even, in some cases,
permanently from these ailing sectors. While traditional retail and
office buildings may struggle to adapt, one area ripe for
adaptation in the post-pandemic world is the concept of what is
often called the “third space”. In its most general
terms, the third space is space outside of the home and office
where people can work but also collaborate and socialize with
others. The third space concept is not new. In fact, many hotel
operators had, prior to the pandemic, invested money, time and
design into flexible spaces in their buildings to maximize
utilization of their common areas. That said, the flexibility that
employers are now willing to give to their employees makes this
third space concept even more attractive for hotel operators and
guests alike. With telecommuting becoming more of the norm rather
than the exception, workers may be able to parlay working from home
into longer vacation stays at hotels in desirable locations.
Workers who were once hesitant to take longer vacations can now
work remotely part time utilizing hotel facilities, while also
being able to enjoy time away with their families.
On a similar note, as members of the work force spend less time
in office buildings and more time working from home, suburban areas
and related businesses appear poised to benefit. Suburban
restaurants, bars and hotels may very well serve as a replacement
for people looking to scratch that social itch. A key factor to
this suburban revitalization is the explosion of the residential
real estate market in suburban areas since the onset of the
pandemic. Workers are fleeing tighter quarters in more expensive,
densely populated areas and seeking larger homes with home offices
and other amenities (e.g., pools) in the suburbs. To that end, we
suspect that suburban areas located outside of, but still
relatively close to, major city hubs will be the subject of
increased investment and development.
Practical and Legal Challenges.
From a practical perspective, it is clear that in a
post-pandemic world, preserving the flexibility for other permitted
uses of office buildings is critical. It should be noted, however,
that there are a myriad legal issues that landowners, developers,
tenants and lenders must navigate to achieve such flexibility. In
the commercial leasing context it is important to first look at
one’s lease. For tenants, negotiating commercial leases with
broad permitted use provisions is important. Often, landlords
attempt to narrow the tenant’s permitted use for a variety of
reasons, whether it be for zoning purposes (more on that below) or,
in the retail setting, preserving a good tenant mix and navigating
exclusive use clauses granted to certain attractive tenants. A
savvy tenant will try to expand permitted uses during lease
negotiations. Similarly, landlords should understand that, in many
respects post-pandemic, flexibility is beneficial from their
perspective as well.
Another major hurdle to seeking flexibility for existing and
future projects includes working within the constructs of existing
zoning laws, which limit property utilization and adaptation.
Throughout the United States and particularly in the northeast,
local municipalities codified various restrictions as to size and
use of certain parcels of land. These restrictions, while well
intentioned, restrict existing landowners and future developers
from quickly adjusting to market trends. While there is some reason
to remain optimistic that zoning authorities acknowledge the issue
at hand, rezoning has typically been a slow development process
requiring, among other things, public hearings. For example, when
seeking to modify existing uses or developing projects, one must
confirm whether such modifications are permitted “as of
right”. If not, a variance or special permit would likely be
required, and approvals must be sought which may further require
studies, public hearings and various other governmental signoffs.
These zoning challenges not only impact construction budgets, but
may also cause long term construction delays and threaten project
milestone dates. It is consequently important for all parties
involved to take serious note of the zoning landscape before taking
any meaningful steps towards the repurposing of existing
developments or the commencement of new development projects.
Parties may also run into issues from a financing perspective,
whether they are operating with an existing lender or seeking new
financing. Lenders often have various financial benchmarks and
covenants regarding the operation of the subject property in order
to ensure appropriate cash flows to adequately service the debt.
Converting existing commercial property into a different use
entirely (for example, converting office space into hospitality)
can run afoul of these types of covenants. Seeking an existing
lender’s cooperation in these types of projects is therefore
vital to the success of the property. When seeking new financing, a
prospective lender will typically want some level of certainty as
to the future use of the property as well as an idea as to the
proposed tenant mix. As a result, future flexibility regarding a
commercial property’s use is likely to be limited unless the
appropriate changes can be negotiated in the loan documentation.
Accordingly, in either scenario it saves borrowers a lot of time
and money if these issues are broached up front with a prospective
lender.
From a non-legal perspective, assuming all other hurdles have
been cleared (or at least taken into account), parties should also
consider whether undertaking such drastic overhauls to existing
properties makes financial sense. These concerns include
potentially costly and time intensive construction and renovation
to existing structures to keep up with market trends. While new
developments in underdeveloped portions of the U.S. will likely
seek (and be granted) as much flexibility when it comes to building
use and composition, existing properties in heavily restricted
areas (e.g., New York City, San Francisco) will have a tougher and
more expensive situation to address.
Conclusion
As mentioned, the key to maximizing existing and current real
estate projects is increased flexibility as to the use and services
provided by each respective property and, most notably, to take
advantage of this emerging demand for so-called third space.
Failure by local and state governments to quickly adapt to and
revise applicable zoning laws will cause significant and perhaps
permanent damage to these properties (and, by extension, the
municipality and state governments themselves, which rely on real
estate as a tax revenue generator). Similarly, lenders will also
need to provide some degree of flexibility to existing and new
borrowers to give their borrowers a chance at maximizing revenues.
When navigating these challenges it is imperative for all
stakeholders to have knowledgeable and experienced counsel.
Withers Bergman LLP is an international
law firm with substantial experience with diverse leasing from
anchor tenancies in shopping centers to large office leases, luxury
brand single city retail leases and multiple city retail rollout
programs, residential portfolios as well as diverse lending and
development matters. For additional guidance on these matters and
other COVID-19 related items, please
reach out to our New York Commercial Real Estate Team to develop a
legal strategy to plan for near- and long-term solutions tailored
to achieve your specific goals.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.