By Carl Pebworth and Mark Sausser
The COVID-19 pandemic has fundamentally changed the development, construction and use of commercial real estate. Prudent property owners, developers, property managers and builders (and the lawyers they represent) need to recognize this changing environment and act accordingly.
Certain post-COVID market segments and functions are irrevocably affected. How we shop and travel has been influenced. The areas for retail, food and gastronomy, hospitality and transport therefore look different. Shopping in stores – especially in individual or focused retail functions – will decrease. The demand for space for traditional shopping centers is falling.
The change has been good in many segments. The internet has changed the way we shop, so the demand for retail space is growing. For Indiana, where logistics is important to the economy, these changes offer commercial opportunities.
But the pandemic accelerated some worrying trends. There is a shortage of available housing, although the construction and purchase of luxury and vacation homes is increasing. At the same time, COVID-19 exacerbated the affordable housing crisis. Office use in central business districts has also decreased, and in some areas this decrease may be permanent.
The COVID-19 pandemic has disrupted the supply and demand of real estate to a greater extent than it has ever seen in recent times. Commercial office space and the way we work is in the midst of a fundamental change. One commenter noted that in certain markets, Class B office space is virtually out of date with no predictable demand for aging and more modest leases.
Many employees return to work, but not necessarily five days a week. Remote work – at least temporarily – will continue to be the norm. Employers will encourage or at least tolerate more "hoteling" if employees share work space. Other organizations also conclude that common, open areas are not required. Similarly, COVID-19 has also shown that certain functions and certain industries – information technology, finance, and insurance – may not need central offices as long as productivity remains stable or improves. This reduction in office use can have a cascading effect, reducing residential and retail leasing in the central business district, which depends on office workers and downtown residents. This could also affect mixed-use developments in suburbs that encourage a work / shop / leisure model.
Management, operational challenges
Construction, procurement, and delivery complications have made operations and management more difficult. COVID-19 revealed how vulnerable many supply chains are to unexpected structural disruptions. The supply chains have been impacted in ways that have not yet been fully realized.
The pandemic has ushered in a new period of mounting financial uncertainty affecting commercial real estate, perhaps most fundamentally, how much real estate is worth and what it will be worth in the future. To exacerbate this uncertainty, the government intervenes in unprecedented ways in peacetime. Trillions of dollars are being introduced in various forms of pandemic aid and economic stimulus. While the investment is welcomed in many circles, it adds additional obscurity to an already uncertain financial environment.
There is no certainty of what the new post-COVID-19 environment will mean for real estate law, but flexibility will certainly be a hallmark. Owners and developers may need to convert existing projects into different tenant mixes and include more restaurants, entertainment and retail office space unlike traditional retail tenants. Some building uses can change completely, e.g. B. the conversion of office or retail space into flex, warehouse or industrial space.
Such changes of use require a close examination of ownership agreements, declarations, zoning and land use restrictions. This could require renegotiating existing agreements so that the owner of the larger mall or project can be assured that changes in use will not materially affect the value of the entire project. For example, in exchange for a change in the use of the flex space, the owner may agree to improve the external appearance of the converted space.
Changes in use also apply to future developments. Lawyers who will represent successful real estate players in the future must therefore be careful when drafting declarations, facilitations and zoning obligations so that clients can react as flexibly as possible to unpredictability.
Changes in the drafting of the contract
Most lawyers currently have provisions in place that nobody would have thought would be included in an agreement in early 2019 that must now become standard leasing provisions. For example, it is no longer an academic question to clarify how a pandemic or similar health event acts as force majeure and whether this extends to the tenant's obligation to pay the rent. In many cases it is at least a problematic editorial mistake to leave these terms ambiguous after the pandemic.
Similarly, leases may need to think about granting rent relief to a tenant due to a government shutdown, partial shutdown, or if the tenant chooses to suspend operations for security reasons for employees and invitees. The final form of these provisions will, as always, vary from document to document depending on factors including the relative bargaining power of the parties involved. However, lawyers representing parties in real estate contracts will need to consider and address these issues in future transactional documents.
Eviction or not eviction
In an environment with new risks, lawyers need to identify and support clients more proactively than in the past. Reassessment for creditors and sellers may be more common and in many cases should take a different approach to the interpretation and enforcement of contract law. The evacuation of a below-average tenant makes less sense if there is no replacement tenant on the horizon. Enforcing outdated valuation assumptions can be unrealistic and counterproductive. As uses and values change, property owners, lenders, managers, tenants and sellers need to be flexible in precarious and unpredictable circumstances.
Value creation opportunities
Homeowners who own properties that no longer hold the same value can mitigate the impact by challenging the property tax assessment. For properties that have been built for increasingly obsolete purposes, it is imperative to repurpose the space, which creates legal issues related to reallocating, remodeling, and remarketing spaces. Much value can be achieved by carefully challenging outdated, outdated reviews.
Changes in real estate construction
Design and construction related to the reconfiguration and refurbishment of existing rooms are becoming more common. This also applies to the demolition and rebuilding of property that until recently seemed to have a more useful lifespan. Builders and contractors must anticipate further disruptions in supply that could increase construction costs unless the parties develop new, creative methods of assigning the risk of delay due to material disruption. Lawyers need to advise clients on all of these opportunities and challenges, and draft contracts that take these new realities into account.
COVID-19 created uncertainty and triggered the need for more careful strategic deliberation and advice to customers. For example, the supply chains are rebalancing and shifting. Companies have to plan for disruptions and unexpected delays, among other things. Customers need to be instructed to plan more conservatively.
The changes brought about and accelerated by the pandemic are a reality in the real estate market of 2021. The success or failure of many players in the real estate market will activate the ability to recognize and accept these changes. And lawyers will play a central role in addressing these new challenges and opportunities. •
• • Carl Pebworth is a partner in the Construction and Real Estate Disputes practice group and Mark Sausser is a consultant in the real estate practice group at Faegre Drinker Biddle & Reath. The opinions expressed are those of the authors.