Market Intelligence: What Commercial Real Estate Owners, Tenants, and Lenders Need to Know Now

By: S.H. Spencer Compton, COMMONWEALTH LAND TITLE INSURANCE COMPANY

CLIMATE CHANGE AND THE NEED FOR AFFORDABLE HOUSING are looming concerns in most U.S. cities. The impact of COVID-19 is still being felt as remote and hybrid work reshape the real estate landscape. Substantial rises in interest rates have dampened investor appetites for commercial real estate buying and lending. Commercial real estate owners, tenants, and lenders are facing unprecedented challenges and raising novel issues for their attorneys to address. Market intelligence has a crucial role to play in helping industry players navigate this rapidly changing environment. It is important for real estate attorneys to keep up to date with market data to maintain a competitive edge in deal negotiations, thereby producing additional value for their clients beyond the traditional legal realm.

This article discusses the important role market data plays in helping attorneys provide practical and effective counsel to clients, using the New York City real estate market as an example.

Climate Change Legislation

Buildings generate the largest share of greenhouse gas emissions in many U.S. cities. In New York City, for example, buildings account for about two-thirds of greenhouse gas emissions. It is no surprise, then, that cities like New York are focusing their climate change legislation on reducing building emissions. In 2019, New York City enacted Local Law 97 as part of the Climate Mobilization Act, which commits the city to reducing its emissions 40% below a 2005 baseline by 2030 and 80% by 2050.1 The law establishes carbon emission limits for New York City buildings over 25,000 gross square feet. Buildings that exceed annual emissions limits will face an annual financial penalty of $268 per ton of carbon dioxide equivalent over the limit based on 2024 energy usage and emissions. Most buildings have until 2024 to meet Local Law 97 emission targets. Annual fines for buildings that fail to meet the 2024 deadline will begin in 2025. These emission caps will become more stringent over time.

It is critical for developers, owners, tenants, lenders, and their attorneys to be mindful of how climate legislation across the country affects the commercial real estate market. Market data can offer unparalleled insight into how deal terms are evolving against this legislative backdrop.

Building Condition and Inspection Requirements

Local laws governing building inspections can impact the cost of owning, operating, and maintaining real property. These laws often require the building owner to hire professionals to conduct inspections and impose fines for failure to comply. Real estate owners and lenders should be aware of how laws that increase the cost of ownership can interact with, and potentially drive, market trends in their geographic region.

For example, last year New York City implemented new inspection requirements for parking garages.2 Real estate owners must hire a professional engineer registered with the Department of Buildings (DOB) as a Qualified Parking Structure Inspector (QPSI) to survey the condition of their parking structures every six years and file a compliance report with the DOB. After conducting the condition assessment, the QPSI then files the compliance report with the DOB, classifying the parking structure as one of the following:

• Safe. No repair work is needed. The garage is safe until the next inspection cycle.
• Safe with repairs and/or engineering monitoring. There is minor damage to the garage framing elements. The QPSI will set a timeline for repairs, and the DOB will require a follow-up inspection and subsequent compliance report filing. If repairs are not completed prior to the next filing cycle, the parking structure automatically will be classified as unsafe.
• Unsafe. There is severe damage to the garage framing elements which is a hazard to people or property. Repairs must be performed within one year of completing the condition assessment, and unsafe conditions must be remedied within 90 days after the date of the compliance report. Within two weeks after completing repairs, the QPSI must perform a subsequent inspection and promptly file an amended compliance report with the DOB.

As another example, look to New York City’s Facade Inspection & Safety Program, a set of regulations addressing the condition of buildings’ exterior walls and appurtenances.3 The purpose of the regulations is to protect the aesthetic quality and structural integrity of all buildings in New York City, particularly those located on busy streets or other high-traffic areas. Every five years, facades of all New York City buildings over six stories must be examined by a Qualified Exterior Wall Inspector (QEWI) and a report filed with the DOB. A QEWI must be a licensed architect or professional engineer with at least seven years of relevant experience. In addition to substantial fees paid to QEWIs and other professionals, the DOB charges filing fees, amended filing fees, late filing fees, failure to file penalties, and failure to repair penalties.

Similar inspection requirements can be found in cities across the country and may impact owners’ capital repair obligations. Real estate owners and lenders should watch how the market responds to increasing costs of ownership, and their attorneys should keep these market considerations in mind during deal negotiations to get the best results for their clients.

Rent and Eviction Considerations

Building owners, tenants, and lenders should pay particular attention to market trends around rent and eviction.

Housing Stability and Tenant Protection Act

In New York, the Housing Stability and Tenant Protection Act of 2019 (HSTPA)4 increased protections for residential tenants. Among the law’s expanded tenant rights, landlords should be aware of the following:

• HSTPA sharply curtailed opportunities for regulated rents to rise at rates higher than the Rent Guidelines Board’s annual limits. Rent-stabilized tenants can no longer lose their preferential rents during their tenancies.
• Before the HSTPA was passed, property owners could remove apartments from regulation by performing renovations to vacant apartments, but loopholes in the law have now been closed, and rent increases from renovations have been curtailed.
• Owners are now limited to taking only one month’s rent for security and are prohibited from asking for first and last month’s rent in any rental unit. If the broker was hired by the landlord to rent the apartment, the broker may not charge the tenant a broker’s fee. The broker’s fee regulation is being challenged in the courts, so stay tuned for the outcome of this litigation. Application fees which could often add up to a hundred dollars or more are now capped at twenty dollars.
• Unregulated apartment owners may charge whatever rate of rent increase they wish when it comes time to renew a lease, and they need not offer a lease renewal at all. Tenants in market rate apartments, however, now must be given the following advance notice for any rent increases over 5% or if the landlord plans not to offer a renewal:
  
  • 30 days for those who have been tenants for less than
    a year
  • 60 days for those who have been tenants for more than a year but less than two years
  • 90 days for those who have been tenants for more than two years
• Late fees may not exceed the lesser of 5% of the monthly rent or fifty dollars.
• The HSTPA outlaws the selling of the names of tenants who appear on a so-called blacklist and prohibits landlords from denying tenant applicants an apartment based exclusively on their status as a respondent in an eviction proceeding.
• Finally, the HSTPA includes changes to the way eviction cases are processed in housing court. The HSTPA increases the time tenants are given to be notified and respond, strengthens available tenant defenses, and broadens opportunities to avoid or lessen the impact of eviction.

Good Cause Eviction

Under New York State law, a residential tenant may be evicted only if a landlord has brought a court proceeding and secured a judgment of possession from the court. Only a sheriff, marshal, or constable can carry out a court ordered eviction. A landlord may not evict a residential tenant by use of force or unlawful means.

First proposed in 2019, a good cause eviction statute would apply to residential premises and would amend the existing law to provide that a landlord cannot evict a residential tenant who pays rent on time, except under specific circumstances. Although there are already eviction regulations, current New York law allows landlords to raise rents at their discretion and deny a lease renewal to any tenant who does not inhabit a rent-controlled or rent-stabilized apartment.

A good cause eviction law would effectively cap residential rent increases in New York State at 3% per year regardless of the percentage increase in real estate taxes or other operating expenses and give judges the power to decide if repairs and improvements are necessary in privately owned real estate. Such a law would also mandate renewal leases and limit landlords from being able to regain apartments they own. Proposed good cause eviction legislation seemingly is premised on the belief that landlords can subsidize their tenants indefinitely while slowly working through the courts to be able to operate their properties.

Under a good cause eviction regime, building owners would be unable to evict a squatter without demonstrating to the satisfaction of a judge (and then most likely an appellate court) that they have good cause in wanting to reclaim the apartment in order to demolish it even after the lease requires the tenant to vacate. In addition, an employee who is provided housing (e.g., a superintendent) cannot be evicted after being terminated until the landlord demonstrates that the employment was lawfully terminated. Note that the HSTPA already permits judges to allow tenants to remain in occupancy for a year after a default in the event of a hardship, while the landlord has to continue making payments for real estate taxes, heat, insurance, repairs, etc.

Not surprisingly, good cause eviction legislation is opposed by most landlords and, if past is prologue, likely will be sponsored in one or both houses again. Residential building owners will want to follow the progress of any proposed housing legislation closely.

Other Costs of Building Ownership in a Changing Market

In addition to legislative compliance costs, a building owner must also pay real property taxes, debt service on its mortgage and other financing, insurance premiums, and utilities and other operating expenses, all of which historically increase every year whether or not the property’s rental income rises or falls.

Some building owners today have the financial resources to withstand a down real estate market because either the building they own is in a desirable location, recently constructed with strong tenancies and vibrant amenities, or they have deep pockets.

Other owners have buildings where leases are gradually expiring with many tenants not opting to renew, resulting in diminishing available cash flow to pay for improvements or the cost of refinancing their mortgage at today’s substantially higher interest rates. What can these owners do to protect their real estate investments in today’s changing market?

Let’s look at a worst-case scenario: An urban commercial building owner is faced with diminishing tenancies and increasing property taxes, utilities, and maintenance costs,
as well as interest rates significantly higher than when the property was last financed. When the owner offers the building for sale at a reduced price, there are no takers and so it elects to default on its mortgage and walk away from its asset. Not wanting to own this abandoned collateral, the mortgagee writes off the loan, preferring to take a loss on its balance sheet rather than become a real estate operator in a distressed market. The abandoned property reverts to the city. Real property taxes go unpaid, weeds grow, and windows and doors are smashed. The values of neighboring properties go down.

Potentially, entire commercial neighborhoods could shrivel and lie fallow for decades.

What should owners, buyers, tenants, lenders, and their counsel be paying attention to in the months and years ahead? What can a commercial building owner do to maximize the value of its property? Here are some suggestions:

• Analyze your existing rent roll. Diagram lease expiration dates. Gather the best possible information about each tenant’s financial condition. What are your tenants’ financial disclosure obligations under their leases? Can they afford to pay rent for the rest of their lease term on what now may be barely occupied office space? Does the lease give the landlord any rights to updated tenant financial information?
• Consider existing floorplates. Is it feasible to offer premises with less square footage going forward? How flexible can you be?
• What amenities does your building offer? Consider a cost-benefit analysis of adding, for example, a tenant cafeteria, conference rooms rentable by the hour or day, on-site pet or child daycare facilities, or a shared roof deck. Think: what will attract people to come to work in your building?
• Determine whether climate regulations like Local Law 97 are applicable to your building, and, if so, commission an energy survey and a carbon emission abatement plan. Even if your building does not fall under the regulation’s requirements, an energy survey can help you reduce annual energy costs by investing in better insulated windows, dimmable lights, and more efficient air conditioners and heating systems. The more energy efficient the building, the less costly it is to operate.
• If garage, facade, or other inspection requirements apply to your building, determine when inspections are due and how much compliance will cost.
• When must your underlying mortgage be refinanced? What is the debt service differential between your existing interest rate and today’s rate? Will your current rent roll support these new payments? Considering the points listed above, how likely will a refinance lender be to offer favorable terms or any terms at all? Is it viable to take out a short-term bridge loan in the hopes that rates will be lower after a year or two?

In all cases, data on market trends can be a critical resource for real estate owners, tenants, and lenders. By knowing where the market stands and where it’s headed, real estate players can develop practical strategies to deal with rising ownership and compliance costs. It is important for real estate attorneys to stay on top of market intelligence to best advise their clients and protect their interests in deal negotiations and beyond.

Conclusion

With climate change, hybrid work patterns, and changing market trends, today’s commercial building owners are faced with more costly regulatory compliance and marketplace considerations than ever before. New York and other U.S. cities have insufficient affordable housing at too high a cost. Many legislative solutions have been proposed but few enacted. Although the recent good cause eviction bill did not become law in New York, as the urban housing crisis persists, bills
to address housing concerns likely will be passed. Owners, lenders, tenants, and their lawyers must pay attention to market intelligence to navigate these increasingly challenging real estate trends.

S.H. Spencer Compton is Senior Vice-President and Senior Counsel, Commonwealth Land Title Insurance Company.

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