In mostly normal times (which they are not), investing in commercial real estate is attractive.
The investor buys or builds a building for commercial use – shops, restaurants, offices – largely with borrowed money. The investor then brings tenants into the building, paying the rent and an additional amount to cover operating costs – insurance, maintenance, repairs, property taxes, utilities. The investor uses the rent to pay off the mortgage and takes the rest home as a return on investment.
From the investor’s point of view, the transaction is income tax-privileged as the depreciation can be used as a tax deduction even though it is not an actual expense. And if the property increases in value, the investor can sell the property and pay income tax at lower capital gains rates or postpone income tax indefinitely by exchanging the property for another, similar property.
But what if a pandemic comes? The short answer is: legal chaos. The tenants cannot pay their rent because their shops have closed. The investor could sue the tenants for unpaid rent, but now that they are bloodless turnips, this strategy is futile and only incurs legal costs. An eviction is useless as no new tenants want to move into the property. In addition, the courts are locked and cannot process a sudden increase in debt collection and / or eviction suits.
Now the investor has to try to cover the operating costs previously paid by the tenants. Maintenance work is postponed, repairs stopped when necessary, and landscaping is neglected and dies. Without rental income, the investor will be in default with the mortgage.
Then the mortgagee, who no longer receives payments from his borrower, fails to meet his obligations and has to fend off several creditors. In theory, the mortgagee could foreclose the property, but that would mean repossession of a property with no rental income and in a deteriorating condition. Or the mortgagee could sue their defaulting borrower for the unpaid balance of the loan, but now that the borrower is insolvent and threatened with bankruptcy, this would be another practice for throwing good money after bad money.
What ultimately emerges from this chaos are complex negotiations driven by necessity. Investors and their tenants are negotiating about rent deferrals and contract adjustments. Mortgage holders and their borrowers negotiate deferral – rate cuts and deferred or waived payments. Other creditors and debtors negotiate adjustments on the premise that something is better than nothing.
To make matters even more complicated, there is government aid to save the economy. This leads to additional negotiations on the use of government funds. For example, tenants want the money to cover their unpaid rent obligations. Real estate investors want the money to cover their defaulted loan payments.
These negotiations are driven by the fact that trying to enforce legal obligations to insolvent parties is a waste of resources and that waiting for the storm to come is the only viable option.
This is what commercial real estate investors find themselves in now, and it will likely be years before anything returns to normal. There will continue to be sacrifices along the way, and those who survive will have deep wounds.
Jim Flynn works for Flynn & Wright LLC in Colorado Springs. You can contact him at [email protected].