In most cases, during normal times (which it is not), investing in commercial real estate is an attractive proposition.
An investor buys or builds a building for commercial use – shops, restaurants, offices – mostly with borrowed funds. The investor then places tenants in the building, who pay 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 home what is left as a return on investment.
From an investor’s point of view, the deal is tax-friendly because depreciation can be used as a tax deduction even if it is not an actual out-of-pocket expense. And when the value of the property rises, the investor can sell it and pay income tax at lower capital gains rates, or postpone income taxes indefinitely by exchanging the property for another similar property.
But what happens when a pandemic hits? The short answer is legal chaos. Tenants cannot pay rent because their businesses are closed. An investor can sue tenants for unpaid rent, but since they are now bloodless turnips, this strategy will get you nowhere and will just lead to legal costs. Eviction is not beneficial as there are no new tenants willing to move into the property. In addition, the courts are locked down and cannot deal with the sudden surge in debt collection and / or eviction claims.
The investor must now try to cover the operating expenses previously paid by the tenants. Maintenance is delayed, repairs are no longer made as needed, and landscaping is abandoned and dying. In the absence of rental income, the investor defaults on the mortgage.
Then the owner of the mortgage, no longer receiving payments from his borrower, defaults on his obligations and finds himself fighting off several lenders. The mortgage owner could theoretically repossess the property, but this would mean returning the property that has no rental income and is in deteriorating condition. Or the mortgage owner could sue his defaulted borrower for the outstanding loan balance, but since the borrower is now insolvent and threatened with bankruptcy, this would be another exercise in throwing good money after bad money.
Ultimately, out of this chaos, a complex set of negotiations emerges, driven by necessity. Investors and their tenants agree to defer the lease and change the terms of the lease. Mortgage holders and their borrowers are negotiating leniency – lowering interest rates and deferring or forgiving accrued payments. Other creditors and debtors negotiate agreements on the premise that something is better than nothing.
To complicate matters further, the mix includes government aid to bail out the economy. This generates additional negotiations about how public money will be used. Tenants, for example, want money to cover their rent arrears. Real estate investors want money to cover late loan payments.
These negotiations are driven by the fact that trying to enforce legal obligations against parties unable to pay is a waste of resources and that weathering out the storm is the only viable option.
This is the situation now for commercial real estate investors, and it will most likely take years for something like normal to return. The victims will continue along the way, and the survivors will have deep wounds.
Jim Flynn works for Flynn & Wright LLC in Colorado Springs. You can contact him at email@example.com…