What are we currently seeing in the commercial real estate space?

For the most part, we are still in the “wait and see” stage as to what longer-term impacts or changes may result from this pandemic. That said, activity levels have picked up, particularly longer-term development deals with long horizons. We take a look at market activity, trends in deal and contracting terms, and the latest from the courts in our latest real estate update.

Market overview

There is still reticence in the marketplace around particularly harder-hit sectors such as retail and downtown office—although with office and in particular, Toronto office, there is still optimism due to the extremely low vacancy rate pre-COVID and an expected economic rebound and immigration levels. Malls and gyms, as well as the hospitality sector, are struggling under lockdown orders and ongoing international travel restrictions. Courts in common and civil law jurisdictions have released differing views on the obligations of tenants to pay rent as a result of these orders and restrictions.

There has been greater confidence in certain asset classes, such as industrial, ecommerce/data centres, supply chain/logistics/distribution, and multi-family residential. Industrial is a highly sought-after asset class along with an acceleration of a growing trend in “industrial condominiums”. As e-commerce and warehousing become more important to businesses, some are seeing rents increase in the space.

Infrastructure and transit-oriented developments are still proceeding as are multi-residential and mixed-use deals; however, with increased demand and pressure for affordable housing, we expect that public-private cooperation will become even more important than ever.

Discussions among industry players are ongoing with respect to novel ways to reconfigure or redevelop assets that have become less desirable as a result of the pandemic—for example, potential conversion of some suitable retail space into smaller-scale urban logistics/distribution centres, or the creation of more flexible office space and shorter-term dynamic leases.

Key drafting considerations as we recover from the pandemic

Contractual parties are cooperating with one another to find solutions to the ongoing challenges resulting from COVID-19. By way of example, lenders are working with purchasers and borrowers to modify customary tenant estoppels to address rental arrears, government supports, rent abatement and deferral-related matters, and landlords demonstrating flexibility in shorter lease renewals and more flexible terms to deal with ever-changing circumstances. Below we cover more specific drafting considerations in this new environment.

• We are seeing some changes to standard legal clauses to more clearly deal with the contractual obligations of parties during government-ordered shutdowns. The key factor, as always, is the delicate dance between balancing pursuing opportunity and mitigating risk.
• On balance, we are not seeing wholesale changes to force majeure or “material adverse event”/“material adverse change” (i.e., MAE/MAC) clauses, but rather a tweaking of those clauses to include pandemics and health emergencies as well as government-ordered shutdowns associated with those events, and occasionally in the leasing context, specific carve-outs to allow for ceasing of operations or reduced hours of operation during such events.
• We are starting to see some agreements, including in M&A, refer specifically to COVID-19 measures and covenants that purchasers and lenders are requiring of their vendors or borrowers, such as protection of employees and compliance with government measures.
• The common law duty of good faith in contractual negotiations is a consideration that parties need to think about, particularly where a contract is silent on what happens in the event of an emergency or force majeure; in instances where there is litigation around contractual uncertainty, courts will generally look to the reasonability of the parties in dealing with the situation at hand.
• In the commercial leasing arena, some tenants are asking for shorter terms coupled with a greater number of options to extend/renew, smaller footprints, lower deposits applied sooner during the term, termination rights to be exercised earlier on during the term, broader use and force majeure clauses, and sometimes the right to go dark. Landlords will want larger deposits from able tenants, as well as additional covenant support by way of guarantees or indemnities in some cases. Negotiations are ultimately still primarily being driven by the bargaining powers of the parties.
• Some of the key takeaways and lessons learned that are shaping contractual negotiations and drafting are outlined below.

Acquisitions and dispositions

• For sellers, ensure that you have a robust “as is, where is clause”, and if estoppel certificates are being provided as part of the deal, be clear that there is an understanding on the part of the purchaser that estoppels may disclose that there are abatement or deferral arrangements in place that the purchaser will need to assume.
• For purchasers, ensure that you adequately diligence the rental income and understand any deferrals, abatements or prohibitions on future evictions that impact adjustments, reconciliations, recuperation and remedies after you become the owner of the property. If you are assuming any financing, be sure to carefully diligence all aspects of that and understand that if there are any forbearance agreements still in force, ensure that the loan agreement is in good standing and that you can comply with the covenants contained therein.

Borrowing and lending

• For borrowers, be mindful of negotiating for reasonable cure periods and pay particular attention to what will or will not constitute a material adverse event which could put your loan into default.
• For lenders, on the flip side, ensure that your material adverse event clauses are robust enough to protect and preserve your rights in the event where your borrower or the rental stream may be in jeopardy.
• Tenants should consider negotiating for and entering into non-disturbance agreements with their landlord’s lender to protect their tenancies in the event that the landlord defaults on its mortgage.

Leasing

• For tenants, pay particular attention to renewal, extension, expansion and contraction options clauses and ensure that they are as flexible as possible to deal with changing dynamics and allowance for time to see how market conditions play out; in particular, consider shorter-term lease renewals or extensions.
• For landlords, ensure that leases are drafted in such a way as to require that tenants are still responsible for paying rent during a force majeure situation, even where they are unable to occupy the premises due to a government-ordered lockdown.
• Environmental, social and governance (ESG) and sustainability are big factors that landlords and office owners are thinking about and tenants are demanding, and we can expect to see this as a pressure point for both parties in lease negotiations going forward.
• Tenants and landlords alike should be alive to the different implications of rent deferral and abatement versus rent forbearance arrangements, including when GST/HST obligations arise, what is recoverable in the event of bankruptcy, and how they impact the government subsidies available.
• In the context of relief from forfeiture, the courts are willing to consider the current climate and the resulting circumstances in which landlords and tenants find themselves. Courts will favour parties who seek to negotiate commercially reasonable compromises in good faith and take into account the magnitude of loss to each party—but to date, we are generally seeing a pro-tenant approach in granting relief from forfeiture.

What the courts have said

As a result of the pandemic and government intervention, force majeure and quiet enjoyment clauses in commercial leases have come under scrutiny. The Québec court’s decision Hengyun International Investment Commerce Inc. v 9368-7614 Québec Inc.¹ was unexpected by many. The court relied on the “superior force” concept under the Civil Code of Québec in excusing the tenant, a gym, from paying rent during the government mandated shut down. The Québec court ruled that the tenant’s right to peaceable enjoyment of the premises is the essence of a lease, which right the landlord could not provide during the shutdown.

Courts in common law jurisdictions have mostly distinguished themselves from the Québec jurisprudence. The Ontario court considered the application of the force majeure clause in the context of the pandemic for the first time in Durham Sports Barn Inc. Bankruptcy Proposal.² Even though the tenant was prevented from operating in the leased premises as an elite athletic performance centre due to government mandated shutdowns, the court did not excuse the tenant from the obligation to pay rent by virtue of the force majeure clause. The court ruled that the landlord’s obligation to provide quiet enjoyment was subject to payment of rent by the tenant. The court also looked to legislation enacted by the government during the pandemic and noted that they did not suspend the obligation of tenants to pay rent.

We have not yet seen the final verdict on this issue as these cases are going through appeal. In the meantime, tenants will continue to argue that quiet enjoyment is so fundamental a right that if disturbed, it should excuse them from the obligation to pay rent. Landlords on the other hand will be careful to ensure that paying rent is a precondition to quiet enjoyment and that force majeure clauses do not excuse tenants from such obligation.

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¹2020 QCCS 2251.

²2020 ONSC 5938.