The Real Estate Market In 2019 And What The Future May Hold: The View From Los Angeles - Landlord & Tenant - Leases

Greetings from Los Angeles, and welcome to this year's edition of Real Estate Rewind. 2019 is in the books!

Each year, we use this time to reflect on the trends and market developments we saw over the last 12 months. Our hope is that we will be better informed to serve your needs.

This year's Real Estate Rewind includes contributions from my colleagues, Jessica Fluehr (San Francisco), Skyler Anderson (San Diego), Barbara Trachtenberg and John Sullivan (both Boston).

In a word, we would describe 2019 as choppy. We were frequently reminded of the adage "a smooth sea never made a skillful sailor." The lessons learned from 2019 will be beneficial to you in 2020.

Here is how the Los Angeles team spent its time in 2019:

Deal Type	Number of Transactions
Purchase and sales	19
Big lease / lease workouts	3
Mortgage loans (acquisition loans and refinancings)	20
Mezzanine loans and preferred equity	4
Construction and improvement loans	3
Loan workouts and modifications	5
Loan assumptions	4
Joint ventures and recapitalizations	6
Environmentally-challenged transactions	5
REIT and DST formations and offerings	6
Corporate restructurings	3

The notional amount of the transactions for our LA-based team in 2019 was approximately US$4 billion. The map at the end of this report shows the locations of many of the properties we worked on over the last few years – far beyond the borders of California.

The primary market trends observed in 2019 are summarized below. In addition, we have included the annual analysis of transaction vitals – key metrics in purchase and sale and CRE finance (ie, "what is market"). These charts have been useful to many of you, allowing you to gauge your deal terms against the charts. The vitals are followed by a reader favorite – "Servicer shenanigans, origination commiseration and transactional twists." We conclude with thoughts about the future of contracts and the impact of new technologies on the way we do business.

So, here we go, fast-forward to the rewind...

Purchase and sale observations for 2019

In the purchase and sale arena, although we closed nearly 20 deals, we had 10 or so failed deals. As noted, it was choppy. Four general observations are set forth below followed by the PSA vitals for 2019.

Smart(er) money: Like Warren Buffet sitting on US$130 billion and (wisely)(?) refusing to chase deals, clients were less inclined to engage in bidding frenzies. Price was the culprit in many of the failed deals. Greater emphasis was placed on conventional due diligence. Buyers were careful and in some cases looked for reasons to cancel. Brokers are also telling us that the number of buyers bidding on properties is significantly less.
Off-market: Relative to prior years, more of our transactions occurred "off-market" in 2019. Sellers seemed more willing to engage in exclusive dealings with one or two buyers. One would have expected that to mean compressed timelines to get deals done with fewer contingencies – but that was not the case. Again, even in a non-competitive situation, buyers were careful.
Conditions precedent: In 2018, we observed the increasing use by buyers of conditions precedent tied to property performance or key tenants. That continued in 2019. In three of our transactions, occupancy thresholds in the multifamily context were imposed as conditions precedent. In other transactions, conditions related to ongoing tenancies by key tenants in the office and retail contexts were imposed. Fact-specific conditions were prevalent, particularly in industrial, self-storage and single tenant deals.
Environmental risk: Notwithstanding the above, buyers have become more willing to accept known and unknown environmental risks. Environmental conditions are viewed by some buyers as potential profit centers. Also, historically, the purchase of environmental insurance was not the norm. Now, even in certain instances where the phase I ESA is clean, buyers are purchasing coverage or adding properties to their blanket policies. Premiums have come down and buyers are generally more informed about the utility of the product.

Purchase and sale vitals for 2019

Issue	Market Observation / Comparison to Prior Years	Comment
Due diligence periods	Flat to lengthening – 30 to 60 days *Our East Coast colleagues advise that the norm in New York, Boston and Washington, DC remains at 30 days.	Access agreements are more common, such that one should not necessarily expect the longer due diligence period to occur while under contract (it may include time pre-PSA).
Rights to extend DDP	Not hard-wired in the contract, but frequently given upon request when more time is needed/desired.	Where available, always coupled with a non-refundable deposit (credit to purchase price)
Closing period	Flat to Lengthening - 30 to 45 days after DDP (very rarely the shorter periods, eg, 10 days, we saw in prior years except in highly cooperative deals).
Financing contingencies	As to new debt, still rare. But, loan assumptions were more common. Loan assumptions typically involve an amendment to the loan and replacement of guarantors. This presents greater risk to sellers (as the condition may not be satisfied), but sellers were willing to entertain these conditions (reluctantly).	Certain sellers who have institutional access to capital are strategically obtaining financing (at currently low rates and favorable terms) within 3-6 months of going to market to sell the asset. For properties encumbered by CMBS debt, borrowers are seeking to ensure that lockout periods on loan assumptions, which in the past have been 1 to 2 years post origination, are limited to short windows before and after securitization (60 days on either side).
SNDAs as conditions to closing	Yes, about the same as prior years. Continues to be a thorn for sellers – who perceive it as a disguised financing contingency.	Particularly important in single or major tenant properties. Less important in multi/minor-tenant properties.
Right of buyer to extend closing date	Yes, but greater resistance to the concept in 2019. *Still in high use on the East Coast	The extension periods are limited (typically not more than 30 days), and sometimes require a fee or additional deposit.
Reps and warranties	Static to shrinking list. We also have seen a few clients entertain rep and warranty insurance (which has traditionally been limited to corporate deals, but is now gaining traction in the real estate industry). Similar to environmental insurance, as this trend continues, expect premiums to go down and this to be an option in certain circumstances. In the M&A world, this is perceived as the norm – and a substitute, to some degree, for protracted rep negotiations.	This is consistent with our comment above re: simplicity – clients are less interested in extended negotiations over reps and warranties; they recognize their limited utility.
Survival period for reps and warranties	Seems to be shortening. Shortest: 0 months (2 deals) Longest: 12 months (excluding certain matters involving entity purchases). Market: 9 months	*Colleagues from the East Coast characterize "market" as being 6 to 9 months.
Limitation on liability for seller breach of representations and warranties, covenants and post-closing obligations	Decreasing. In general, market remains at 1.5% to 3% of the purchase price. But more sellers are starting at 0.5% and 1% (even on smaller deals). Basket and minimum claim amounts also apply – typically $25,000 to $50,000 (on larger deals, it will go to $100,000) For larger deals (ie, > $100 million, 1% or less)	Increased number of exclusions from the cap – for fundamental reps (not just fraud) – and we saw this in fee deals as well as entity deals in 2019. Entity purchases are more highly negotiated (with more exclusions from the caps in general). There is generally an inverse relationship: the lower the purchase price, the higher the cap (on a percentage basis).
Indemnity (by buyer of seller) as part of as-is and release provisions	Less frequent.	Sellers who seek to impose indemnities are setting themselves up for failure – as the request for a mutual indemnity (for pre-closing events) will follow. Given the use of SPEs and general lack of credit support behind these indemnities, we encourage our buyers and sellers to focus on more important items.
Buyer right to damages if seller defaults (in addition to termination, return of deposit, or specific enforcement in the alternative)	No, continues to be limited to out of pocket costs and expenses only – not general damages.	Where the deals were designed for very specific purposes, such as fulfilling one side of a 1031 transaction, or where a hedge has been purchased by the buyer, sellers were generally willing to afford actual damages in relation to such exposures.
Caps on buyer's (and seller's) out of pocket costs and expenses in the event of default (primarily intended as recoupment of legal fees and buyer's due diligence costs)	Yes, almost uniformly. Caps were less dependent on deal size. In most of our deals, the cap will be between $150,000 and $250,000.	In the past, it would be unusual for Sellers to be entitled to out of pocket costs and expenses in addition to capture of the earnest money as liquidated damages. On the West Coast, we saw 2 sellers seek this in 2019. Ultimately, they conceded the issue.
Conditions precedent tied to property performance	Yes, more common.
Risk of loss (casualty or condemnation) thresholds	3% to 5% of purchase price *Buyers have been willing to accept a credit in lieu of termination right where the casualty is less significant.	Deductible credit to buyer. We also see other thresholds for rights to terminate (eg, permanent loss of parking, tenants terminating their leases, etc.)
Post-closing holdbacks, guaranties or credit support (by seller in favor of buyer)	Sought by buyers but not frequently given by sellers. Buyers who have historically insisted on guaranties or holdbacks are settling more often for "seller shall maintain x net worth and y liquidity for the survival period" or more general covenants by the seller to "maintain sufficient capital to satisfy post-closing obligations" (a redundant requirement of state law in most instances).	Holdbacks were in certain cases less than the limitation on liability (seller friendly). With a growing number of funds (as sellers) nearing the end of their lifespan, holdbacks are very common.

Based solely on our deals over the last 12 months^[1], here are the market vitals that the LA team observed in our purchase and sale transactions:

CRE finance observations for 2019

As many of you know, our LA team's finance practice focuses almost exclusively on borrower-side representation. Over the last 20 years, we have represented borrowers in more than US$100 billion of real estate debt. In 2019, we noted the following:

Minimum interest. Floating rate debt (including construction debt) has historically been freely prepayable without premium or other expense. Over the last few years, minimum yield and/or minimum return features have become more widespread. Some lenders are also asserting that guarantors should be liable for the same (default before minimum return paid). We resist the same obviously.
Fewer rate locks: Historically low interest rates coupled with less day-to-day volatility in rates resulted in fewer rate lock agreements being executed by our clients. Borrowers on large loans (>US$100 million) continued to use rate locks in some, but not, all instances. Middle-market borrowers chose to maintain optionality and avoid the potential for rate lock fee forfeitures. Rate lock terms, such as the lock periods and fees, remained mostly unchanged.
LIBOR replacement: With the date for replacement fast approaching, we spent considerable time focused on provisions regarding LIBOR replacement. While a standard market provision continues to evade us, we did see many lenders accept the notion that the replacement rate should be neutral to the borrower (as Wells Fargo describes it, there should be "no value transfer"). Lenders were amenable to consultation with our borrowers before implementing any such replacement index. For larger loans, the replacement index (but not the spread adjustment) was subject to borrower's (reasonable) approval in certain instances. The one sticking point that remains in these discussions is whether the actual replacement index can fall below zero (as borrower's counsel we don't think that a floor is necessary, but lenders have continued to insist on a floor). Give us a call if you would like to discuss what you are seeing and whether we think it reflects current market standards. LIBOR replacement is not only relevant to floating rates during the term of a loan, but also to hedges (swaps, rate caps).
Recourse high. The legalization of marijuana and the expanding presence of cannabis-based business has given rise to a new non-recourse carveout for "forfeiture of the Property or any portion of the Property as a result of the violation of law by the borrower" (or variations thereon).
Lease-related cash sweeps: We saw many lenders across all property types attempt to address leasing concerns, at least at the initial stage of a transaction, with a cash sweep triggered by particular tenants going dark, terminating their leases or notifying landlord that they would not exercise a renewal option under their leases. While we have seen these types of sweeps over the past couple of years in cases where one or two tenants occupy all or substantially all of a property, we had not seen these sweeps widely applied to all property types, regardless of number or types of tenants. In many cases, borrowers with a diverse tenant group were able to negotiate these sweeps out of the transaction, but the frequency with which we saw these sweeps in initial drafts of term sheets, gives us reason to believe that these may become (or are already becoming) a standard lender request. Rights to cure these cash sweeps varied, but generally lenders accepted such tenant's space being re-let to a new tenant or otherwise meeting certain debt yield or DSCR thresholds for at least one calendar quarter.
Release rights: Negotiating release rights into loan documents was increasingly important to a number of our clients this year. As clients continue to think strategically about the future potential uses or dispositions for portions of their properties (including vacant and improved portions), they are pre-negotiating the right to release the same from the lien of the applicable mortgage or deed of trust. This was particularly true in the retail context as shopping malls undergo transformation. In many cases, where the portion of the property requested to be released is not generating income at the time of the loan origination, lenders will release the same without a concurrent partial repayment of the loan or a release price.
Deposit account control/blocked account control agreements: Deposit accounts over which a lender has control either as of day one of a transaction, or upon cash management event, are being required in almost all financing transactions. The "KYC" diligence required to create such an account and the actual negotiation of the account control agreement remain time consuming. We typically see this process take 3-4 weeks, and as such, this is a reminder that this process needs to start early in the transaction. Certain banks have also exited the cash management business in recent years.
Property fundamentals: As we saw in 2019, lenders (and their counsel) spent more time diving into property fundamentals during underwriting and diligence. We saw a heightened focus on title, survey and zoning matters, particularly with respect to legal compliance (eg, parking). The secondary loan market appears to be driving heightened scrutiny of property fundamentals (economic, physical and legal).

CRE finance vitals for 2019

Based solely on our own deals over the last 12 months, here are the market terms that we observed in commercial mortgage loans (across numerous asset classes):

Finance Parameter	Market Observation / Comparison to Prior Years	Comment
Going-in fundamentals	Flat to tightening LTV: 45% to 62% DY: 8% to 10% DSCR: 1.4 to 1.8x	Closely tied to asset type and subclass and property fundamentals
Loan amounts (of our deals)	Generally, greater than $50 million
Origination fees	0% to 1%	1% should no longer be presumed. Highly negotiable. In large loan CMBS, 0%.
Ongoing annual administration fees	Yes, more prevalent	On CMBS, borrowers are bearing more servicing administration fees.
Term	Generally, 8 to 10 years; range from 2 to 15 years.
Borrower right to add mezzanine debt	Lenders will entertain this, but will ultimately be involved in the later mezz loan process (with either approval rights over the loan, the lender, or both).
Amortizing vs. I/O	A good mixture of both. Amortization triggers (low DSCR) were employed more often, and many deals had an initial I/O period (3 to 4 years), followed by 25 to 30 year amortization thereafter.	Where the deal has extension terms, almost uniformly required amortization and heightened LTV, DSCR or DY thresholds as conditions to extension. For purposes of amortization, lenders are actually imposing hyper amortization – with imputed interest rates in the calculations that are greater than the actual rate.
Open windows for prepayment (no penalty)	CMBS: 3 to 4 months (6 months is atypical) Bank loans: This has become more negotiable, as we've seen our borrowers ask for longer prepayment windows. Extraordinary circumstances are also the basis for waiver of penalties – such as when LIBOR is going away (in case the market goes awry).
Floating rate floors	Yes, almost uniformly
Hedge triggers	LIBOR at 3 to 3.5%	Lenders generally willing to accommodate shorter term hedges, coupled with covenant to renew (saves borrowers $$)
Loan assumption rights	Yes, almost uniformly (for permanent loans)	Widespread use of pre-approved, objective criteria (sponsorship total assets and net worth), without lender consent of any type. Specific criteria are highly negotiable.
Loan assumption fees	Movement away from the standard of 1% to negotiated amounts (substantially less than 1%). No fees for affiliated party loan assumptions (where sponsorship continues to hold some % and/or control).
Prepayment penalties	Yes, typically a yield maintenance / spread protection formulation. Life companies continue to agree to T+50 discounting. Defeasance remains most common in CMBS. Sophisticated borrowers are requesting YM in lieu of defeasance in term sheets, for an additional few bps.	If you need to determine the cost of defeasance versus the cost of yield maintenance, see Chatham Financial' s calculators per the following links: Defeasance Calculator: here Prepayment Calculator: here
Minimum interest amounts	Typical minimum interest amount is 1 to 3 years of interest.
Reserves for property taxes	Yes, more often than not
Reserves for insurance	Typically waived until cash management period	Many borrower clients carry blanket policies, such that this is waived for that reason
Reserves for TILCs	Yes, almost uniformly – for upfront and ongoing needs	Lenders will agree to cap these at one- to two-year accumulation amounts
Reserves for CapEx	Yes, almost uniformly – for upfront and ongoing needs	Lenders will agree to cap these at one- to two-year accumulation amounts
Reserves for free rent	Yes, almost uniformly. No reserves typically for free rent periods of less than 3 months
DSCR thresholds for springing cash management	Retail: 1.25 – 1.40 Office: 1.06 – 1.30
Principal payment guaranties	No
Non-recourse carveout guaranties	Yes, with very few exceptions	No meaningful expansion of the scope of carveouts. In our workouts and loan assumptions, we continued to see gaps in recourse limitations (for loans we did not originate). In many instances, these loans have recourse for cash flow insufficiency and insolvency (those should have been eliminated in all post-2010 debt). Workouts in this context are much more difficult.
Carry guaranties (construction loans)	Yes, in construction loans and quasi-construction / value add loans. Almost uniformly styled as "carry overrun" guaranties (call for details)	Less lender tolerance for capped carry obligations. The carry will continue until the property is stabilized (as opposed to end of construction). Very limited carry of default interest, late fees and other miscellaneous lender fees. Offsets against loan funds intended for carry (non-sophisticated borrowers frequently miss this). Give us a call for a set of basic rules to adopt with respect to completion and carry guaranties.
Environmental indemnities	Increasing tolerance for insurance in lieu of indemnity	When an indemnity is required (despite also having environmental insurance), most lenders will agree to look first to any insurance before making a claim under the indemnity.
Guarantor financial covenants	Yes, almost uniformly across all guaranties (including NRCO) Market standards: net worth of not less than the loan amount and liquidity equal to 1/10th of net worth	Uncalled capital commitments and untapped credit lines are counted for purposes of various tests. Marketable securities in some instances. Increased use of corporate finance definitions – which are generally more favorable to borrowers.
Major lease approval thresholds	Retail: 10 to 20,000 square feet (experienced managers) Office: 1 full floor or greater
Permitted alteration thresholds	Retail: specific projects plus 5% of original loan amount Office: specific projects plus 2 to 5% of original loan amount	Be certain that the capped alteration thresholds do not include the specified projects that you know or anticipate undertaking.
Risk of loss (casualty) thresholds	3 to 5% of original loan amount	Below this threshold, few conditions to use/release of insurance proceeds
New reps, covenants and other provisions	LIBOR substitute No crowd-funding of equity CFIUS requirements
Loan syndication rights in favor of lender	Yes, almost uniformly. Lenders guarded their exit rights much more so in 2019 than in the past. Lenders were less agreeable to minimum hold amounts. Syndication rights were robust.	Restrictions on sales of the loan to borrower competitors are tolerated (this is becoming a market standard). Certain clients also get approval rights over the buyer of the debt. Borrowers are increasingly reluctant to pay costs and expenses associated with syndication – including borrower's own legal fees. Those costs are being borne by lenders more frequently.

Servicer shenanigans, origination commiseration and transactional twists

As in years past, we encountered numerous CMBS servicing issues, oddball loan origination issues, and other transactional twists, some of which are highlighted here:

A well-known servicer on a large loan secured by multiple single-tenant NNN properties asserted that a credit tenant's press release in a small-town newspaper that it intended to lay off employees and shut down operations at two of its many properties constituted "going dark" and "notice of intent not to renew" its lease with our borrower. The lender then unilaterally imposed a cash trap. The only problem (for the servicer) – we expressly reserved the right of the tenant to go dark and excluded that from all of the cash management provisions. After a bit of educating, the servicer relented.
Lenders and their counsel routinely access information about prior loans made to a subject borrower and/or sponsor. They then use that information to their advantage in negotiations. Not only do they have access to loans that they originate or participate in, but they also access Edgar, Trepp and other subscriber-only, invite-only databases (to which borrowers are not invited...). On three occasions this year, when we took the same approach and referenced prior loans that a lender had made, they cried foul. Hmm...
A lender made a mortgage loan on one property to a borrower. The sponsor of the borrower went back to the same lender for a mortgage loan on a second property. The lender declined to make the loan on the second property due to litigation relating to the sponsor. The lender then sought to call the first loan in default because of that litigation. In both loans, the litigation had been disclosed (lender claimed it simply "missed it" in the first loan origination). Litigation relating to a sponsor (as distinct from a borrower) in an SPE, non-recourse loan should never be the basis for a default.
As some of you are aware, one of our specialties is handling the purchase and sale of environmentally-challenged properties. In one of those transactions, an agency who had issued a closure approval nearly 30 years ago asserted that the closure was incomplete and that a site-wide RCRA investigation is required. We expect this risk when new environmental conditions are discovered. But re-opening a decades-old closure, absent a new discovery, was not expected.
On a less cynical perspective, many of our transactions are successful because of the solution-oriented relationships we have built with opposing parties over many years. Good relationships lead to more efficient and better outcomes for all involved. In certain instances, those relationships paved the way in 2019 for badly needed assistance in loan servicing for certain of our clients. Thank you to those involved − it is not always shenanigans!

Thoughts about the future

As some of you know, we are very focused on the future of legal services and the impact of new technologies and ideas on commercial real estate. In January, I had the opportunity to speak on the MIT/Tata stage at the Davos World Economic Forum about the impact of artificial intelligence on transactions. I was asked to provide a short burst of thought-provoking ideas about the future of contracts (that is not an oxymoron...). Here are some of those ideas:

Artificial intelligence affords us the opportunity to realize one of the fundamental assumptions (currently flawed) of free market economics – that all participants have "perfect knowledge." A market reaches equilibrium when, among other things, knowledge discrepancies disappear (thereby closing the gap between bid and ask). Until the modern age, informational asymmetries have created inefficiencies in the market. AI will help solve those imbalances.
Artificial intelligence and machine learning will help to eliminate "cognitive bias" in corporate boardrooms. Rather than decisions being made on heuristics and instinct (or worse, human bias), we now have the capability to base decisions on a growing abundance of data and predictive analytics (or to simply have those decisions autonomously made for us!). These tools will help us to "replace individual subjectivity with objectivity of the market" (a goal Friederich Hayek extolled in his 1974 Nobel Prize speech).
Artificial intelligence and other modern tools (such as cryptocurrencies) will make it possible for us to create "dynamic contracts." Contracts are currently static (for the most part). That is, the terms are established and do not change (absent later agreement). Imagine a contract where the terms adjust, constantly, moment-by-moment, to reflect then-applicable market conditions. Rudimentary forms of this exist already – such as in demand-side pricing in the energy, insurance and travel industries.
Finally, with greater access to data, the use of predictive tools and dynamic contracting, I envision a "migration to the mean," where perfectly informed parties will dispense with extended negotiation and go directly to (or start from) the middle ground (and contracts will be much shorter and legal fees much less).

Thank you and Happy New Year.

Footnotes

1 Not necessarily representative of the Firm's broader experience, and reflects the more prevailing terms observed – excludes outliers. In addition, these vitals are also informed by 100s of transactions over the past 20 years, such that they are more reliable than the limited data from a given year's deals.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

United States: The Real Estate Market In 2019 And What The Future May Hold: The View From Los Angeles