Pebworth and Sausser: Change, opportunity in post-pandemic real estate market

By Carl Pebworth and Mark Sausser

The COVID-19 pandemic has fundamentally altered how commercial real estate will be developed, built and used. Prudent real estate owners, developers, property managers and builders (and the lawyers who represent them) need to recognize this changed environment and proceed accordingly.

Certain post-COVID market segments and functions are irrevocably impacted. How we shop and travel has been impacted. So, space devoted to retail, food and dining, hospitality, and transportation all look different. Shopping in stores — particularly single or focused retail functions — will diminish. Demand is declining for space devoted to traditional shopping centers.

In many segments, change has been good. The internet has transformed how we shop, so distribution space demand is growing. For Indiana, where logistics is important to the economy, these changes present commercial opportunity.

But the pandemic accelerated certain disconcerting trends. There is a dearth of available housing, though luxury and vacation homebuilding and buying is rising. At the same time, COVID-19 exacerbated the affordable housing crisis. Office use in central business districts also has declined and, in some areas, this drop may be permanent.

The COVID-19 pandemic has disrupted real estate supply and demand to a greater extent than at any other time in recent memory. Commercial office space and the ways in which we work are in the midst of a fundamental shift. One commentator observed that, in certain markets, Class B office space is effectively obsolete and that there is no foreseeable demand for aging and more-modest tenancies.

Evolution, innovation

Many employees will return to their workplace, but not necessarily five days each week. Working remotely — at least part of the time — will remain common. Employers will encourage or at least tolerate more “hoteling” where employees share workspace. More organizations are also concluding that common, open areas are unneeded. Similarly, COVID-19 also revealed that certain functions and certain industries — information technology, finance and insurance — may not need centralized offices so long as productivity remains stable or improves. This reduction in office use may have a cascading effect, reducing central business district residential leasing and retail leasing that relies on office workers and downtown residents. This could also affect mixed-use developments in suburban areas that promote a work/shop/play living model.

Management, operation challenges

Building, sourcing and supply complications have made operating and managing more challenging. COVID-19 exposed how vulnerable many supply chains are to unanticipated structural disruptions. Supply chains have been impacted in ways that have yet to be fully realized.

The pandemic has ushered in a new period of increased financial uncertainty impacting commercial real estate, perhaps most fundamentally, how much real estate is worth and what it will be worth in the future. Compounding this uncertainty, the government is intervening in the economy in an unprecedented way during peacetime. Trillions of dollars are being introduced in various forms of pandemic relief and economic stimulus. While the investment is welcomed in many circles, it adds additional unfamiliarity to an already uncertain financial environment.

Flexibility

There is no certainty in predicting what the new environment following COVID-19 will bring to real estate law, but flexibility will certainly be a hallmark. Owners and developers may need to convert existing projects to different tenant mixes and include more restaurants, entertainment and retail office space as opposed to traditional retail tenants. Some building uses may change entirely, such as converting office or retail space into flex space, storage or industrial space.

Such use changes will require close examination of property covenants, declarations, zoning and land-use restrictions. This could require renegotiating existing agreements so that the owner of the larger shopping center or project has assurance that changes in use will not materially affect the value of the project as a whole. For example, in exchange for a change of use to flex space, the owner may agree to upgrade the exterior appearance of remodeled space.

Changes in use will also apply to future developments. Lawyers representing successful real estate actors in the future must therefore be careful when drafting declarations, easements and zoning commitments to allow as much flexibility for clients as possible to adjust to unpredictability.

Changes in drafting contracts

For most lawyers at this point, there are provisions that no one would have thought to include in an agreement in early 2019 that must now be considered standard lease provisions. For example, clarifying how a pandemic or similar health event works as a force majeure and whether that extends to the duty of the tenant to pay rent is no longer an academic question. Leaving those terms ambiguous after the pandemic is, in many instances, at least a problematic drafting mistake.

Similarly, leases may need to contemplate whether a tenant is afforded rent relief as a result of a government shutdown, a partial shutdown or when the tenant elects to suspend operations for the safety of employees and invitees. The final form of these provisions will, as always, vary from document to document depending on factors including the relative negotiating strengths of the parties involved. However, lawyers representing parties in real estate agreements will need to consider and address these issues in transaction documents in the future.

To evict or not to evict

In an environment with new risks, lawyers need to recognize and assist clients more proactively than in the past. Revaluation for creditors and vendors may be more customary and, in many instances, should guide a different approach to interpreting and enforcing contract rights. Evicting an underperforming tenant makes less sense if there is no replacement tenant on the horizon. Enforcing obsolete valuation assumptions may be unrealistic and counterproductive. As uses and values shift, property owners, lenders, managers, tenants and vendors will have to be flexible in precarious and unpredictable circumstances.

Value opportunities

Property owners who hold real estate that no longer retains the same value can mitigate the impact by contesting property tax valuation. For real estate built for increasingly obsolete purposes, repurposing space, which entails legal issues around rezoning, remodeling and remarketing space, will be imperative. Much value can be realized by prudently contesting obsolete, outdated valuations.

Real estate construction changes

Design and construction around reconfiguring and rehabilitating existing space will be more common. So will demolition and reconstruction of property that, until recently, seemed to have more useful life. Constructors and contractors will need to plan for more supply disruption, which could increase the cost of building unless the parties develop new, creative ways to assign the risk of delay because of material disruption. Lawyers will need to advise clients regarding all these opportunities and challenges and draft contracts that contemplate these new realities.

Strategic thinking

COVID-19 introduced uncertainty, triggering the need for more careful strategic thinking and advice to clients. For example, supply chains are rebalancing and shifting. Among other things, organizations must plan for disruptions and unexpected delays. Clients need to be advised to plan more conservatively.

The changes brought on and accelerated by the pandemic are a reality in 2021’s real estate market. The success or failure of many actors in the real estate market will turn on the ability to recognize and embrace those changes. And lawyers will play a central role in addressing these new challenges and opportunities.•

• Carl Pebworth is a partner in the construction and real estate litigation practice group and Mark Sausser is counsel in the real estate practice group at Faegre Drinker Biddle & Reath. Opinions expressed are those of the authors.