A recent story by Bloomberg has documented a landlord’s worst nightmare: many retailers are planning to withhold rent due to virus-related closures. This could spell disaster for the economy at large. But who can blame the business tenants? In many cases, they have been ordered by the government to close their stores indefinitely with very few alternative ways to drive revenue. Even so, this decision by many retailers to withhold rent could trigger a chain reaction towards a recession.
The Seeds of a Recession Have Been Planted
With government orders effectively pausing most business activity, the flow of commerce has been drastically reduced. Consumer fear has slowed it even more. Joblessness is beginning to increase as businesses lay their workers off.
The bizarre part about the looming downturn is that it is manufactured, in a way. The economy was plugging along before the health crisis. Debt was fairly cheap. Unemployment was quite low and continued to decrease steadily. The stock market was continuing a record bull run. All seemed fine.
But then, concerns over the Coronavirus quickly saw governments around the world take drastic measures to quarantine their citizens to slow the spread. This stunted business everywhere. Now, in the United States, stagnant business is starting to cause severe problems.
Businesses like Mattress Firm, Subway, and others have expressly stated that they are planning to not pay rent to their landlords.
A Chain Reaction Towards a Foreclosure Crisis Will Be Next
If retailers withhold rents, landlords will have little way to pay for mortgages and other major expenses. Some landlords have agreed to waive or defer rent for their business tenants for a couple of months. However, not every landlord is in this same position to buy time for their tenants.
Unless a landlord has substantial reserves to whether a storm for quite some time, there are very few alternatives. Landlords could try evicting tenants, but that is extremely expensive. It also is highly impracticable if there are no other viable business tenants out there. So, landlords appear to be stuck, too.
Given the previous decade of relatively cheap debt, many landlords are sitting on fairly large mortgages. Many may be ill-equipped to handle even a slight decrease in rent. They may be forced to stop paying their mortgages in turn. Perhaps some might be in a position to take out new debt (to then have a cash pile to make mortgage payments). But many already have near maximum debt loads and low cash balances and will be unable to make payments very soon if rent is withheld.
And when landlords can’t pay mortgages, mortgage holders will be in trouble, too. Pension funds, investment firms, and banks that hold mortgages will suddenly bring in less revenue. They will be less able to fund pensions or relend money out to other borrowers. When credit starts drying up due to increasing defaults, we need to look no further than the 2008 crash.
In addition to credit drying up, there will be an increase in the number of foreclosures. Lenders and mortgage holders do not want to hang on to properties, especially if the tenants in them are not paying rent! They will instead try to sell the property, even at a significant loss. As foreclosures increase, more properties will start to flood the market, triggering a crash in real estate values.
Unfortunately, the economy is very delicate. One break in the chain can cause the whole thing to fall apart. Thankfully, the government is trying to do something to combat the problem, but it will not be enough.
The Stimulus Will Not Be Enough if Quarantines Continue
Congress is close to passing a $2 trillion stimulus package. Most Americans would get a direct payment of something like $1,200, assuming the bill passes as drafted. Many small businesses and larger companies would get substantial loans as well.
This will only buy a little bit of time, a couple of months at most. Quarantines will still remain as devastating for businesses as ever whether or not the virus recedes. And, in all likelihood, the virus will likely still be a significant problem a couple of months from now, barring a major change of events.
Battling the virus will probably be a long, drawn out process. The more time is spent, the more money both landlords and tenants will need to remain operational. Every day of frozen commerce is millions of dollars lost.
The Courts May Become Overwhelmed with Disputes
In the meantime, the courts may become overwhelmed with disputes between landlords and tenants. Tenants will argue that they should not have to pay rent. And they may have standing, as I’ll get to shortly. But the number of cases will skyrocket, legal costs will drain already cash poor businesses and individuals, and the problem will probably only get worse.
How the courts end up deciding will probably be mostly irrelevant. These sorts of disputes can take many months to sort out. By then, the problem will have already grown significantly, since mortgage payments don’t wait for a borrower’s lawsuit against its tenant to end.
Residential Properties Might Be Next
As I mentioned already, companies have already been laying a lot of workers off. Jobless claims have skyrocketed. Those now jobless workers will similarly struggle to pay rent.
The same problem for retail landlords will soon plague residential landlords if it has not started affecting them already. Tenants who were in a decent economic position a month ago may be out of work indefinitely. Others have had hours drastically reduced and their incomes slashed. They may suddenly be unable to afford rental payments now, which can trigger the same chain reaction towards foreclosure if the economy does not get up and running again soon.
Some residential landlords are also offering temporary rent cuts to buy time. But this will not be sustainable for much longer, for the same reasons as retail landlords.
Can a Tenant Legally Withhold Rent?
Before answering this question, I have to emphasize that this article is not legal advice and you should consult with a licensed attorney in answering any legal questions that you might have. Every one’s problem is different, and your situation may be extremely different than someone else’s. The advice you receive may be very different as well.
But, in general, tenants do not have to pay rent to their landlords if they can prove a valid claim under the force majeure clause of their lease.
Force majeure is a fancy legal term that’s French for “superior force.” It refers to an unforeseeable circumstance making performance of a contractual obligation, like paying rent, impossible. The event has to be out of the control of a party to a contract. Many leases, especially in the commercial realm, have different force majeure clauses that list different events that would be eligible for a valid claim.
Generally, if a contract does not list “government orders” or “pandemics” as a force majeure event, then the clause will not be enforceable in this case. That is, unless the court is more forgiving to tenants. Every court is different, but courts typically defer to the language in the contract in deciding whether something falls under the clause. Many contracts do include an “act of God” as a force majeure event, but it is unclear whether a pandemic would automatically fall under that language. The many coming legal disputes will probably clarify this issue soon.
Even if a tenant can legally withhold rent, this does not mean that there will not be an economic chain reaction. The unfortunate reality is that someone is going to have to bear the loss; whether that is the tenant, the landlord, the lender, or everyone is the undetermined question.
In short, the fact that retailers will withhold rent is incredibly dangerous and could help to trigger a much larger downturn. The fact that they are candidly declaring that they will do it shows how bad the situation is. Unless the health crisis and quarantines end soon, a recession appears to be well within reach.