How to Negotiate and Structure a Workout with Tenants in Default

With a recession looming, commercial landlords and tenants may once again need to exhibit the flexibility they displayed to get through the COVID-19 pandemic. While helping tenants meet their rent obligations will be the first-choice approach, landlords also need to be prepared in case tenants default. Rather than automatically seeking eviction, landlords may need to consider the possibility of letting the tenant remain in the space and gradually pay off what it owes, either with or without interest. Here’s how to implement such a workout strategy.

Should You Roll the Dice on a Workout?

The central issue for landlords is deciding whether to offer tenants that are in arrears on their rent a workout arrangement at all. Evicting tenants in arrears is a no-brainer when the market is strong. But replacing tenants isn’t so easy during a recession, let alone replacing them at or above a pre-recession rental rate. In these circumstances, workouts may offer you the chance to turn lemons into lemonade.

Workouts make sense when:

• The tenant has previously proven reliable in paying rent on time;
• The current payment challenge is due to short-term challenges or temporary circumstances that are likely to be resolved soon;
• The tenant’s business is otherwise financially stable;
• The tenant is part of a corporation that can stand behind the debt; and
• There’s enough time left on the lease—including future rent increases—to justify the investment and risk of forbearance.

The one thing that’s clear is that you’ll need information about the tenant’s current finances to assess whether a workout makes sense. If a tenant refuses to provide you this information, you should take the workout option off the table and proceed with eviction or other legal remedies, attorneys advise.

Negotiating Strategy

Make the tenant agree to demonstrate good faith by paying a portion of the back rent as a condition for your entering into the workout agreement. The higher the good-faith payment you can get upfront, the stronger your financial position will be. “Each month that repayment isn’t made adds to the total debt and reduces the likelihood of full recovery,” a Florida attorney advises. Rule of Thumb: Ask for 50 percent of the arrearage but be prepared to accept less or demand more depending on the tenant’s payment history, short-term financial situation, and other circumstances.

Timing is also crucial. Offering the workout before the tenant falls too far behind in rent makes the good-faith payment manageable. One month of nonpayment doesn’t generally justify activating the workout option, but you don’t want to wait much longer than two months.  

How to Structure the Workout Agreement

Workouts with tenants that have just hit a temporary rough spot and aren’t currently in arrears can typically be implemented via revising or restructuring the lease. However, tweaking the lease may not be enough for tenants in default. Such workouts require you to execute two additional agreements:

• A stand-alone workout agreement obligating the tenant to pay all back and future rent; and
• A promissory note setting out terms of payment for the arrearages.

How to Create the Workout Agreement

Like our Model Agreement: Require Defaulting Tenant to Repay Back Rent, your workout agreement should include seven elements:

1. Amount owed. Specify the exact amount of back rent owed and require the tenant to pay both the back and future rent as it comes due. The full back rent should be paid off by six months at the maximum, whether with or without interest [Agr., Sec. 1].

2. Default of agreement is lease default. Link the payment obligations under the workout agreement to payment obligations under lease and promissory note signed by the individual corporate officer and spouse by stating that breach of the agreement or promissory note entitles the landlord to all of the rights it would have if the tenant breached the lease—namely, to evict the tenant [Agr., Sec. 1].  

3. Liability of corporate officer’s spouse. Make somebody personally liable for the full amount of back rent due in the event of default on the agreement. If possible, that somebody should be the tenant’s corporate officer and his or her spouse. Imposing a personal obligation on corporate decision makers is a very powerful tool that significantly increases your chances of collecting the money you’re owed, according to attorneys who’ve used this strategy successfully. Adding the spouse ensures that corporate officers can’t avoid personal liability by shifting all of their personal assets to their spouse [Agr., Sec. 1].   

4. Waivers. Indicate that the workout agreement represents a ratification and approval of the existing lease terms and have the tenant acknowledge that “it has no claims, defenses, or offsets regarding the performance of any of its obligations” under the lease. Require any waivers to the agreement to be contained in a signed and written instrument [Agr., Sec. 3].

5. No tenant assignment and sublease rights. Close a potential escape hatch by banning the tenant from assigning or subletting the premises unless and until it pays all back rent due under the promissory note. At the same time, give yourself some flexibility by stating that if you do permit a third party to take over the lease, the assignee will be obligated to pay the back rent until the promissory note is satisfied. Bottom Line: The agreement and promissory note enable you to collect back rent from either the tenant or assignee (but not both) [Agr., Secs. 2 and 6].

Practical Pointer: Note that the workout agreement doesn’t ban the landlord from assigning its own rights under the agreement to another party, in effect converting the right to receive the back rent into an asset that can be sold with the property.

6. No tenant deduction of repair expenses. In many lawsuits for back rent, tenants claim that they used the rent money to make repairs the landlord was obligated to make under the lease. The agreement takes this argument out of play by saying that the tenant has no claims, such as expenses to repair or maintain the property, that would offset payment of back rent [Agr., Sec. 1].

7. Tenant confidentiality duty. The last thing you want is for your tenants to compare notes on their respective workouts, or even disclose that they were able to make a workout deal at all. So, specify that the existence and terms of the workout agreement are confidential and that the tenant’s unauthorized disclosure is a material default under the lease triggering the landlord’s right to demand the full amount of the promissory note then outstanding [Agr., Sec. 5].

How to Create the Promissory Note

The centerpiece of the workout deal is the terms of payment. Our approach involves creating a separate promissory note, but you can also incorporate the payment terms in the workout agreement. In either case, you need to list the total amount due from the tenant, the number of installments, and the specific date and amount of each installment. The first installment should be due immediately after the workout agreement is signed and the total repayment period should last no longer than six months, attorneys advise. Also insist that the tenant pay the full amount before the lease expires since tenants are less likely to pay installments after they vacate the property.

Keep in mind that standard promissory note templates may not be appropriate for this particular workout arrangement. Three additions or alterations may be necessary:

1. Signature of spouse. The spouse of the corporate officer who signs on behalf of the tenant should also sign the promissory note, even if he or she has no connection with the corporate tenant. Note that refusal to have a spouse sign need not be a deal breaker if you have confidence and trust in the signing officer, such as when you’re dealing with a large retail chain, as opposed to a small mom-and-pop tenant.

2. Cross-default. Specify that a default under the lease or workout agreement is a default under the promissory note, as well. The cross-default language in the promissory note corresponds to and coordinates with the cross-default provision in the workout agreement that we discussed earlier. Together, these provisions serve to make the corporate officer and spouse liable for the total debt if the lease or promissory note is breached, for example, where the tenant fails to pay its current rent. Ask your attorney about adding the following model language to your promissory note:

Model Language

Cross-Default. Any breach or default under the certain lease dated __________________, 20__, between Holder as “Landlord” and Maker as “Tenant,” as the same may have been modified, amended and/or supplemented in writing (the “Lease”), or under the Agreement Regarding Payment of Lease Arrearages and Future Rents, dated ____________________, 20__, between Holder as “Landlord” and Maker as “Tenant,” will be deemed to constitute a default in the payment of sums due under this Promissory Note, without the necessity of notice from Holder to Maker regarding such default. Maker acknowledges that the indebtedness evidenced hereby consists of previously billed Lease arrearages now owing from Maker (as Tenant) to Holder (as Landlord).

3. Tenant pays administrative fees. Require the tenant to pay any administrative fees that may be necessary to validate the promissory note under state or local law.

Model Language

Payment of Expenses. Upon request (which may be made subsequent to the maturity date hereof), and as additional rent under the Lease, Maker shall pay to Holder any amount that Holder may pay or be required to pay to any governmental or quasi-governmental authority in connection with this Promissory Note (for state documentary stamps, imputed interest or otherwise).  

Finally, be sure to include that “The obligations of Maker hereunder shall survive the expiration, or earlier termination, of the term of the Lease.”