Real Estate Transactions: Consider These Safeguards During Times of Economic Uncertainty

Higher interest rates, inflation, and a looming recession have all had an impact on the economy at large, but they have especially roiled the real estate industry.

The federal funds rate, now targeted at 4.25 and 4.5 percent, stands at a 15-year high and is certain to climb, if only at more modest increments. Inflation, continued kinks in the supply chain, and a very tight labor market have slowed down execution on projects and increased costs. The threat of a downturn has cooled lending and chilled borrowing.

Higher rates on loans have contributed to spiking the cost of rents for tenants in all industries. Home builder and multifamily developer confidence has significantly declined because of financing constraints, increased costs, and flat or falling property values. Work-from-home trends have continued to dampen office occupancy and depress commercial real estate values.

In the midst of uncertainty, buyers and sellers may consider some safeguards when conducting purchase transactions.

More deals are likely to fall apart over financing or the costs of construction. Buyers may seek to mitigate the uncertainty through longer review periods, more favorable deposit terms, or closing conditions that provide “outs” if a project is no longer viable. Buyers cannot count on being able to line up last-minute financing on favorable terms, and should make a point of having financing lined up with rates locked in advance, or seek to include financing as a condition to closing. Sellers, conversely, should be wary of deal terms that may allow a buyer to lock up their property for an extended period and then walk away if the economic winds have shifted.

Spiking interest rates may affect purchase prices and chill the resale market, while also making refinancing more difficult. This combination can lead to a wave of distressed properties, as debt service coverage ratios are reduced when fixed rents under long-term leases cannot support increased financing costs.

Similar considerations apply to landlords and prospective tenants when completing lease transactions.

Landlords now face more risk in entering into long-term leases with fixed rental rates, and may want to consider adding language in leasing agreements to adjust rents to reset to the market periodically. Tenants also may be reluctant to enter into long-term agreements with the risk of recession and the ongoing post-pandemic trends of work-from-home.

Tenant build-out costs are increasing with inflation in the construction industry, and projects take longer due to supply chain issues and tight labor markets. Landlords performing build-out work should build in adequate time and flexibility to complete the work. Tenants may need adequate remedies if space is not delivered on time. Both sides of the transaction may need to negotiate pricing risks to share the pain of increased costs. And landlords should be wary of provisions that limit their rights to pass through increases in common area maintenance charges to tenants in an inflationary environment.

Ballard Spahr’s Distressed Assets and Opportunities team draws on attorneys with specific skill and experience in real estate and corporate lending, bankruptcy and restructuring, distressed M&A, distressed real estate, public and project finance. We also handle secured and unsecured commercial lending, tax, municipal recovery, loan servicing, and corporate trust services, litigation, and other areas of practice. Our Real Estate attorneys cover all aspects of commercial real estate law and transactions, including permitting, title, environmental issues, acquisitions and dispositions, site development and construction, project financing, loan workouts and acquisition of distressed assets, and leasing. Please contact us for more information.

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