NEW YORK CITY—This past spring, veteran real estate attorney Y. David Scharf, partner with Morrison Cohen LLP, noted the comparative lull in commercial real estate litigation, and predicted that we'd be seeing more activity related to retail tenancies. Come early 2018, and his forecast has been borne out. Nor does he anticipate much change in that forecast.
Retail-related lawsuits will take on one of two facets, Scharf sells GlobeSt.com. ”I expect there to be continued litigation like we saw with Teavana”—in which an Indiana judge ruling in favor of Simon Property Group barred Starbucks from closing 77 Teavana locations in malls—“related to the no-go-dark provisions in many of these leases, because it is truly is the only option for a landlord—to try to enforce those provisions. And the tenants are desperate to get out. In my practice, we have seen retail owners looking at every opportunity, any potential basis to find a constructive eviction in some way, shape or form to claim a breach of the lease by the tenant.”
The current retail environment is also leading to distress resulting from cash flow being impacted. “We're going to start seeing more defaulted mortgages, workouts and foreclosures relating to large retail properties or retail condominiums,” Scharf predicts.
In terms of litigation, “Retail is leading the pack,” he says. “However, we're starting to see this now in development projects as well,” notably in multifamily.
With developments that were completed and came to market during the second half of 2017, “we're starting to see less foot traffic coming through the doors, asking prices not being met, pricing being adjusted by the developers again and again,” Scharf says. “Unless there is incredible product differentiation at discounted prices, developers are not getting the volume and prices that they need to meet their pro formas.
“We're starting to see a lot of mezzanine loan debt trading from lenders to mezz loan traders who will buy mezz debt that is underwater at distressed prices with the intention of foreclosing,” he continues. “We're starting to see mezz lenders and senior lenders begin to talk about their inter-creditor rights, with mezz lenders sometimes looking to buy out the senior loan to protect their mezz positions.”
As a result, Scharf says, “we're seeing mezz equity, which is out of the money on many development projects, begin what I call the finger-pointing process to find out what happened beyond the market. Did the project manager do their job? Did they keep cost controls in place? Did they make sure that all of the consent rights, which the limited partners had protected for themselves on major decisions like budget overexpenditures and new placement of contractors or subcontractors, faithfully maintained from a governance perspective?” If not, he says, then there has been a breach of fiduciary duty.
Given a development environment in which pro formas are not always being met, equity investors are directing some of that finger-pointing on contractors. Were cost overruns appropriate? Was the contractor's mismanagement responsible? “We're also now seeing potential claims against the architects,” Scharf says. “They were supposed to be making sure that these change orders were appropriate. Were there errors they made in the original design plans that resulted in these cost overrruns? People are looking for other pockets to be responsible for the distress that we're seeing.
“The market-wide distress causes finger-pointing,” says Scharf. “Once that begins, then people start looking under the hood, saying, “Somebody other than the market is going to be responsible for this,” so that they're not losing the totality or large portions of their equity.”
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Paul Bubny
Paul Bubny is managing editor of Real Estate Forum and GlobeSt.com. He has been reporting on business since 1988 and on commercial real estate since 2007. He is based at ALM Real Estate Media Group's offices in New York City.
