Federal Real Estate in a Turbulent Market, Part II

This is the second of a two-part series addressing special considerations for government lessors in the current commercial real estate market. Part I addressed the risks posed by government downsizing and early lease terminations. Part II discusses distressed assets and the unique challenges posed by distressed assets in two contexts: 1) lease expirations and government holdovers and 2) assignment of lessors' rights in the event of a change of ownership or assignment of claims.

As explained in detail below, distressed assets present a number of pitfalls and opportunities for lessors (and their lenders) with government tenants. The primary takeaway for all of the scenarios outlined below is that better outcomes will result from early, effective engagement and a sophisticated understanding of both the legal rules and the government's standard practices and policies.

Holdovers and Short-Term Extensions

Since the easing of the COVID-19 pandemic and the beginning of the government's return to office, there have been a number of acknowledgements from the White House, U.S. Office of Management and Budget (OMB)¹ and U.S. General Services Administration (GSA) that agencies should pause and reflect upon their space needs moving forward. The practical result of these policies has been that agencies have, for the past few years, been revisiting and reconsidering their long-term space needs, and this has resulted in a slowdown or, in some instances a pause, in procurements for new space.

The government's decision to pause its long-term lease procurements could not have come at a more inopportune time for government lessors. As noted in Part I of this series, commercial office vacancy rates in some markets are the highest they have been in decades, and many commercial real estate loans are coming due in 2024 and 2025. Against this backdrop of difficulties in the commercial real estate market, uncertainty with respect to government tenants' intentions at lease expiration has lessors seeking to understand their rights and remedies. In particular, once a government tenant goes into holdover, it becomes even more difficult to market or refinance a distressed asset. And it makes it nearly impossible to plan for a follow on tenant or – as is common with distressed assets – a complete redevelopment.

What, then, are the landlord's remedies for government tenants in holdover? First, note that the government cannot be evicted, even in the event that it stays past the expiration of the lease term. Though there is an implied duty to vacate inherent in every lease,² a breach of this duty entitles the lessor only to monetary damages; eviction is unavailable as a remedy because it would constitute an order of specific performance of a contract obligation, and neither the U.S. Court of Federal Claims nor the Boards of Contract Appeals have jurisdiction to entertain such a request under the Contract Disputes Act. See Podlucky v. United States, 2021 WL 2627130, at *2 (Fed. Cl. June 21, 2021) ("Plaintiff is, essentially, asking the court to order defendant to specifically perform its obligations under the contract. But a request for specific performance is equitable in nature, and falls outside this court's jurisdiction."), aff'd, 2022 WL 1791065, at *1 (Fed. Cir. June 2, 2022); Harmonia Holdings Group, LLC v. United States, 157 Fed. Cl. 292, 301–02 (2021) ("[Plaintiff] cannot co-opt the Court's bid protest jurisdiction simply by reframing its claims as alleged violations of procurement law and requesting injunctive relief (which is not available under the CDA)." (emphasis added)); Tenaska Washington Partners II, L.P. v. United States, 34 Fed. Cl. 434, 443–44 (1995) ("[S]pecific performance is not a remedy available against the United States, because sovereign immunity has not been waived for such relief[.]"); Pellegrini v. United States, 103 Fed. Cl. 47, 55 (2012) ("Equitable relief is not available to enjoin an alleged taking of private property for public use, duly authorized by law, when a suit for compensation can be brought against the sovereign subsequent to the taking." (quoting Ruckelshaus v. Monsanto Co., 467 U.S. 986, 1016 (1984) (citation omitted)).

However, landlords do have some small amount leverage in negotiating the terms of extensions and standstill agreements. First, in the event of a holdover, the lessor "is entitled to the fair market value of the premises for the holdover period less what GSA has paid appellant during the holdover period."³ See Cafritz Co. v. GSA, GSBCA No. 13525-REM, 98-2 BCA ¶ 29,936 (Aug. 3, 1998) (citing Rupert v. GSA, GSBCA No. 10523, 93-1 B.C.A. (CCH) ¶ 25243 (June 30, 1992)) (emphasis added). Similarly, "[t]he rent in the lease is evidence of rental value, but a landlord may establish a rental value greater than [current contract] rent." See Rupert v. GSA, GSBCA No. 10,523, 93-1 BCA 25,243 (June 30, 1992). So, if the fair market value rent is significantly higher than the rent provided in the lease, then landlords have some leverage to negotiate favorable terms and conditions of any lease amendments that extend the term and keep the government out of holdover.

Next, there are internal policies and incentives in place at the GSA to encourage contracting officers to avoid holdovers. Following the release of a 2015 U.S. Government Accountability Office (GAO) Report on the prevalence of short-term extensions and holdovers in GSA leasing, GSA committed to implement a program of setting goals for reductions in holdovers and, as part of that program, GSA maintains a "Key Performance Indicator" database that tracks holdovers and credits contracting officers who keep their leases out of holdover. This also provides the lessor with some amount of leverage to negotiate favorable extension terms.

So, while short-term lease extensions and holdovers are becoming more and more common, there is an opportunity for lessors to take advantage of the – admittedly limited – leverage these situations provide to negotiate rental increases and other concessions.⁴ The best practice in this scenario is to identify expiring leases early, consider under what terms lease extensions might be acceptable and engage with government tenants and the contracting officer long before lease expiration. Lessors seeking to re-let the premises to other tenants or redevelop the property should ensure the government is aware of these plans and that any lease extension memorializes the potential impact a holdover would have. This may provide some entitlement to consequential damages in the event of a subsequent holdover.

Lessors should also be aware that the government's timeline for developing new lease requirements for succeeding leases begins three years out from lease expiration. This process involves a number of stakeholders – to include the tenant agency and its real estate and finance teams, as well as GSA – and typically includes a cost-benefit analysis to determine whether a succeeding lease would yield cost savings over a competitive procurement. See 48 C.F.R. § 570.402-6. Early in this period, engagement with the government can effectively shape the evaluation of succeeding leases versus competitive procurements.

Assigning Government Leases in Distressed Assets

Unlike traditional commercial leases, leases with the federal government cannot be assigned, either through sales contracts or through operation of law, in the event of a foreclosure or a receivership. A group of statutes, collectively referred to as the Anti-Assignment Acts, have been enacted to ensure the government doesn't run into a bait-and-switch scenario in which the government contracts with one entity, only to have it assign the contract to another. The statutes expressly prohibit any such assignment:

The party to whom the Federal Government gives a contract or order may not transfer the contract or order, or any interest in the contract or order, to another party. A purported transfer in violation of this subsection annuls the contract or order so far as the Federal Government is concerned, except that all rights of action for breach of contract are reserved to the Federal Government.⁵

What this means as a practical matter is that unlike traditional commercial leases, the tenant – in this case, the federal government – has the authority to refuse to acknowledge a successor in interest to a landlord who no longer has title or control of the leased asset.

But while there is a blanket prohibition on the assignment of government contracts and leases, the law and the lease language provide three mechanisms for ultimate recognition of a new owner – or at least payment of rent – whether that owner obtains title through sale, foreclosure or some other operation of law: Novation, Assignment of Claims and Attornment.

Each of these three pathways for assignment of interest in a government lease has its benefits and drawbacks, and for each of these pathways to assignment, the status of a distressed asset can impact the cost-benefit analysis. For example, the question of whether the owner of a distressed asset remains solvent or has wound down its operations may impact whether and how the new owner or receiver seeks to execute a novation agreement – which typically must be executed by both parties to the transfer – or seeks another route.

Below, we describe each of these pathways and their requirements.

Novation

In light of the prohibition on unilateral assignment of government contracts and leases described above, the government has implemented a process to allow for assignment once both parties to the asset transfer and the government have all agreed on the terms of the transfer: novation.⁶

The purpose of the novation process is to protect the government's interests. The Federal Acquisition Regulation (FAR) explicitly acknowledges this purpose at 48 C.F.R. § 42.1204(a), which gives the government the right to recognize a third party as the successor in interest to a government contract when it is in the government's interest to do so. Conversely, the government may exercise its discretion not to approve transfer of a lease or contract. Specifically, 48 C.F.R. § 42.1204(c) indicates that when it isn't in the government's interest to approve a transfer, the original party to the contract (which seeks to transfer the contract or lease) shall remain under contractual obligation to the government, and the contract or lease may be terminated should the original lessor or contract party not perform.

In practice, particularly in real estate, the government only very rarely refuses to recognize a successor in interest following the purchase and sale of real property that is leased to a government tenant once the prospective lessor has offered some evidence of the purchase and its ability to perform under the terms of the lease. But the process requires three parties to actively participate: the original lessor, the new lessor and the government.

For distressed assets, this process can become problematic. The original lessor may not be a willing participant in any assignment and, in some cases, the original lessor may no longer exist. Alternatively, the property may be managed by a receiver or a special servicer with legal authority to maximize the value of the distressed asset.

These situations will require deviation from the standard novation practices laid out in FAR Part 42.12.⁷ First, the standard novation language may need to be amended from three-party form into a two-party form. Additionally, many of the required document submittals outlined in the lease and the FAR (parts 42.1204(e) and (f)) may not be available.⁸ Finally, purchasers or lenders foreclosing on a borrower should consider whether they are willing or able to accept liability for all of the previous owner's acts and omissions, as the standard novation language requires.

The best way to approach the novation in the event of a sale of a distressed asset is to address these concerns early in the process. Novations often take several months to complete and, if there are any deviations from the standard language or deliverables based upon the distressed nature of the asset, the novation process can take even longer. Additionally, it is a best practice to engage early in obtaining a System for Award Management (SAM.gov) registration, as this can take several weeks (or longer) and is often the reason for delayed novation approvals; contracting officers cannot and will not recognize new lessors until they have completed this registration.

Assignment of Claims

Though assignment of government contracts is prohibited, the same statute that prohibits such assignments – 41 U.S.C. § 6305 – expressly allows for the assignment of rents due under a federal contract or lease. Specifically, this statute allows for the assignment of all rents due to "a bank, trust company, Federal lending agency, or other financing institution." Id.

The FAR⁹ clause that implements this statute – 48 C.F.R. § 52.232-23 – provides as follows:

The Contractor, under the Assignment of Claims Act, as amended, 31 U.S.C. 3727, 41 U.S.C. 6305 (hereafter referred to as "the Act"), may assign its rights to be paid amounts due or to become due as a result of the performance of this contract to a bank, trust company, or other financing institution, including any Federal lending agency. The assignee under such an assignment may thereafter further assign or reassign its right under the original assignment to any type of financing institution described in the preceding sentence.

This right is permissive, meaning the lessor has the right to assign its rents at its discretion, provided such assignment is a complete assignment and is to a "bank, trust company, or other financing institution." Notably, the government does not have the right to refuse such a request, provided the assignee meets the criteria outlined in the clause. The statute provides that "an assignment under this subsection is a valid assignment for all purposes." 41 U.S.C. § 6305(b)(7).

GSA publishes a Leasing Desk Guide (LDG) that "contains authorities, policies, technical and procedural guides, and administrative limitations governing the acquisition by lease of real property" and that "appl[ies] to all PBS personnel engaged in the acquisition and administration of lease contracts." Id. The LDG also "applies to agencies leasing space under delegated authority from the General Services Administration (GSA)." This guide provides as follows with respect to the mechanics of assigning claims under GSA leases:

Note that the lease should not designate a different payee, except under rare circumstances where the lessor has designated a different payee through an Assignment of Claims. In such an instance, a Lease Amendment is necessary to process a change in payee. Such a change must be documented through a Lease Amendment, along with the executed Assignment of Clams.¹⁰

In its LDG, GSA also provides a proposed subordination, nondisturbance and attornment (SNDA) agreement that addresses assignments of claims and rental payments, and this template confirms that the government will not recognize the lender as the payee until and unless the lessor and the government execute a lease amendment memorializing the assignment:

In accordance with Paragraph __ of the General Clauses of the Lease, Assignment of Claims, (48 C.F.R. 52.232-23) the Lessor may assign its rights to be paid to the Lender. Following such assignment, to be made in accordance with the Assignment of Claims Act, as amended, 31 USC 3727, and following the execution of a Supplemental Lease Agreement changing the named Payee in the Lease, the Lessee shall pay all rent and all additional rent to the Lender. Such assignment shall not be deemed to (a) cause the Lender to succeed to or to assume any obligations or responsibilities as the landlord under the Lease, all of which shall continue to be performed and discharged solely by the Landlord, or (b) relieve Landlord of any obligations under the Lease.¹¹

Finally, note that an assignment of claims does not allow the landlord and lender to avoid one of the more onerous obligations for government landlords: the SAM.gov registration. The FAR clause governing SAM registrations – 48 C.F.R. § 52.204-13, which is included in the General Clauses of GSA leases – provides that "Assignees [of claims] shall be separately registered in the SAM." Just as with more traditional novations, as a best practice, lenders anticipating either an assignment of claims or attornment (or both) should begin their SAM registrations sooner than later, as these can take several weeks to complete.

For distressed assets, there are a number of additional considerations that lessors and lenders should take into account. First, establishing the correct assignee may be difficult for assets in foreclosure, governed by receivership or under a special servicer arrangement; understanding the relationship and the order of precedence of the various stakeholders is key. Second, a lessor that is in default or has ceased functioning as a viable business may not be a willing participant in an assignment, in which case lenders should consider their rights to attornment, laid out below.

Attornment

For lenders seeking to foreclose or to obtain a deed in lieu of foreclosure, there is a third option for recognition as the landlord: attornment. However, while government leases typically include a provision governing attornment (explained below), it's extremely rare to see the government take advantage of this option and treat lenders as the landlord without further action. Accordingly, lessors and lenders should not expect a simple attornment process and should instead plan on a traditional novation, albeit with some tailoring to address the unique circumstances surrounding the change in title.

First, most government leases¹² include a provision governing SNDAs¹³ that provides as follows:

In the event of any sale of the premises or any portion thereof by foreclosure of the lien of any such mortgage, deed of trust or other security instrument, or the giving of a deed in lieu of foreclosure, the Government will be deemed to have attorned to any purchaser, purchasers, transferee or transferees of the premises or any portion thereof and its or their successors and assigns, and any such purchasers and transferees will be deemed to have assumed all obligations of the Lessor under this lease, so as to establish direct privity of estate and contract between Government and such purchasers or transferees, with the same force, effect and relative priority in time and right as if the lease had initially been entered into between such purchasers or transferees and the Government; provided, further, that the Contracting Officer and such purchasers or transferees shall, with reasonable promptness following any such sale or deed delivery in lieu of foreclosure, execute all such revisions to this lease, or other writings, as shall be necessary to document the foregoing relationship.

As a practical matter, the requirement that "transferees shall … execute all such revisions to this lease, or other writings, as shall be necessary to document the foregoing relationship" typically means that lenders seeking attornment or purchasers at a foreclosure sale will have to go through the novation process outlined above.

GSA's LDG confirms that the government will likely seek to effectuate a novation as part of the attornment process. In Chapter 17, it provides a draft SNDA agreement that states:

If the Lender forecloses the Loan or acquires title to the Real Property by deed in lieu of foreclosure, or in any other manner succeeds to the interest of the Lessor under the Lease, or if the Lender shall take possession of the Leased Premises, the Lessee shall attorn to the Lender as its Landlord under all of the terms, covenants, and conditions of the Lease for the balance of the term thereof remaining and any extensions thereof which may be effected in accordance with any option therefore as set forth in the Lease, with the same force and effect as if the Lender were the Lessor under the Lease. Such attornment shall be effective and self-operative immediately upon the Lender's succeeding to the interest of the Lessor, whereupon the Lessee shall recognize the Lender, or any person claiming by through or under the Lender (immediate or remote), as the lessor under the Lease without the execution of any further instruments on the part of any of the parties hereto. The Lease shall at all times continue in full force and effect, and the respective rights and obligations of the Lessee and the Lender upon such attornment shall be governed by the Lease. However, the Lessee agrees to execute, acknowledge, and or deliver to Lender any certificate or other instrument that Lender reasonably requests to confirm such attornment. Likewise, the Lender agrees to execute a Novation Agreement in the form required by FAR Part 42.12.

LDG, Ch. 17, Attachment 4 (emphasis added)

For distressed assets, the process can become more complicated. Specifically, nonfunctioning or defaulting lessors may be unable or unwilling to participate in the novation process or to execute the novation agreement, which typically requires commitments from both the current owner and prospective owner. Effective outreach to GSA contracting officers and counsel is vital in these cases, because it involves deviating from regulatory requirements and lease provisions.

Conclusion and Takeaways

The first and most important takeaway for exercising rights in connection with a distressed asset under a GSA lease is to understand those rights and the obligations that come with them. While these rights differ dramatically from typical commercial leases, there are nonetheless a number of powerful protections available for lessors and lenders.

Next, early and effective engagement with GSA will typically yield better outcomes. Once the parties identify a need for an assignment or an attornment, they should consider an immediate outreach to the contracting officer and – when appropriate – regional counsel.

Distressed assets present a number of unique challenges, but ultimately, those challenges have no impact upon the lessor's and lender's rights under the terms of GSA leases.

Holland & Knight's GSA Leasing & Federal Real Estate Team is experienced and available to discuss how best to engage with the government to ensure a successful outcome when the lease involves a distressed asset. For more information, contact the authors. 

The Series

Part 1: When the Government Leaves Early, April 2, 2024

Part 2: Special Considerations for the Purchase and Sale of Distressed Assets Leased to the Government, August 15, 2024

Notes

¹ OMB Agency-Wide Capital Planning Memorandum No. M-22-14.

² "The general rule is that 'an implied duty to vacate is an inherent part of every fixed term lease agreement unless the parties explicitly express an intention to the contrary.'" Allenfield Assocs. v. United States, 40 Fed. Cl. 471, 486 (1998) (quoting Prudential Ins. Co. of Am. v. United States, 801 F.2d. 1295, 1298-99 (Fed. Cir. 1986) cert. denied, 107 S.Ct. 1289 (1987)). For such a breach, the landlord's damages are calculated as the fair market rental value minus the rent actually paid. Cafritz Co. v. GSA, GSBCA No. 13525-REM, 98-2 BCA ¶ 29,936 (Aug. 3, 1998). In order to bring a suit against the government to recover these damages, lessors must adhere to the requirements of the Contract Disputes Act, discussed in Part I.

³ For many lessors, this remedy will not provide adequate redress, particularly in situations where the lessor seeks to either empty the building and redevelop the property or has a follow-on tenant waiting for the government to vacate the premises. Damages stemming from the lost opportunity for follow-on leases or redevelopment are called "consequential" damages, and it is difficult to recover these damages under applicable U.S. Court of Appeals for the Federal Circuit precedent.

⁴ One concession lessors should consider is a one-time escalation of operating costs. Government leases typically escalate the operating costs portion of the rent using a Consumer Price Index (CPI) multiplier from the U.S. Department of Labor's Bureau of Labor Statistics. This multiplier has not kept up with the pace of inflation of operating costs in the years following the COVID-19 pandemic. Specifically, energy costs in many markets have risen at a rate that exceeded the historical CPI multiplier, often dramatically. In light of this, the government may agree to an escalation in these costs, which will benefit lessors due to the continuing annual escalation of these costs.

⁵ 41 U.S.C. § 6305.

⁶ For previous discussed the novation process in detail in partnership with LexisNexis, see Holland & Knight's previous guidance.

⁷ The standard GSA lease form L100 incorporates this portion of the FAR by reference.

⁸ While the standard GSA Lease form L100 expressly incorporates FAR Part 42.1204 in the "Change of Ownership" section, in practice GSA has adopted a Novation Checklist with an abbreviated set of deliverables that is more tailored to real estate transactions.

⁹ The FAR does not generally apply to leasehold acquisition (see 48 C.F.R. § 570.101(d)), but government leases will often expressly incorporate FAR clauses that implement applicable statutory mandates, such as this one.

¹⁰ LDG, Ch. 17 at 17-25 (emphasis in original). The LDG also notes that "Regional counsel must be consulted prior to processing an Assignment of Claims." Id.

¹¹ Id. at Attachment 4. This is not a lease or statutory requirement, but rather an internal GSA policy. As noted above, the statute expressly provides that "an assignment under this subsection is a valid assignment for all purposes" provided it meets the statutory requirements in 41 U.S.C. § 6305(b)(6)).

¹² The language cited herein governing SNDAs comes from the GSA Form 3517B – General Clauses. The GSA serves as the procuring agency for most of the federal government's commercial office space leasing needs, as it possesses the statutory authority to enter into leases with terms of up to 20 years, while most other government agencies may only enter lease subject to annual appropriations, which has the practical effect of forcing other agencies into one-year lease terms with multiple one-year renewal options. Compare 40 U.S.C. § 585(b) (providing that the GSA administrator may enter into leases of up to 20 years) with 31 U.S.C. § 1341 (limiting the obligation of funds to existing (annual) appropriations).

¹³ The General Clause language governing SNDAs also provides that "[i]t is the intention of the parties that this provision shall be self-operative and that no further instrument shall be required to effect the present or subsequent subordination of this lease." However, the government also commits to executing other "reasonable" instruments upon request by the lessor and lender:

Government agrees, however, within twenty (20) business days next following the Contracting Officer's receipt of a written demand, to execute such instruments as Lessor may reasonably request to evidence further the subordination of this lease to any existing or future mortgage, deed of trust or other security interest pertaining to the premises, and to any water, sewer or access easement necessary or desirable to serve the premises or adjoining property owned in whole or in part by Lessor if such easement does not interfere with the full enjoyment of any right granted the Government under this lease.

In practice, the approval process can take significantly longer than 20 days, and it requires the approval of GSA regional counsel.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.