Residential or Nonresidential Determination as to a Commercial Lease: Implications and Strategy

Whether a lease constitutes a lease of residential property or of nonresidential property can significantly impact the reorganization effort of a chapter 11 debtor-lessee. Questions may arise as to whether a lease entered into as part of a commercial transaction in which the debtor-lessee neither resides nor intends to reside in the leased premises constitutes a lease of residential or of nonresidential real property. Debtors operating skilled-nursing, assisted-living and other longer-term-care facilities should be aware of the implications of the residential/nonresidential determination. [1]

Leases involving residential real property are governed by Bankruptcy Code [2] § 365(d)(2), while leases of nonresidential real property are subject to § 365(d)(3) and (3)(4). Section 365(d)(4) provides a debtor-lessee with 210 days in which to assume or reject an unexpired lease of nonresidential real property, [3] plus a potential additional 90 days, which the court can order for cause. Thereafter, there can be no further extension without the lessor’s consent. If the debtor takes no action, such lease will be deemed rejected.

Absent consent, the debtor is faced with the choice of either losing its lease through deemed rejection, or assuming the lease prematurely and facing a significant administrative expense claim if it later determines rejection is necessary. Moreover, § 365(b) requires a debtor assuming a lease to promptly cure all outstanding lease defaults at the time of assumption, which may constitute a substantial amount. Consequently, a lessor may have significant leverage in any negotiation for a consensual extension. In contrast, § 365(d)(2) generally provides a debtor-lessee leasing residential real property until plan confirmation to assume or reject its lease and to cure defaults if assumption is determined to be the best course.

With the exception of the limited relief afforded under certain COVID-19-related legislation currently scheduled to expire in December 2022, § 365(d)(3) affirmatively requires a debtor-lessee under a lease of nonresidential real property to timely perform obligations under the lease during the pendency of the bankruptcy case. Section 365(d)(2) does not mandate such performance with respect to a lease of residential real property.

Courts are divided over the question of whether the phrase “lease of non-residential real property” as used in § 365(d)(3) and (4) should be interpreted to mean a lease of real property where the lease itself is commercial in nature as between the parties, regardless of the manner in which the property will be used, [4] or whether the phrase refers to the manner in which the property is intended to be used, i.e., whether individuals reside upon the premises. [5] The former analysis is sometimes referred to as the “nature of the lease test,” while the latter is referred to as the “property test.” Most of the published opinions addressing the question have utilized the property test. [6] However, because there is no controlling case law, good faith arguments can be made on both sides.

Because of the more stringent statutory requirements placed on a debtor-lessee under a lease of nonresidential real property, the debtor will typically be the party asserting that the lease should be characterized as one of residential real property. However, the addition of COVID-19-related amendments to the Bankruptcy Code recently caused the debtor-lessee and the lessor to swap arguments, with the debtor-lessee taking the position that its lease was nonresidential in nature. [7] Chapter 11 debtor Northwest Senior Housing Corp., d/b/a Edgemere, operated a 400-plus resident continuing-care retirement community in Dallas, the premises of which were leased by the debtor. Upon filing its chapter 11, the debtor sought relief under the provisions of Bankruptcy Code § 365(d)(3)(A) that were added to address the hardships experienced by lessees due to the COVID-19 pandemic. [8] Section 365(d)(3)(A) provides that a debtor may seek relief, for cause, from the requirement that it timely perform all lease obligations during the first 60 days of its bankruptcy case. By its terms, § 365(d)(3)(A) is only applicable to a debtor-lessee under a lease of nonresidential real property.

The lessor responded by arguing that, pursuant to the property test, the lease between itself and the debtor was a residential lease, thus the relief provided by § 365(d)(3)(A) was not available to the debtor. [9] The debtor’s secured lender then pointed out that to the extent the lease was of residential property as argued by the lessor, the debtor had no statutory obligation of post-petition performance and the lessor was limited to seeking an administrative expense claim. [10] Ultimately, the debtor withdrew its motion, so the court was not required to render a decision.

While the arguments in the Edgemere bankruptcy are an interesting departure from the parties’ typical roles, because the COVID-19 provisions of § 365 are scheduled to sunset in December 2022, it is likely that going forward, debtors will largely continue to argue that the property test provides the correct analysis.