on More leases
Leases are pretty important in the process. How does the mortgagee preserve a
favorable lease thats junior? We know how to get rid of it: join the tenant, and the
foreclosure terminates the lease. If you want to keep the lease in a pick and
choose state, you can omit the junior tenants from the judicial foreclosure. But in
some states, there are powerof sale foreclosures. A power of sale is a right the
mortgagor (or the person in the position of the mortgagor) gives to the trustee to
sell the property and apply the proceeds to satisfy the debt. In a judicial state
like Ohio, only the sheriff can execute the foreclosure sale. In a power of sale
state, you can hold on to your tenant by not giving proper notice. As a result, they
are unaffected by the proceeding.
If youre in a state that doesnt allow you to pick and choose, the junior tenants can
intervene even if you dont join them in a judicial foreclosure state. And in a
power of sale state, the tenant is bound anyway. Automatic termination may be
better because it allows the parties after foreclosure to renegotiate the lease more or
less on equal footing. The parties can contract around this if they want. This is an
area where the lawyer plays a number of different roles. The lawyer is a planner,
drawing up leases and mortgages. The lawyer may also be a litigator. The person
drafting the instruments must think about what happens to them in the event of a
dispute. The lawyer also plays the role of financial advisor. They advise
borrowers as to what terms may and may not appear in the lease such that theyll
be able to get a mortgage later. Some lease terms may even render the
property unmortgageable.
Lenders evaluation of leases
When the lender looks at leases, the lenders wants to know what the rent is and
what it will be in the future. The lender wants to know about the tenants financial
condition. Are they creditworthy? The lender is especially interested in anything
that will cost it money, so if the landlord has financial obligations to the tenant, the
lender will want to know about it. If the landlord is obligated to rebuild in the
event of a casualty loss, the lender will be concerned. If there is an exclusive
clause in the lease, the lender will be concerned because the lender or purchaser at
foreclosure may be in violation immediately upon completion of the sale or
mortgage. These clauses say that only a certain number of similar businesses can
be in the same shopping center, for example. The lender is also concerned with
assignment and subletting. The lender wants to have the same control in the future
as a potential landlord as does the current landlord. One of the most heavily
negotiated clauses is the duty to operate, or operating covenant. Landlords want
shopping centers to have tenants who are operating. Its bad for the shopping
center to have a lot of empty storefronts. It has a cascading effect on the other
stores in the center. The landlord establishes that the tenant is creditworthy, but the
landlord also wants a promise that the tenant will stay in business. The tenant will
tend to resist this clause.
When the lender evaluates the collateral, the income the property is bringing in is
the most important factor to be considered. The lender will impose on the
developer some kind of debt service ratio. The net rents must equal some
percentage greater than the debt service (your monthly payment, principal plus
interest). 120% is not uncommon, and the riskier the project, the higher the ratio
will be. If you have 120% as the ratio, the lender wants to see operating income
that is at least 120% of the amount that must be paid on the debt. So the lender is
looking at rents and operating expenses. The net operating income is the gross rent
minus the expenses of operating the building. Then you subtract the debt service
and you get your net cash flow. You calculate your debt service ratio by dividing
your net rents before debt service by the debt service itself.
When lending on a building thats already there and has existing tenants, the lender
requires estoppel statements from the tenants. The estoppel certificate is
designed to estop the tenant from denying the truth of certain facts, even if those
facts arent actually true. The tenants must state that the lease is valid and
binding. The lender wants to know that the lease that the landlord has looked at
and approved is actually the lease in effect (no modifications have been
made). The lender wants to know that the rent is whatever is stated in the
lease. Also, landlords engage in lots of tricks to make their property look better to
lenders. They know about the debt service coverage ratio. So if the tenant cant
pay enough, the landlord will sign a side agreement with the tenant saying that they
get every twelfth month free. This is called a rent concession agreement. If the
tenant denies that such an agreement exists, it could be fraud, but the tenant can
play it both ways as long as the tenant isnt deceptive. Prepaid rent is particularly
dangerous: when the landlord is in financial trouble and asks for a years rent in
advance in exchange for a 25% discount, then the rent may already be in the
pocket of the landlord before it gets into the lenders hands. The lender also wants
to know how large the security deposits are, the term of the lease and renewal
options. Finally, the lender wants to know that the tenant has no claims against the
landlord for breach.
Subordination, nondisturbance and attornment
This is known as SNA. These are the three basic agreements that adjust the postforeclosure/post-default relationship between the lender and the
tenant. A nondisturbanceagreement is an agreement by the lender that if the lender
or a purchase at foreclosure into comes possession, that person will not disturb
the tenants right to possession. The lender promises on behalf of itself and its
heirs and assigns (namely, the purchaser at foreclosure). If the leases are in place
when the loan is made, it may be necessary to have a three-way negotiation
(mortgagor-mortgagee-tenant). If there are no leases yet, this is just a negotiation
between the mortgagee and mortgagor.
What terms are favorable to the mortgagee? The mortgagee wants subordination,
that is, that the lease is junior to the mortgage, and also wants attornment. The
mortgagee can kick the tenant out, but the tenant cant decide to terminate on her
own. You can kick the tenant out because the lease is subordinate, but you can
keep the tenant because the tenant has promised to attorn. Other clauses you can
have are the new lease clause or optional unsubordination.
When you have a small tenant, the deal that the landlord offers them and the
mortgagee will try to insist on is automatic subordination plus a promise
to attorn. In the Fiber Form case, only the mortgagee could exercise the option. It
is a stronger clause to have the tenant agree to attorn to any person acquiring the
premises.
The tenant would like to only have a nondisturbance agreement: a promise from
the mortgagee that the mortgagee and purchaser at foreclosure wont kick the
tenant out and terminate the lease even though the relative priorities of the parties
would give them the right to do that. This is the mirror image of
the attornment agreement.
In the real world, the parties will bargain, and depending on the bargaining power
of each party, one side or the other will get their preferred clauses, or the parties are
balanced, you get all three agreements:
subordination, nondisturbance and attornment, which have some benefits to both
sides. But why would the lender care about a subordination from the tenant if the
lender is going to give the tenant a promise not to disturb the tenant? If the lender
cant throw the tenant out on foreclosure, why bother to get the tenant to
subordinate? Many states require that certain kinds of lenders only have first
liens. Youre required by law if youre a certain kind of company to secure all or
most of your loans with first liens (not second, third etc.). Also, the lease and
mortgage may have some conflicting provisions.
Any subordination agreement should be recorded. Does the attornment agreement
need to be recorded? Is there a possibility of a good faith purchaser for value
without notice? Yes, for all three of these agreements. The rights of third parties
could intervene and they wont be bound if they dont have notice. They dont
need to be recorded necessarily in that they are valid as to people with actual notice
of them and they will probably be discovered without recording from the estoppel
certificate, but they may not be. The best practice is to record.
There are some rights or obligations that the lender may be unwilling to assume
that would be included in the nondisturbance agreement. But there are some
exceptions. The lender or purchaser at foreclosure is willing to be bound by the
lease, but not by things that happened before they became landlord. They want to
have a clean slate when they take over. You can include, for example, that the
lender isnt bound by modifications to the lease that occur without the lenders
consent.
Assignment of rents
So far, weve been talking about the fact that the lender wants to ensure a stream of
income (i.e. rents) available to repay the loan. How does the lender get possession
of the rents? What priority does the lender have with respect to the rents? The
purchaser at foreclosure gets the title as it was just before it was foreclosed. What
about judgment creditors? They may come in first in time with respect to the rents
(though not to the realty). The obligation to pay rent is treated as if it were part of
the real estate. Courts get confused about this: they talk about both when
assignment of rents becomes effective and when it becomes perfected (which is the
language of the Uniform Commercial Code having to do with security interests in
personal property rather than real property). The proper way to do it is to talk
about rents as real property.
There are lots of reasons to want assignment of rents. You might want to get the
rent during a foreclosure proceeding. The foreclosure period may be lengthy. If
the mortgagor is getting rent but not paying the mortgage, its a problem that
assignment of rents can solve. If waste is ongoing, an assignment of rents will
allow the mortgagee to capture the rents and stop the waste. The mortgage on the
rent must be drafted to trigger assignment of the rents upon particular events.
What does rents mean? The Restatement defines it pretty broadly: its not just
payments by lessees, but also licensees and others. The common law would limit
rents to payments made by lessees. A common question is whether something is
rent or not. These are tough questions under common law, but not under the
Restatement. If a payment is made in exchange for the right to use or possess the
property, then its a rent. There are other things that could be financial obligations
of the tenant that may not be included in the Restatement definition. A lease may
commonly provide that the tenant is required to help maintain the common
areas. You could argue that such payments are not made for the right to use or
occupy the property. If the tenant is required to purchase insurance, and the
landlord is authorized to purchase it on behalf of the tenant if the tenant doesnt do
it, is that a rent? There are a lot of questions remaining. But lenders will insist that
in leases, all of these things are to be defined as rents.