Estate Finance Notes
More on leases
are pretty important in the process. How
does the mortgagee preserve a favorable lease that’s 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 power of 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
If you’re in a state that doesn’t allow you to pick and choose, the junior tenants can intervene even if you don’t 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 they’ll be able to get a mortgage later. Some lease terms may even render the property unmortgageable.
Lender’s 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 tenant’s 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. It’s 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 that’s 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 aren’t 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 can’t 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 isn’t deceptive. Prepaid rent is particularly dangerous: when the landlord is in financial trouble and asks for a year’s 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 lender’s 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 post-foreclosure/post-default relationship between the lender and the tenant. A nondisturbance agreement is an agreement by the lender that if the lender or a purchase at foreclosure comes into possession, that person will not disturb the tenant’s 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 can’t 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 won’t 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 can’t 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. You’re required by law if you’re 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 won’t be bound if they don’t have notice. They don’t 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 isn’t bound by modifications to the lease that occur without the lender’s consent.
Assignment of rents
So far, we’ve 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, it’s 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: it’s 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 it’s 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 doesn’t 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.