Real
Estate Finance Notes
More on leases
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.