When a landlord and a tenant agree to a commercial lease, it may contain clauses covering things that neither party to the lease ever expects to happen. Occasionally, one of these will happen with costly and damaging consequences to the tenant.
One lease clause that may seem very reasonable to a tenant is one that agrees to subordinate the lease to any future mortgages that the landlord may place on the property. After all, it is reasonable for an owner to want to refinance a property. The result of the provision is that the foreclosure of a mortgage loan will either automatically terminate the lease or entitle the lender, at its option, to terminate the lease (depending on the law of the state involved).
Tenants entering into leases at current market rentals often assume (if they think about the problem at all) that any foreclosing lender will be happy to keep them as tenants. This may not be the case, however, if market rents have risen sharply or where a tenant has received substantial concessions in the form of free rent periods or below-market renewal options–a common situation in an oversupplied marketplace.
As a result, a tenant who may have spent hundreds of thousands of dollars in improving office premises or fixturing commercial space could conceivably be put out of business in the event the landlord defaults on the mortgage. At the very least, the tenant may be able to retain possession of the premises only by accepting a lease with much less favorable terms.
Non-Disturbance Agreement
The landlord wants the lease to be subordinate to mortgages because financing otherwise might be unavailable. A lender may not be willing to finance a property if, in the event the lender takes over, it will be saddled with the existing leases that may be the cause of the landlord’s problems.
A small tenant in a large building is not likely to get very far in seeking to eliminate the subordination clause. However, an office tenant taking a large block of space, or a commercial tenant prepared to invest a substantial amount in a restaurant or retail facility, is in a stronger bargaining position. Such a tenant may agree to subordinate only if the tenant receives in return a non-disturbance agreement (also known as a recognition agreement). This provides that so long as the tenant is not in default under its lease a foreclosing lender will recognize the lease and permit the tenant to remain in possession for the balance of the lease term. The clause normally also provides for “attornment,” that is, requiring the tenant to acknowledge the lender (or other third party) as its landlord entitled to receive rent.
Will the Lender Agree
A Lease that provides for tenant subordination only in exchange for a non-disturbance clause will not guaranty that a future lender will agree. At the very least, the lender may insist that certain conditions be met before the tenant will be assured of non-disturbance. These conditions should be included by the landlord in the lease clause itself.
Typically, these include the following:
• The lender must not be liable for any unperformed obligations of the original landlord (e.g., unpaid tenant allowances) or be obligated to recognize any rent prepayments by the tenant or future periods of free rent.
• The tenant must not be in default under any provision of the lease.
Note: The main objection of a lender to giving a non-disturbance agreement if the lender takes over the property is that rents may have risen above the contract rental. The landlord then may want to include in the lease a provision that, in the event a lender does take over, the tenant will agree to pay the market rent (as determined by an independent third party). A tenant is not likely to agree to this, except possibly in exchange for an option for the tenant to cancel the lease if the new rent is unacceptable.