Anyone in the commercial real estate business can tell you that the past couple of years have seen a significant uptick in the number of commercial foreclosures and owner bankruptcies. While it does appear that the market is improving, we’re certainly not out of the woods. We are likely to see headlines declaring the latest big bankruptcy or foreclosure for a few more quarters. Sometimes lost in the headlines is the impact such issues have on the tenants in these commercial properties. A business owner must be aware of the different scenarios that can follow the property owner’s bankruptcy or foreclosure.
One needs to have working understanding of a few legal terms to understand the issues. The first two terms are priority and subordination. Commercial lenders typically require that their mortgage have priority—or be superior to—all other interests in the property, including the commercial tenants. The tenants’ interest are thereby subordinate to the mortgage. This is to protect the lender in a strong market where the lender would want flexibility to terminate the lease and lease the property to a prospective third party for a higher rent or (maybe more typically) to sell the property for a higher and better use. The new owner can evict the current tenants (even if the tenants have fully complied with their leases). This isn’t all that common of course—paying tenants represent continuing income to the lender or post-foreclosure owner. But it does happen, and one can see how a new owner could even threaten termination as a way to wring higher rent from an existing tenant.
Foreclosure works both ways, though—if the lender forecloses all of the subordinate interests, including the tenancies, then the tenants could choose to walk, too. This brings us to the next term: attornment. The concept of attornment developed so that tenants could and would promise to recognize the lender (or post-foreclosure owner) as the tenant’s new landlord after foreclosure. Most commercial leases include automatic subordination and attornment language whereby the tenant agrees to be subordinate to and to attorn to any lender on the property—whether the loan predates the lease or not. The attornment language may even say that the tenant will attorn to the lender at lender’s option. This obviously preserves the greatest degree of flexibility possible to the lender. One might say that this isn’t particularly fair to the tenant. It does, however, comply with the golden rule: “Those with the gold make the rules.”
So how does a commercial tenant protect its leasehold interest against these risks? This brings us to the next term: nondisturbance. A non-disturbance agreement is one between the lender and the tenant whereby the lender agrees it will not disturb the tenant’s possession so long as the tenant continues to pay rent and otherwise complies with the terms and conditions of the underlying commercial lease. Nondisturbance language is not typically included in a commercial lease (and if the loan predates the lease, the lease language would not be binding on the lender anyway) so it is typically negotiated between the parties in a comprehensive agreement typically titled a “subordination, nondisturbance and attornment agreement,” or “SNDA.”
The negotiation of such an agreement will add cost and time to any leasing transaction. Whether or not the additional expense is worth it will depend on the type of lease at issue. For a two-year deal at a couple thousand dollars per month, it would not typically make sense—such a tenant can probably easily find replacement space in the unlikely event the lender evicted said tenant.
Remember that such evictions of willing, paying tenants are not usual. However, sites with long-term leases (where the contract rent rate is likely to be under market in the future) or which included significant investments of tenant capital should be protected.
Restaurants are a classic example. While most restaurants are only a couple thousand feet, they are not very portable. The leases are generally longer terms (with options to extend them out as much as twenty or thirty years), kitchen buildouts are very expensive, and restraunteurs spend lots of time and money building up “location” capital. Being forced to move (or pay a higher rent) can be the death of a successful business.
SNDAs negotiated at lease signing—before a landlord gets into trouble and when the lender has time to devote to the agreement—can eliminate this risk or at least make it so that the tenant can negotiate a buy out in exchange for its agreement to move.
If a tenant undertakes to negotiate an SNDA, it should be conscious of the terms of said agreement. The typical SNDA contains carveouts from lender liability for, for example, lease modifications not explicitly agreed to by it, unpaid tenant improvement allowances, offset rights construction obligations and security deposits. If a leasing deal includes a significant allowances or security deposits, tenants may consider requiring that such rights be recognized in the SNDA. This may then result in the lender having to pay such finds into an independent escrow or post a security deposit, but given the events of the past several years and the current economic climate, including such provisions may be a good idea.
As the commercial real estate industry continues to improve, it may be a good time to look for lessons to take from the downturn. With respect to owner foreclosures, the lesson is: yes, it does happen but tenants that understand the risks can proactively manage these risks at lease execution.
John B. Benazzi is an attorney in the Portland office of Davis Wright Tremaine LLP, where he focuses on all aspects of real estate transactions. He can be reached at 503-241-2300 or johnbenazzi@dwt.com.
As published in the Daily Journal of Commerce, Portland, Ore., Apr. 2011. To view this column and other legal commentary, click here.
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