Leases: Negotiating Subordination Provisions

Commercial lease agreements are often long and complex, containing numerous clauses that neither party expects will ever be triggered by events. But sometimes they are triggered. One such agreement is the lease subordination clause, by which the tenant agrees the lease will be subordinate to any present or future mortgage the landlord may put on the property. Accordingly, foreclosure of the mortgage loan (depending on the law of the state involved) either automatically terminates the lease or entitles the lender, at its option, to terminate the lease. (If the building has been constructed on leased land, the subordination clause normally makes the lease subject to present or future ground leases as well.)

Tenant Acceptance

Tenants who enter into leases at market rentals often assume (if they think about the problem at all) that foreclosing lenders or repossessing landowners will be happy to keep them as tenants. This may or not be the case, however, particularly where a tenant has received extensive concessions in the form of free rent periods or desirable renewal options, a common situation in today oversupplied marketplace. As a result, a tenant who may have spent several hundred-thousand dollars in fixing commercial space could conceivably be put out of business simply because his landlord failed to pay the mortgage or the ground rent. The lender or ground lessor who takes over the mortgage can then force a re-negotiation of the lease. The absence of a subordination clause prevents the lease from becoming subordinate to any future mortgages or ground leases. However, the lease remains subordinate to prior mortgages and ground leases because the general rule in law is first in time, first in right. Consequently, the tenant must still act to be protected.

Landlord Position

The landlord wants a subordination because this eliminates one potential problem in refinancing the property. Consequently, a tenant leasing only a small amount of space in a large building and who spends little money on leasehold costs will not get very far in seeking to eliminate the subordination provision. However, a major tenant prepared to invest a substantial amount is in a much stronger bargaining position. That tenant should seek protection with a non-disturbance agreement (sometimes called a recognition agreement). Such an agreement provides that as long as the tenant is not in default under the lease, a foreclosing lender or re-possessing ground lessor will recognize the lease and permit the tenant to remain in possession of the space. If at the time the lease is entered into there already is a mortgage or ground lease, the non-disturbance agreement should be signed by the lender or ground lessor. With respect to future mortgages or ground leases, the lease should either contain no subordination provision (so that the tenant maintains his priority position) or should specifically provide that a non-disturbance agreement will be offered to the tenant by a future lender or ground lessor.

Non-Disturbance Clause

A lender or ground lessor may be willing to give the tenant a non-disturbance clause but only if certain conditions are met at the time the tenant takes possession of the property. Typically, these include the following: (1) the lease has not been modified by the original landlord without the approval of the lender or ground lessor; (2) the lender or ground lessor is not liable for any obligations not performed by the original landlord; and (3) the lender or ground lessor shall not be obligated to make any payments promised by the landlord or be obligated to recognize any rent prepayments by the tenant. In addition, the lender or ground lessor may insist that, at the time of taking over the space, the tenant must provide an appraisal by an independent appraiser certifying that the rent then paid represents a fair rental value of the property. This condition is intended to meet the main objection to a non-disturbance agreement by the lender or ground lessor, that the agreement may prevent space in the building leased at below market rentals to be re-leased at market rates

David Tevlin is a partner in the Real Estate Industry practice in BDO New York office. This article originally appeared in BDO USA, LLP Real Estate Monitor newsletter (Fall 2011). Copyright © 2011 BDO USA, LLP. All rights reserved. www.bdo.com