Leases: Subordination Clause Could Harm Tenants

Commercial lease agreements often are long and complex, with clauses neither party may expect will ever be triggered by events. But sometimes they are. One such is the lease subordination clause, by which the tenant agrees the lease is subordinate to any present or future mortgage that the landlord may put on the property. Accordingly, foreclosure of a mortgage (depending on the law of the state involved) either will automatically terminate the lease or entitle the lender, at its option, to terminate the lease.

Tenants who enter into leases at market rentals often assume (when they think about the problem at all) that foreclosing lenders will be happy to keep them as tenants. This may not be the case, however, where a tenant has received extensive concessions in the form of free rent periods or desirable renewal options—a common situation in today’s oversupplied marketplace. As a result, a tenant who may have spent a large sum in fixturing commercial space might be put out of business because the landlord failed to pay the mortgage or it might be forced to re-negotiate the lease.

A new lease is subordinate to existing mortgages on because the general rule in law is “first in time, first in right.” A landlord wants the lease to be subordinate to future mortgages as well because this eliminates a potential problem when future financing is sought. A tenant leasing a small amount of space in a building and who spends little money on leasehold costs will usually be unable to eliminate the subordination provision. However, a major tenant prepared to invest a substantial amount is in a much stronger bargaining position. The tenant should seek protection with a non-disturbance agreement (sometimes called a recognition agreement). Such an agreement provides that so long as the tenant is not in default under the lease, a foreclosing lender will recognize the lease and permit the tenant to remain in possession of his space.

Non-Disturbance Agreement

If the property is mortgaged at the time the lease is entered into, the tenant should seek a non-disturbance agreement from the lender. With respect to future mortgages, the lease should contain no subordination provision (in which case it maintains its priority over future mortgages) or should provide that future subordination will be conditioned on a non-disturbance agreement by the lender. A lender may be willing to give the tenant a non-disturbance agreement if certain conditions are met if and when the lender takes possession of the property following a default by the landlord. Typically, these include the following:

• The lease has not been modified by the landlord without the approval of the lender;
• The lender will not be liable for any unperformed obligations of the landlord;
• The lender will not be obligated to make any payments promised by the landlord (e.g., a cash bonus) or be obligated to recognize any rent prepayments by the tenant.

In addition, the lender may insist that if and when it takes over the space, the tenant’s rent will remain unchanged only if an independent appraiser certifies that the amount reflects the fair rental value of the property. This meets the main objection to a non-disturbance agreement by a lender —that the agreement may prevent space leased at below-market rentals to be re-leased at market rates.