What Happens When a Tenant Wants the Right to Mortgage Its Lease? Five Basic Legal Points for Landlords and Tenants
 
March 1, 2000
 
Curtis L. Sano- Washington

While leasehold mortgages have been around for a long time, in recent years the financial markets have made them more attractive to retailers as a way to finance expansion. When tenants are in a strong bargaining position during lease negotiations, they often obtain the absolute right to mortgage their leasehold interest, and sometimes, in the context of ground leases or subdivided pad leases, have the ability to mortgage the landlord's fee as well. When the tenant is in a weaker position, the landlord often bars any mortgage of the tenant's leasehold altogether.

However, more and more, we have been seeing tenants with a bargaining position somewhere in the middle, especially chain tenants, negotiate in advance for leasehold mortgage provisions to assist in their future financing efforts.

Landlords typically consider these provisions both as an incentive for the tenant to sign the lease and as a means of promoting the tenant's future financial viability.

Chain tenants, especially those growing quickly, need to have leasehold mortgage clauses in place in their leases. The tenant's bargaining position is usually at its peak at lease signing and it runs the risk of one or more landlords extracting costly concessions or simply refusing to consent when the tenant tries to finance its leases throughout the chain at a later date. Without the leasehold mortgage provisions already in place, separate negotiations with each landlord will impede a chain tenant's efforts to finance using its leases as collateral.

In this article we will identify and address five major legal issues that have a significant impact on landlords and tenants when they negotiate leasehold mortgage provisions in leases.

Making Sure the Tenant's Financing is "Bona Fide"

Leases commonly restrict leasehold financing to institutional lenders and have a definition of "bona fide financing," generally to avoid the use of a leasehold mortgage to avoid assignment restrictions. In addition, landlords often prefer that their chain tenants' leasehold financing be done for more than just one or two stores, whether on a chainwide basis or for all stores under a particular trade name or in a particular geographic area or with respect to a certain minimum number of stores.

Does the Lease Survive Foreclosure?

There are three basic items the lender needs to protect its mortgage interest. First, the lender will typically want to record a memorandum of the lease. Second, the tenant's lender also needs a nondisturbance agreement providing that the lease remains in place if the landlord's lender forecloses or if the tenant's lender forecloses and succeeds to the tenant's interest. Finally, many lenders also ask that if tenant goes bankrupt and the lease is terminated, the landlord will enter into a new lease directly with the lender on the same terms as the tenant's lease.

Notices and Rights to Cure

The tenant's leasehold lenders usually want notice of tenant's defaults and the option to cure a tenant's default beyond the tenant's cure period so that the lender can protect its collateral. Landlords may want to consider permitting such protections, provided there are appropriate time frames for the cure, taking both the tenant's cure period and the lender's cure period together. A related issue is that lenders typically want the landlord to agree not to accept a voluntary surrender of the lease from the tenant without the lender's consent.

Lender's Right to Assign the Lease

Once the lender begins its foreclosure process, it needs to dispose of the lease - after all, an institutional lender does not typically want to operate a tenant's business.

Unrestricted assignment can be problematic for landlords, especially for shopping center landlords, for whom tenant mix, use clauses contained in the lease, protection of other tenants' exclusive use clauses, and restriction of noxious uses are critical issues. In addition, all landlords are concerned with the financial viability of the potential assignee.

The landlord should consider making it easier for the lender to assign - the landlord does not want to have the lender operate the premises for any extended period of time, either. But at the very least, the lender should have the same right to assign as the original tenant had, and subject to all of the terms and conditions of the lease, including exclusives and use restrictions. The lender, however, will need to be released from all liabilities and obligations under the lease accruing after assignment and the lender will also need to retain any rent premium or other consideration paid by the assignee - after all, these monies are the lender's collateral.

When Might the Landlord Want to Subordinate Its Fee Interest to the Lender?

Often, leasehold lenders want to bind the fee or be superior to the interests of the landlord and its lenders. Landlords rarely agree to subordinate their fee interest to the tenant's mortgage. Occasionally, subordination may be agreed to in a standalone lease or on a subdivided pad where the landlord/fee owner would otherwise take out a loan itself to build the tenant's building or pay a tenant improvement allowance but the tenant can more cheaply obtain the same loan. In this case, the landlord will want the right to cure any defaults by the tenant under the loan documents and have the tenant's default under its loan documents also be a default under the lease. Subordination is nevertheless a rare occurrence and leasehold lenders typically accept this limitation.

The foregoing are basic points for landlords and tenants to consider when negotiating leasehold mortgage provisions. Of course, there are many additional and critical details and legal issues that will need to be addressed when a landlord and tenant agree on a leasehold provision to be added to a lease. The facts and circumstances of each transaction must be considered as well.

Mr. Sano is an associate in Holland & Knight's Real Estate Group in the Washington, D.C., office. He can be reached at 202-862-5980 and csano@hklaw.com.