Leasehold Finance: A Powerful Tool
 
November 22, 2004
 

Part II of a Two-part Series

Leasehold finance can be a powerful and valuable mechanism, but if a lease does not contain certain critical provisions called “lender protections,” then that lease will have difficulty functioning as security.

Part I of this two-part series, which can be found in the 2004 third quarter issue of Property Writes, addressed the basic elements of leasehold finance: (i) what is a “leasehold mortgage?” (ii) what makes a lease “marketable?” and (iii) how is the lien of a leasehold mortgage filed and perfected? That article explained that, although leasehold mortgages have traditionally encumbered ground leases, they can also encumber space leases of all types, and can add value to a wide variety of deals.

Part II of this series addresses lender protection issues related to leasehold financing, including important terms that the landlord, tenant and lender must negotiate and draft into a lease in order for that lease to be “financeable.” Lender protection provisions allow the lender to protect the lease from unexpected termination, to foreclose the lien that encumbers the lease by taking over the tenant’s position, and to quickly “sell” the lease by assigning it to a third party for value. Landlords often resist unfamiliar changes to their leases and it is essential that the tenant have sufficient leverage to convince the landlord to incorporate these non-standard terms. However, leverage alone is not enough: the lender’s counsel must fully understand, and be prepared to explain, the function and importance of each lender protection provision. An explanation of the major lender protection provisions are as follows:

Assignable to lender – If the borrower tenant is in default under the leasehold mortgage, the lender must be able to take over the tenant’s position under the lease quickly and without interference from any third party, such as the landlord. While a lender can take over a lease through a judicial foreclosure process, it might also be advantageous to take over the lease by assignment in lieu of foreclosure. Most leases contain general restrictions on assignment, and therefore a lender’s attorney must draft an exception to those restrictions to allow for an assignment to the lender.

Assignable by lender – Once the lender takes over the tenant’s position under the lease, the lender will need to assign the lease to a third party for value, quickly and without interference or delay. Lease assignment is urgent because when the lender forecloses on the lease, the lender becomes a tenant. As a tenant, the lender must pay rent and is liable for all other monetary and non-monetary obligations of the tenant. On the other hand, landlords usually want control over tenant selection, especially with respect to the tenant’s financial stability and proposed use of the premises. Leases often contain general restrictions on assignability and sometimes even contain provisions that allow the landlord to recapture a portion of any profits resulting from sublet or assignment. Leases often contain “use” provisions that restrict the manner in which the property may be used, thus limiting the marketability of the lease.

How can one possibly balance the urgent needs of the lender against the business priorities of the landlord? One way to reconcile this seemingly impossible conflict is as follows:

(a) Regarding consent to assignment, lender and landlord should agree on the standards that must be met for an assignment, such as that any new tenant will be credit worthy. The lender’s attorney might point out that if the tenant is in default under the mortgage, it is likely that almost any replacement tenant will be an improvement from a credit standpoint.

(b) Regarding use restrictions, lender and landlord should negotiate a “use” provision that is broad enough so that the lease remains marketable yet narrow enough so that the landlord has confidence that any new tenant will be acceptable. This will differ depending on the type of lease. For example, an office lease might allow a general office use. However, a retail lease may allow for the premises to be used for certain, specified retail uses, but restrict others in order for the landlord to try to control the tenant mix within the retail development. These conditions will serve to give the landlord comfort without delaying the lender’s foreclosure and sale process.

Subject to the above conditions, the lender would like to assign without restriction. The lender also needs to be entitled to keep any and all value received in connection with such sublet or assignment in order to receive the full benefit of the leasehold collateral.

Lender’s performance/cure rights – It is of paramount importance to a lender that the lease does not terminate, because termination causes the lender’s security to vanish. Therefore, the lender must have the ability to maintain the lease, even if the tenant does not. The landlord must be required to send copies of any official notices to the lender with an opportunity to cure any default, so that the lender will be aware of any potential or actual defaults as early as possible. In addition, the landlord must be required to accept any cure or performance under the lease from the lender. For example, if the tenant were to miss a rent payment, the lender might choose to make that rent payment on the tenant’s behalf in order to prevent the lease from terminating. A landlord might refuse to accept the cure tendered by lender for various reasons, including that the lease is below-market. Many landlords will relish any excuse to terminate a below-market lease and evict the tenant in order to re-let the premises at a higher rent. A landlord should understand that the lender must be able to preserve and access the value inherent in the below market lease or else the leasehold financing is impractical. In addition, the borrower should be required under the terms of the credit agreement (or other operative contract between the lender and the borrower) to properly maintain the lease. “Maintaining” a lease includes paying rent, not committing monetary or non-monetary defaults, exercising renewal provisions in a timely manner and any other actions that a tenant must take to prevent a premature lease termination.

New lease – If for any reason a party cannot continue as tenant under the lease, or if the tenant rejects the lease in bankruptcy, the lender should have the right (but not the obligation) to enter into a new lease with the landlord under the same terms as the original lease. This “new lease” mechanism provides an additional protection against termination of the leasehold security.

Standard tenant protections – All standard provisions that protect the tenant’s position should be present in the lease, for example: the landlord must be obligated to obtain Subordination and Non-Disturbance Agreements (SNDAs) (which protect the tenant’s position in the event that the landlord’s lender forecloses on the fee estate), properly drafted casualty and condemnation provisions, and all other clauses that a tenant’s attorney would customarily require in a commercial lease. In essence, the lender’s lawyer must put him or herself “in the shoes” of the tenant and confirm that the lease will not be unexpectedly terminated or become valueless in some other way.

Proper definition of “lender” – Lender must be defined under the lease to include the party that is initiating the loan, as well as any potential successors or assigns to the lender’s position. Loans and loan portfolios are often sold, pooled, syndicated, securitized or otherwise marketed in a variety of ways. In order for a loan to be marketable, the security under that loan must be transferable.

Collusion or mistake – Because the lender is essentially a third party to the lease, the lender must protect itself against collusion or mistake by the landlord and tenant. The lease should prohibit the landlord and tenant from making any changes to the lease, including termination, without first obtaining consent from the lender. The credit agreement or other operative document between the lender and the borrower should contain similar restrictions.

Prior to closing the financing, the lender must confirm that the lease is in full force and effect, that there has been no event of default (as defined in the lease) and that there exist no amendments or other relevant agreements that the lender has not seen. The lender should receive a landlord’s estoppel certificate that represents the above facts. Any estoppel certificate or other representation should contain the landlord’s signature and should be dated as of the date of closing. The borrower should make similar representations to the lender in the credit agreement.

Finally, as in any mortgage transaction, the lender should review the public record of title to confirm that the asset which provides security is not previously encumbered by other liens.

Conclusion

All parties must be “on board” with respect to the leasehold financing process. Many landlords are not familiar with leasehold financing and their lawyers might resist any changes to the lease. Negotiation of lender protections will proceed smoothly if the landlord and landlord’s counsel understand the logic and importance of the lender protections, as well as the value that the landlord will enjoy as a result of the financing. With a proper understanding of the functioning of lender protections, and a spirit of cooperation among all relevant parties, it is possible to negotiate a safe and effective leasehold financing.

Originally published in the Fall 2004 issue of the Real Estate Finance Journal.

For more information, e-mail Daniel M. Pomerantz at daniel.pomerantz@hklaw.com or call toll free, 1-888-688-8500.