Bridging the Gap Between Leasing and Loan Transactions

Loan underwriting for income producing properties usually takes into account the occupancy rate, the lease terms and the existing and anticipated cash flow from the property. Therefore, leases that provide for below market rents or free/abated rent periods or that allow tenants to go dark or terminate for any reason (other than pursuant to the casualty and condemnation provisions) can negatively impact loan underwriting.

Also, it often is preferable that leases have staggered expiration dates. If most of the leases expire about the same time, lenders will be concerned about the vacancy/re-tenanting risk and cost (if the leases expire during the loan term), or the refinancing risk (if the leases expire near the loan maturity date). To mitigate these risks, lenders may: 1) value the property at a lower amount; 2) reduce the loan term such that the loan matures prior to the expiration of the leases; 3) require a holdback of loan proceeds and/or the monthly funding of a tenant improvements/rollover reserve to pay for the future re-tenancy costs; 4) require additional collateral such as a letter of credit or guaranty; and/or 5) require, for a certain period prior to the expiration of the lease(s), that all excess cash flow be swept into a lender account.

Assignment and Subletting

Since lenders take into account the identities and financial strength of the tenants, leases should include restrictions on assignment and subletting, including those relating to the financial strength of the assignee (and to a lesser extent the subtenant), and provisions to assure that the initial tenant and any guarantor remains liable in the event of any assignment or sublease.

Subordination and Attornment

From a lender's perspective, a lease should provide that: 1) it is automatically subordinate to any loan document currently encumbering the property or subsequently entered into (unless the lender elects otherwise); and 2) the tenant will automatically attorn to a lender that acquires the property either by foreclosure or deed-in-lieu. Having such a provision in a lease may reduce the likelihood that, in connection with a financing, the lender will require a subordination and non-disturbance agreement (an “SNDA”) from the tenant, which is a real advantage given the time such documents often require to negotiate. However, most sophisticated tenants with leverage will require that non-disturbance be a condition to such subordination and attornment. In such event, the subordination should be conditioned upon the tenant and lender entering into an SNDA in a commercially reasonable form typically used by the lender. If the use of the lender's form is not satisfactory to the tenant, compromise approaches include reference to a mutually satisfactory commercially reasonable form (which puts off negotiations and potential disputes to another day) or attaching a form to the lease that is negotiated to reflect the landlord's best guess as to its future lender's requirements (which has the disadvantage of prolonging negotiations without providing any real comfort that the form will be acceptable to a future lender). Many national tenants have their own form of SNDA that they will not negotiate with the landlord; if so, the only alternative may be to agree to use the tenant's form and hope that the tenant will negotiate with the lender at a later time.

Rights of First Offer/Refusal and Purchase Options

If rights of first offer/refusal or other purchase options need to be granted, then such rights should be subordinate to the rights of any current and future lender. Such subordination may protect a lender from the potential risk of having its lien on the property wiped out upon the exercise of such rights. From a lender's perspective, try to get this subordination to be absolute (i.e., tenant's right of first offer/refusal or other purchase option will be wiped out by any foreclosure or deed in lieu). If not, a good compromise is to provide that the right will not affect any foreclosure or deed-in-lieu or the first sale of such property after foreclosure or deed-in-lieu, but will thereafter spring back into effect. It is best to get these lender protections in the lease at the time such rights are granted, as it can be very difficult and costly to get these protections from the tenant at a later time.

Lease Approval Rights

In connection with every leasing transaction, the existing loan documents should be reviewed: 1) to ascertain whether the lender's consent to such transaction is required; and 2) if such consent is required, to understand the process of obtaining the lender's consent. Failure to comply with the leasing approval requirements could cause the owner to be in default under the loan documents.

Insurance, Casualty and Condemnation Provisions

The insurance requirements in leases should be made consistent with the landlord's insurance obligations under the existing loan documents. Also, the landlord's obligations under the leases to repair and restore the premises and for holding and disbursing insurance proceeds/condemnation awards should be consistent with the casualty/condemnation provisions in the existing loan documents. If the tenant is responsible for maintaining insurance for the real property and improvements, the landlord should require that its lender be named as an additional insured, as lenders will typically require this.

Loan Document Provisions That Affect Leasing

Lease Approval

Most loan documents provide that the borrower may not enter into certain leases without the consent of the lender. Such consent rights should normally apply only to retail, office, industrial and other commercial leases, and not to any residential lease, storage lease or any occupancy by a hotel guest.

The lender's consent is typically required for “Major Leases,” which are usually defined as leases that exceed a certain size threshold (e.g., any lease for more than 10,000 square feet) or term (e.g., more than five years). The definition of Major Lease should be narrowly defined, so that it will apply to as few leases as possible. In doing this, your client's future leasing plans for the property should be taken into account.

As to any lease that is not a Major Lease (a “Minor Lease”), the lender's consent is frequently required only if such lease does not provide for market rents and terms or is not on the borrower's standard lease form approved by the lender. Since leases are rarely in the exact form of the standard lease, the lender's consent to a Minor Lease should only be required if the terms of the lease materially and adversely deviate from such form. It is preferable (but frequently not possible) to define in the loan documents specifically what deviations are material and adverse (e.g., changes to the subordination provisions, granting of termination rights in favor of tenants not set forth in the form, granting of rights of first offer/refusal or options to purchase in favor of the tenant, changes to specified mortgagee protection provisions (like notice and cure provisions) and other specified provisions of critical importance to a lender).

Loan documents typically contain provisions that the borrower will not approve any assignment or subletting as to certain leases without the approval of the lender. If so: 1) such provisions should generally be limited to Major Leases; and 2) any existing lease that requires the lender's consent that includes a deemed approval provision of the landlord should be adequately dealt with in the loan documents to make sure that the landlord will not have to give its consent prior to the time in which the lender's consent is due. Deemed approval provisions in future leases should be negotiated only if the provisions can be reconciled with the loan documents. Also, make sure that the lender's approval is not required for any renewal, extension, termination, assignment or subletting of any lease pursuant to the express terms of any existing lease or any lease subsequently approved by lender.

If consent is required and if the borrower has sufficient bargaining power, the loan documents should: 1) provide that such consent may not be unreasonably withheld, conditioned or delayed, and; 2) provide for deemed approval of lender after a specified time period.

Finally, the loan documents may contain a provision that limits the borrower's remedy if the lender improperly withholds its consent so that in such case the lender will merely be required to give its consent. However, this can be a real problem for the owner, since it is likely that the owner will have lost the particular tenant by the time that it is determined that the lender's consent was improperly withheld.

Advance Rent

Loan documents typically include a covenant that the borrower will not accept rent more than one month in advance. Any lease that allows a tenant to pay rent on a periodic basis other than monthly ' and any security deposits ' should be excluded from this covenant. Such covenant should also be revised to provide, on a going forward basis, more flexibility for additional rent (such as operating cost pass throughs and percentage rent). Also, if the property is being used for self-storage, this covenant should be deleted or qualified, as storage tenants are typically required to pay rent more than one month in advance.

Representations and Warranties

It is important to review carefully the representations and warranties relating to the leases and to make sure that there are no exceptions that need to be taken.

Tenant Estoppels

If the borrower is required to deliver tenant estoppels upon request, then such obligation should be limited to borrower using “its commercially reasonable efforts” to obtain and deliver such estoppels in the form required by the lender. Any provision requiring that the estoppels be delivered within a specific time period after request should be made consistent with the time frame required for such delivery under the leases.

Transfer Restrictions

Loan documents typically contain broad transfer restrictions that prohibit the owner from selling, encumbering or transferring the property (or any part) without the lender's consent. These transfer restrictions should not apply to any leasing transaction entered into in accordance with the requirements of the loan documents and the exercise of any existing rights of first offer/refusal or purchase option. If a tenant has the right to purchase only a portion of the property, then you will need to negotiate a partial release provision in the loan documents.

Prepayment

If the loan documents include a prepayment lockout period, then such lockout period should not apply to the exercise by a tenant of any rights of first offer/refusal or other purchase option (if applicable). If a tenant has the right to purchase only a portion of the property, then the borrower will need the right to make partial prepayments.

Insurance Provisions

If the tenant is responsible for maintaining the insurance for the real property and improvements (usually in the case of single tenant properties or in ground leases), make sure that the insurance requirements in the loan documents are consistent with the tenant's insurance obligations under the lease.

Conclusion

This article highlights some (but certainly not all) of the leasing and loan issues that should be taken into account when negotiating leasing documents and loan documents, respectively. It is important to understand and take into account: 1) for lease transactions, the leasing approval requirements under existing loan documents and the interests of lender (existing and future), or; 2) for loan transactions, the obligations of the landlord under the existing leases, the rights of tenants under such leases and your client's future leasing goals for the property.

Steven L. Rosenfeld was an associate at Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago.

Lease documents are often negotiated without sufficiently considering: 1) the effect that certain lease provisions may have on future financings; and/or 2) the lease approval requirements in existing loan documents. Also, loan documents are often negotiated without sufficiently considering how some of the loan provisions will affect the owner's future leasing activities. These problems can be exacerbated when different attorneys (and potentially different business people) are responsible for negotiating the leasing documents and the loan documents without sufficient coordination. This article seeks to address how lawyers representing owners in negotiating leases and/or loan documents can help bridge these gaps.

Financing Considerations in Leasing Transactions

Underwriting

Loan underwriting for income producing properties usually takes into account the occupancy rate, the lease terms and the existing and anticipated cash flow from the property. Therefore, leases that provide for below market rents or free/abated rent periods or that allow tenants to go dark or terminate for any reason (other than pursuant to the casualty and condemnation provisions) can negatively impact loan underwriting.

Also, it often is preferable that leases have staggered expiration dates. If most of the leases expire about the same time, lenders will be concerned about the vacancy/re-tenanting risk and cost (if the leases expire during the loan term), or the refinancing risk (if the leases expire near the loan maturity date). To mitigate these risks, lenders may: 1) value the property at a lower amount; 2) reduce the loan term such that the loan matures prior to the expiration of the leases; 3) require a holdback of loan proceeds and/or the monthly funding of a tenant improvements/rollover reserve to pay for the future re-tenancy costs; 4) require additional collateral such as a letter of credit or guaranty; and/or 5) require, for a certain period prior to the expiration of the lease(s), that all excess cash flow be swept into a lender account.

Assignment and Subletting

Since lenders take into account the identities and financial strength of the tenants, leases should include restrictions on assignment and subletting, including those relating to the financial strength of the assignee (and to a lesser extent the subtenant), and provisions to assure that the initial tenant and any guarantor remains liable in the event of any assignment or sublease.

Subordination and Attornment

From a lender's perspective, a lease should provide that: 1) it is automatically subordinate to any loan document currently encumbering the property or subsequently entered into (unless the lender elects otherwise); and 2) the tenant will automatically attorn to a lender that acquires the property either by foreclosure or deed-in-lieu. Having such a provision in a lease may reduce the likelihood that, in connection with a financing, the lender will require a subordination and non-disturbance agreement (an “SNDA”) from the tenant, which is a real advantage given the time such documents often require to negotiate. However, most sophisticated tenants with leverage will require that non-disturbance be a condition to such subordination and attornment. In such event, the subordination should be conditioned upon the tenant and lender entering into an SNDA in a commercially reasonable form typically used by the lender. If the use of the lender's form is not satisfactory to the tenant, compromise approaches include reference to a mutually satisfactory commercially reasonable form (which puts off negotiations and potential disputes to another day) or attaching a form to the lease that is negotiated to reflect the landlord's best guess as to its future lender's requirements (which has the disadvantage of prolonging negotiations without providing any real comfort that the form will be acceptable to a future lender). Many national tenants have their own form of SNDA that they will not negotiate with the landlord; if so, the only alternative may be to agree to use the tenant's form and hope that the tenant will negotiate with the lender at a later time.

Rights of First Offer/Refusal and Purchase Options

If rights of first offer/refusal or other purchase options need to be granted, then such rights should be subordinate to the rights of any current and future lender. Such subordination may protect a lender from the potential risk of having its lien on the property wiped out upon the exercise of such rights. From a lender's perspective, try to get this subordination to be absolute (i.e., tenant's right of first offer/refusal or other purchase option will be wiped out by any foreclosure or deed in lieu). If not, a good compromise is to provide that the right will not affect any foreclosure or deed-in-lieu or the first sale of such property after foreclosure or deed-in-lieu, but will thereafter spring back into effect. It is best to get these lender protections in the lease at the time such rights are granted, as it can be very difficult and costly to get these protections from the tenant at a later time.

Lease Approval Rights

In connection with every leasing transaction, the existing loan documents should be reviewed: 1) to ascertain whether the lender's consent to such transaction is required; and 2) if such consent is required, to understand the process of obtaining the lender's consent. Failure to comply with the leasing approval requirements could cause the owner to be in default under the loan documents.

Insurance, Casualty and Condemnation Provisions

The insurance requirements in leases should be made consistent with the landlord's insurance obligations under the existing loan documents. Also, the landlord's obligations under the leases to repair and restore the premises and for holding and disbursing insurance proceeds/condemnation awards should be consistent with the casualty/condemnation provisions in the existing loan documents. If the tenant is responsible for maintaining insurance for the real property and improvements, the landlord should require that its lender be named as an additional insured, as lenders will typically require this.

Loan Document Provisions That Affect Leasing

Lease Approval

Most loan documents provide that the borrower may not enter into certain leases without the consent of the lender. Such consent rights should normally apply only to retail, office, industrial and other commercial leases, and not to any residential lease, storage lease or any occupancy by a hotel guest.

The lender's consent is typically required for “Major Leases,” which are usually defined as leases that exceed a certain size threshold (e.g., any lease for more than 10,000 square feet) or term (e.g., more than five years). The definition of Major Lease should be narrowly defined, so that it will apply to as few leases as possible. In doing this, your client's future leasing plans for the property should be taken into account.

As to any lease that is not a Major Lease (a “Minor Lease”), the lender's consent is frequently required only if such lease does not provide for market rents and terms or is not on the borrower's standard lease form approved by the lender. Since leases are rarely in the exact form of the standard lease, the lender's consent to a Minor Lease should only be required if the terms of the lease materially and adversely deviate from such form. It is preferable (but frequently not possible) to define in the loan documents specifically what deviations are material and adverse (e.g., changes to the subordination provisions, granting of termination rights in favor of tenants not set forth in the form, granting of rights of first offer/refusal or options to purchase in favor of the tenant, changes to specified mortgagee protection provisions (like notice and cure provisions) and other specified provisions of critical importance to a lender).

Loan documents typically contain provisions that the borrower will not approve any assignment or subletting as to certain leases without the approval of the lender. If so: 1) such provisions should generally be limited to Major Leases; and 2) any existing lease that requires the lender's consent that includes a deemed approval provision of the landlord should be adequately dealt with in the loan documents to make sure that the landlord will not have to give its consent prior to the time in which the lender's consent is due. Deemed approval provisions in future leases should be negotiated only if the provisions can be reconciled with the loan documents. Also, make sure that the lender's approval is not required for any renewal, extension, termination, assignment or subletting of any lease pursuant to the express terms of any existing lease or any lease subsequently approved by lender.

If consent is required and if the borrower has sufficient bargaining power, the loan documents should: 1) provide that such consent may not be unreasonably withheld, conditioned or delayed, and; 2) provide for deemed approval of lender after a specified time period.

Finally, the loan documents may contain a provision that limits the borrower's remedy if the lender improperly withholds its consent so that in such case the lender will merely be required to give its consent. However, this can be a real problem for the owner, since it is likely that the owner will have lost the particular tenant by the time that it is determined that the lender's consent was improperly withheld.

Advance Rent

Loan documents typically include a covenant that the borrower will not accept rent more than one month in advance. Any lease that allows a tenant to pay rent on a periodic basis other than monthly ' and any security deposits ' should be excluded from this covenant. Such covenant should also be revised to provide, on a going forward basis, more flexibility for additional rent (such as operating cost pass throughs and percentage rent). Also, if the property is being used for self-storage, this covenant should be deleted or qualified, as storage tenants are typically required to pay rent more than one month in advance.

Representations and Warranties

It is important to review carefully the representations and warranties relating to the leases and to make sure that there are no exceptions that need to be taken.

Tenant Estoppels

If the borrower is required to deliver tenant estoppels upon request, then such obligation should be limited to borrower using “its commercially reasonable efforts” to obtain and deliver such estoppels in the form required by the lender. Any provision requiring that the estoppels be delivered within a specific time period after request should be made consistent with the time frame required for such delivery under the leases.

Transfer Restrictions

Loan documents typically contain broad transfer restrictions that prohibit the owner from selling, encumbering or transferring the property (or any part) without the lender's consent. These transfer restrictions should not apply to any leasing transaction entered into in accordance with the requirements of the loan documents and the exercise of any existing rights of first offer/refusal or purchase option. If a tenant has the right to purchase only a portion of the property, then you will need to negotiate a partial release provision in the loan documents.

Prepayment

If the loan documents include a prepayment lockout period, then such lockout period should not apply to the exercise by a tenant of any rights of first offer/refusal or other purchase option (if applicable). If a tenant has the right to purchase only a portion of the property, then the borrower will need the right to make partial prepayments.

Insurance Provisions

If the tenant is responsible for maintaining the insurance for the real property and improvements (usually in the case of single tenant properties or in ground leases), make sure that the insurance requirements in the loan documents are consistent with the tenant's insurance obligations under the lease.

Conclusion

This article highlights some (but certainly not all) of the leasing and loan issues that should be taken into account when negotiating leasing documents and loan documents, respectively. It is important to understand and take into account: 1) for lease transactions, the leasing approval requirements under existing loan documents and the interests of lender (existing and future), or; 2) for loan transactions, the obligations of the landlord under the existing leases, the rights of tenants under such leases and your client's future leasing goals for the property.

Steven L. Rosenfeld was an associate at Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago.