It is often the case that parties enter into a lease thinking it is a temporary use of space by the tenant, which frequently amounts to nothing more than an expense line item on the budget. However, if a lease is structured properly, the tenant’s interest under a lease can be pledged to a lender as collateral for a loan, making this especially appealing where the tenant plans on remaining in the building for a long period of time.
Assuming the economics of the lease make the tenant’s interest valuable, the following lease provisions should be carefully considered from a legal perspective. Such provisions, when structured properly, can positively impact the tenant’s ability to obtain financing, therefore leveraging operating cash:
- Use Provisions: The lease restriction on use of the property should be broad enough so that, on foreclosure of a leasehold mortgage, a successor tenant will be able to use the premises for any lawful purpose.
- Term: The lease term should be long enough to extend past the loan’s maturity date, plus an adequate period of time in the event of default, to allow the lender to foreclose and sell the leasehold interest. Although ground leases frequently run for 30- or 50-year terms, leases as short as 15 years, with options to extend in certain circumstances, can be sufficient.
- Assignment Provisions: The lease should not prohibit the tenant from encumbering or hypothecating his interest in the lease. The assignment provision should also be nonrestrictive or have limited restrictions so as to make the tenant’s interest in the lease more marketable in the event a lender has foreclosed and is attempting to sell it.
- Leasehold Mortgage Protective Clauses: The lease should contain certain minimal protective provisions in favor of the lender, including:
- an agreement by the lessor that, except for termination on default, there shall be no termination or material modification of the lease without the lender’s prior written consent;
- the lessor should be obligated to give the lender simultaneous copies of all notices provided to the tenant and, unless the lessor complies with such notice requirement, any modifications to the lease or actions by the lessor should not bind the lender or impair the lender’s position;
- the lender should have the right to perform any covenant or obligation of the tenant included in the lease, and to remedy any default by the tenant. The lessor should be obligated to accept performance by the lender with the same effect as if made by the tenant;
- if the tenant defaults, the lender should have additional time, after receipt of the lessor’s written notice of that default, within which to cure it, and the lessor must be obligated to accept that cure. If the default cannot be cured by the payment of money (i.e., only the performance of an act will cure the default, such as repairing a roof), then the lender should not be obligated to cure the default until it has possession of the premises. If the default cannot be cured by the lender (i.e., the tenant’s bankruptcy), then such a default should be deemed waived as to the lender;
- if the lender has acquired the tenant’s interest in the lease, it should only be liable to the lessor for liability of the tenant during the period of time when the lender owns the leasehold estate. Thus, if the lender assigns the lease to a third party following a foreclosure of the leasehold mortgage, the lender should be relieved of all further liability under the lease;
- the lease should be fully assignable by the lender following a foreclosure of the leasehold mortgage, without any requirement for the lessor’s consent, and any purchaser at such a foreclosure should be able to acquire the leasehold estate without the lessor’s consent; and
- the lease should provide that in the event the lease is terminated under any default provision, or is disaffirmed during the tenant’s bankruptcy, then within 30 days after termination the lender should be entitled to enter into a new lease with the lessor on the same terms and conditions as the terminated lease for the unexpired term. The new lease should be fully assignable by the lender to affiliates and third parties and should provide that on any such assignment, the lender is relieved of all further liability.
- Damage and Destruction Clauses: The lease should provide that the lessor will make available all insurance proceeds for the reconstruction of the improvements following a casualty and, if the lessor fails to do so, the lessor should not be entitled to those proceeds until the lender has been paid in full.
- Condemnation: Unlike typical lease terms, the condemnation provisions should require that, on a partial taking of the property, either the proceeds must be made available for reconstruction of the improvements taken, or, if reconstruction is not economically feasible, the proceeds should be paid first to the lender, with any residual going to the lessor and the tenant. On a total taking, the provisions should benefit the tenant to that portion of the lessor’s award equal to the “bonus value” of the tenant’s leasehold interest, as well as the entire amount of the award attributable to the improvements on the real property owned by the tenant.
- Recordation: Either the lease or a memorandum of the lease should be recordable. A memorandum is preferable so all of the terms of the lease are not available to the public.
- Subordination: The lease should be superior to all existing or future mortgages or deeds of trust entered into by the lessor affecting the real property or the lessor’s interest in it. (If this is not the case, then, on default by the lessor under any mortgage or deed of trust against the real property, the lease could be terminated and the tenant’s lender on the leasehold interest would lose its collateral.)
The provisions discussed above are merely suggested as a general checklist for these types of transactions. Clearly, each transaction is different and needs to be viewed in light of the particular facts and circumstances of that transaction and should always be fully discussed with legal counsel.