Tenants’ limited recourse to their landlords has made “offset rights” a major issue in negotiating Subordination, Non-Disturbance and Attornment Agreements (SNDAs).

Tenant offset rights arise when the tenant has the right to deduct from its future rent obligations money the landlord owes the tenant. Tenant offset rights arise two ways. When the landlord fails to pay money it owes the tenant, such as a tenant improvement reimbursement, the tenant may be given an express offset right. If the landlord fails to perform other obligations under the lease, such as maintaining the parking lot, and the tenant performs that obligation at its own expense, the tenant may also be given an express offset right.

SNDAs create a direct contractual relationship between the lender and the tenants of the property that secures a commercial mortgage loan. Both lenders and tenants commonly require SNDAs to spell out their respective rights and responsibilities in the event of a foreclosure.

SNDAs contain three core elements: (i) the subordination of the lease to the Deed of Trust, (ii) an agreement by the lender not to disturb the tenant’s occupancy of the property after a foreclosure, provided the tenant is not in default under its lease, and (iii) an agreement by the tenant to accept, or “attorn” to, the lender or another purchaser at a foreclosure sale as its new landlord under the lease.

In addition to the three core elements, SNDAs also contain many provisions which lenders have traditionally required as a condition to granting non-disturbance rights to tenants. For purposes of this discussion, three common lender requirements are:

  1. The right to receive notices from the tenant of defaults by the landlord under the lease and an opportunity to cure those defaults;

  2. Limitations on the lender’s liability for acts of the former landlord in the event of foreclosure. Lenders feel strongly that they should not be a guarantor of the former landlord’s obligations and should only be responsible for their own acts after foreclosure; and

  3. As a corollary to the second requirement, a requirement that the lender will not be subject to any offsets or defenses which the tenant might have against a prior landlord under the lease.

Tenant offset rights have grown in importance because landlords are generally single purpose, single asset entities. In addition, many leases limit the landlord’s liability to its interest in the property. Once the Deed of Trust is foreclosed, the landlord has no interest in the property and may have no other assets. As a result, after a foreclosure, the tenant may have no viable claim against a former landlord for its violation of the lease.

Tenants are negotiating express offset rights in their leases to secure repayment, even after foreclosure, of amounts that landlords owe them. Tenants have begun to demand offset rights not only for significant monetary obligations, such as paying a tenant improvement allowance, but for all landlord defaults that may result in the tenant having to perform the landlord’s obligations. Landlords, recognizing that in the worst case scenario they can hand the property over to the lender, may agree to give such broad, express offset rights to the tenant.

To protect their offset rights, tenants want the SNDA to provide that if the lender was given notice of the default that gave rise to the offset right and the lender failed to cure the default, then the lender will be subject to the tenant’s offset rights after foreclosure. The rental income the lender expected to receive from the property could be significantly reduced as a result of tenant offset rights that survive foreclosure. The lender’s response is that it should not, by exercising remedies, become in effect a guarantor of the former landlord’s obligations. While this has been a compelling argument in the past, bargaining power has shifted considerably in recent years in favor of tenants.

If a condition at the property existed at the date of foreclosure and violates the lease, lenders generally acknowledge their obligation to correct the condition. Lenders would generally exclude from these “continuing defaults” the failure of the former landlord to pay the tenant money it owed under the terms of the lease. The lender’s point is that it should only be responsible for curing continuing defaults that affect the property, not all of the prior landlord’s defaults.

Some tenants may not be satisfied with a provision that only deals with continuing defaults and may push the lender to accept all of their offset rights.  The landlord may be willing to provide security for major identified obligations, such as the payment of a tenant improvement allowance, which may satisfy these tenants.  Landlords almost never provide guarantees for all of their obligations under the lease, however. The lender may then be left with the choice of accepting the remaining offset rights, perhaps with a negotiated limit on the percentage of the monthly base rent that would be subject to offset, or losing a valuable tenant.

Lenders can put provisions in their loan documents to help protect themselves from the possibility of having to accept broad tenant offset rights in SNDAs.

Loan documents can contain covenants that the borrower will perform all of its obligations under each lease and not take any action, or omit to take any action, which would result in any tenant having any offset right. The lender can also have the borrower agree that the lender will have the option of curing any lease default by the borrower and that all sums expended by the lender in curing such defaults will bear interest and be secured by the loan documents.

Beyond the borrower’s covenants, which may be hollow in a worst case scenario, lenders can require that guarantors agree to indemnify the lender against any losses arising out of the exercise of offset rights by a tenant. The guarantor’s indemnity obligations would need to survive the enforcement of the Deed of Trust. The existence of a tenant offset right that survives foreclosure may also be an appropriate trigger for liability under non-recourse carve out guarantees, at least to the extent of the loss incurred by the lender.

While these covenants may well be encompassed by existing provisions in loan documents, making them more explicit may make the borrower, as landlord, more conservative in granting broad offset rights to tenants.