There is no one-size-fits-all approach to the scope and level of scrutiny a mortgage lender brings to a lease review. Leases are complex commercial arrangements and lenders invariably face trade-offs between the time and expense of a thorough review and understanding the bundle of rights and obligations that make up a key driver of the value of their collateral. A lender’s lease review will look a lot like a purchaser’s, except that instead of stepping into the landlord’s shoes immediately, it must contend with uncertainty about if and when it will ever have to take over the lease and the added complexities of enforcing security.
Key issues in the lease review will fall under three categories:
- Does the borrower have the set of rights and the income stream it is telling you it has in the loan documents?
- Is there anything in the lease that affects the priority of the mortgage or would prevent you from enforcing your security?
- If you do enforce your security, are there any obligations that you don’t want to be on the hook for?
Terms of the Lease
- Together with verifying the rent in the rent roll, the lender will want to understand whether there are any free rent periods or prepaid rent and whether there are any significant exclusions from operating expenses or taxes that form part of the additional rent.
- Counsel should see all of the documents that comprise the lease. Ensuring that the all documents were actually signed, signed by the correct legal entity and that the lease relates to the correct premises and area are preliminary but important items to confirm.
- A lease review can reveal gaps in the expected rental income stream. The term of the lease (particularly where it expires before the mortgage), renewal options, rights to early termination, rights to assign or sublet, go-dark provisions or rights to terminate if an anchor tenant no longer occupies its premises can all impact the value of the lease as collateral.
Security and Enforcement Issues
- After confirming that there is nothing in the lease preventing the assignment by way of security, the lender will want to ensure that there are no restrictions on or consent rights to transfer by the landlord which could affect its ability to enforce its security.
- The lease should include a subordination provision and an attornment provision, each of which may be conditional on a non-disturbance agreement with the tenant.
- Reviewing the landlord’s termination rights will help to assess the flexibility of the lender would have upon enforcement. Conversely, the ability to cure the landlord’s default may help to preserve a lease on favourable terms.
Significant Landlord Obligations
- Where a building is still being constructed, or as an inducement to the tenant, the borrower may have obligations under the lease to pay for construction or improvements or may have extended a free-rent period. The lender must ensure that it understands the cost of these obligations, the tenant’s remedies for late delivery and whether the tenant must participate in the construction or improvement which offset the rental income.
- A lender will only be able to enforce over the property specified in its security. Where a lease provides for relocation rights, or parking rights in neighboring lands, the lender will not be able to meet these obligations if it has not enforced against these rights or property.
- Options to purchase and rights of first refusal for additional space can affect the value of the collateral, particularly because at the time of enforcement, these may not be at the then-applicable market rates.
- Lenders should pay close attention to any vague obligations which cannot be quantified and which a tenant may use as leverage.