As evidenced by the rise in vacancy rates across Ontario, it is no secret that the current economic environment has had its effect on the province’s commercial leasing industry, and this is most likely the situation in other areas as well.

During these times, landlords spend a great deal of energy determining how to best protect themselves from financially unstable tenants. While this is a valid concern for landlords, tenants should be equally concerned about landlords who may be encountering their own financial problems.

Although most landlords conduct extensive due diligence on a potential tenant before entering into a lease, the same cannot typically be said of tenants. Many tenants know little about their landlords. This article is intended to highlight some of the key ways in which a tenant can better protect itself from a landlord who may encounter financial problems.

Know Your Landlord

The first step a tenant can take to protect itself is to increase the level of due diligence it carries out on a landlord at the offer stage.

A tenant should not assume that all landlords are financially sound. This is even more important in the case of a subtenancy where a sublandlord is trying to divest itself of excess space, often an indicator that the sublandlord is struggling financially.

A tenant should be particularly concerned about a landlord’s financial strength in situations where the landlord is required to pay the tenant an inducement allowance or if the landlord has significant construction, maintenance or repair obligations, especially when the landlord is an individual or not a well-known institution or public company.

Some of the ways in which a tenant can get comfort as to the landlord’s financial position are by requesting a review of the landlord’s financial statements, conducting a credit search or requesting a bank reference as a condition precedent to the offer. Where a landlord is obtaining financing to complete the construction of a property, the tenant may also request a copy of the landlord’s mortgage commitment with its bank.

Obviously, for some of the major landlords this request may not be accommodated and is likely unnecessary.

Subsearch of Title

One of the most important due diligence items for the tenant is to conduct a subsearch of title to the property before entering into a binding agreement. This can be carried out by the tenant’s lawyer by reviewing the public registry records.

The tenant’s lawyer should review the records to confirm that the landlord actually owns the property in which it is purporting to grant a lease. The tenant’s lawyer should also determine if there are prior interests such as mortgages, ground leases or easements to which the lease will be subject.

If there are prior interests registered on title, these interests will have priority over the lease unless the tenant makes other arrangements with those prior interest holders. If the prior registered interest is a mortgage and the landlord defaults under the mortgage, the common law is well established that a prior lender is not bound by the lease and can force a tenant out of the premises by terminating the lease.

The common law has also established that a tenant under a lease that is subordinate to a mortgage is likewise not bound by the lease if the mortgagee takes possession and, accordingly, the tenant may vacate the premises rather than recognize the mortgagee as its landlord. In tough times, a tenant may actually benefit from being able to terminate the lease if a mortgagee goes into possession.

Non-Disturbance Agreement

While there may be circumstances in which it would be beneficial for a tenant or a mortgagee to terminate the lease upon a mortgagee taking possession of the premises, generally mortgagees and tenants prefer to have the security of knowing that the lease will be preserved in the event that the mortgagee takes possession. A Non-Disturbance Agreement (“NDA”) is the tool used to preserve the lease, as it alters the rights of termination provided by common law.

Once a subsearch discloses a prior mortgage, the prudent tenant should try to obtain an NDA from any existing mortgagee simultaneously with negotiating the lease or as soon as possible after the lease has been executed. While most NDAs will provide the tenant with the basic protection needed in the event of a mortgagee going into possession, the tenant should carefully review the form of NDA as there are several significant issues to consider when negotiating the document. For instance, most NDAs simply provide that the mortgagee will not disturb the tenant’s possession so long as the tenant is not in default. However, a tenant should try to make the mortgagee go one step further and covenant to be bound by the terms and conditions of the lease while in possession. Without such an obligation, tenants may find themselves unable to enforce important rights for which they have bargained.

In most cases, a mortgagee will not agree to be bound by the rental account that exists between the landlord and tenant. For example, many mortgagees will refuse to be bound by any prepayments of rent, security deposits or other sums that may be payable by the landlord to the tenant, so that the mortgagee does not find itself out-of-pocket for these items. Tenants are also often required to waive any rights of set-off, defences or claims that they may assert against the landlord.

Notice of Lease

A tenant should also protect its leasehold interest against subsequent mortgages by registering its lease or notice of it on title with the local land registry office. The notice alerts the public that the property is leased and sets out the names of the parties, a description of the premises and the term of the lease, including any options to renew.

Some Final Words

Although it has typically been the landlord who evaluates the financial strength of a tenant before leasing space, especially during difficult economic times, a tenant should spend the necessary time evaluating the financial position of the landlord before entering into a lease. A tenant should no longer assume that as long as it pays its rent, the landlord will abide by all of its obligations under the lease. The reality is that a tenant may find itself out on the street as a result of the financial difficulties of its landlord. A tenant should make every effort to conduct the appropriate due diligence on both the landlord and the property prior to entering into a lease. In addition, registering a notice of lease and obtaining an NDA will help protect a tenant should a landlord default on its mortgage and a mortgagee is entitled to go into possession.