Over the next two years, billions of dollars in commercial real estate loans are expected to mature — loans that many property owners and landlords will not be able to pay off or refinance. As a result, a number of landlords that have purchased, built, renovated and/or refinanced their properties with short-term debt during the previous five years will find themselves in a precarious position. Market forces, combined with the tightening of credit markets, leave landlords holding over-leveraged property, unable to refinance their shortterm debt because of a lack of equity. In addition, these same landlords are finding it difficult to sell their properties for prices that would allow them to pay off their existing loans. Faced with the dilemma of not being able to refinance or sell, landlord bankruptcies and property foreclosures will be prevalent in the next few years. Tenants need to take certain precautions to protect themselves and be aware of their rights when landlords file for bankruptcy or lenders foreclose.
The SNDA — Tenant Protection in Landlord Foreclosure
A subordination, non-disturbance and attornment agreement (“SNDA”) provides significant protection for tenants in situations where their landlord is facing the threat of foreclosure. An SNDA is an agreement between a tenant and the landlord’s lender, where the lender agrees to recognize the tenant’s lease after a foreclosure, in exchange for the tenant's promise to (i) subordinate the lease to the lender’s rights under its mortgage or deed of trust, and (ii) to recognize the lender as the new landlord under the lease.
Tenants should conduct a quick investigation of their lease file to determine whether or not they have an SNDA from their landlord’s current lender. If the tenant has an SNDA, it should ensure that the SNDA is from the landlord’s current lender and covers all modifications to the landlord’s loan. If the tenant does not have an SNDA from the current lender, they should check their lease to see if it requires the landlord to provide an SNDA. If so, and a current SNDA is not in place, tenants should immediately pursue this instrument. If not, the tenant should evaluate whether such an instrument is needed.
Whether the tenant ultimately needs an SNDA depends on the leased premises in question and the economic terms of the lease. High value locations — sites with long term leases and premises with large investments of tenant capital should be at the top of the priority list for getting an SNDA. Locations of lesser value, either by revenue or investment, may not be a priority, and tenants should determine whether trying to obtain an SNDA is worth the cost.
Tenants need to beware that, regardless of how favorable their lease terms are, if a lease is subordinate to the landlord’s financing and the tenant does not have an SNDA, that lease may be terminated by the landlord’s lender in a foreclosure. In fact, tenants enjoying favorable and below market rents are just as much at risk as tenants lacking financial stability, as a lender may view both of these tenants as a detriment in a shopping center. Of course, in a troubled economy, a lender is not as likely to terminate the lease of a paying tenant; however, the lender may opt to terminate the lease with the intention of signing a new lease with the same tenant, on terms that are more favorable to the lender. It is critical that tenants avoid ceding this leverage to a lender, and that they maintain as much control and protection as possible.
At the outset of lease negotiations, if the landlord has an existing lender, the tenant should make the landlord’s obligation to secure an SNDA from its lender a condition to the tenant’s obligations under the lease. Tenants who are able to get an SNDA should ensure that the SNDA is delivered for execution at the time that the lease is signed. In addition, if a tenant is negotiating a lease with a landlord who does not currently have a lender, it is still prudent to include in the lease a requirement that the landlord obtain an SNDA from any future lender.
Tenants who already have SNDAs need to be aware of the scope of protection that their SNDA offers, as lenders tend to include various carve-outs that limit the lender’s obligations to a tenant. In this challenging environment, many tenants have renegotiated their leases to provide more favorable terms. Often times, SNDAs will provide that lease amendments or modifications that have been executed without the lender’s consent will not be recognized by the lender if it steps into the shoes of a landlord. Therefore, as a practical matter, tenants who are renegotiating their leases need to make sure that the landlord’s lender has consented to any lease amendment or modification. A lender may also have the right to avoid liability for the landlord’s prior defaults, unless it receives notice and an opportunity to cure such defaults. As landlords encounter financial difficulties and breach their maintenance or repair obligations, tenants with SNDAs need to be careful to copy the landlord’s lender with any notices of default.
Another SNDA pitfall relates to a carve-out where lenders attempt to shield themselves from any tenant offset rights in a lease. Tenants that have negotiated rent offset rights in their leases should not be prevented or restricted by their SNDA from exercising these valuable rights. In the specific case where the lease allows the tenant to offset against the rent any portion of the tenant improvement allowance that the landlord has failed to pay, the tenant needs to ensure that the SNDA explicitly describes this offset right, and obligates the lender to recognize it.
Finally, the prevalence of bank closures in the current economic environment could present a unique problem for tenants with SNDAs. When the FDIC acts as a receiver for a failed bank, it conducts a review of all of the bank’s outstanding contracts and obligations, including SNDAs. In its role as receiver, the FDIC has the power to repudiate contracts that it deems burdensome and where such repudiation would promote the orderly administration of the receivership estate. If the FDIC determined that an SNDA created burdensome obligations for a bank in receivership, the FDIC might opt to repudiate the SNDA. For high value retail sites, keeping tabs on the stability of a landlord’s lender presents a new twist to what, in the past, was an afterthought.
Protecting the Tenant’s Improvement Allowance
A tenant improvement allowance is a significant monetary concession that should be protected in the case of a landlord bankruptcy. Although Section 365(h)(1)(B) of the Bankruptcy Code may provide a tenant the right to offset unpaid tenant improvement allowance funds against rent, it would be prudent to include express language in the lease providing the tenant with such offset rights in the event of a landlord bankruptcy. In addition, tenants may consider (i) requiring a letter of credit from their landlord, or (ii) structuring the tenant's incentive as free rent (as opposed to a lump sum payment).
Protecting the Tenant’s Security Deposit
The same general principles and Bankruptcy Code provisions discussed above apply to security deposits. In the current economic climate, there may also be some advantages for tenants whose security deposits are held in the form of a letter of credit by their landlords. The letter of credit has traditionally been seen as more landlord-friendly because the landlord can continue to draw against it in the event of a tenant bankruptcy. The advantage of a letter of credit security deposit to the tenant is that, in the event of a landlord bankruptcy, the letter of credit is not part of the landlord’s bankruptcy estate that is subject to the claims of other creditors, whereas a cash security deposit would become part of such estate, with the tenant retaining only an unsecured claim against such estate. Additional measures that tenants might consider to protect security deposits include having the security deposit held in escrow by a third-party, or presenting the landlord with the option of no security deposit as opposed to the tenant accepting a month or two of free rent concession from the landlord. Tenants in good financial standing may also consider requesting that the landlord waive the security deposit altogether based on a review of the tenant’s financials prior to lease execution.
Tenant Due Diligence Considerations
Whether a tenant is negotiating a new lease or is operating under its current lease, it can take certain due diligence steps to help protect it from a landlord that is facing the threat of bankruptcy or foreclosure. Tenants that are about to sign a new lease, a lease renewal, or a lease amendment need to investigate the landlord’s financial health to determine whether the leased premises are subject to any existing mortgages or deeds of trust. Tenants can request that the landlord provide them with copies of any existing financing documents for review, and should strongly consider engaging a title insurance company to perform a title search to identify existing mortgages or deeds of trust.
In addition, tenants should obtain strong selfhelp and access rights with respect to their premises in the event that the landlord is unable to perform its basic common area maintenance obligations, or if portions of a larger shopping center are broken up into small parcels in a foreclosure sale.
Tenants under existing leases can also attempt to take certain measures to protect themselves from landlords facing financial distress. If the tenant obtained a title commitment or title policy at the time of lease execution, it can ask the title company to perform a title update and obtain the current recorded mortgage documents. Further, tenants need to review their leases for any landlord termination rights and flag them to revisit when any opportunity arises to renegotiate the lease. If the tenant is exposed in any of these areas of the existing lease, renegotiation of the lease may be worthwhile.
Tenant Protections — Bankruptcy Code Sections 365 and 363
Tenants with landlords facing bankruptcy can look to the federal Bankruptcy Code for guidance. The Bankruptcy Code permits a landlord in Chapter 11 reorganization to either “assume” an unexpired lease (that is, opt to perform its obligations under the lease), or “reject” the lease (that is, opt not to perform its obligations under the lease). In most instances, a landlord’s bankruptcy or reorganization will not disturb an existing lease, as the rents due to the landlord are administered as assets of the estate. Nevertheless, if the landlord, as the debtor-in-possession, elects to reject an unexpired lease, tenants need to be aware of their rights. Despite attempts by certain landlords to use bankruptcy and the threat of lease rejection as an opportunity to renegotiate a lease, a landlord’s bankruptcy and lease rejection do not necessarily obligate a tenant to renegotiate its lease or give up certain lease concessions.
When a landlord elects to reject an unexpired lease, the lease itself is not terminated. Instead, the lease and the tenant’s leasehold estate continue, although the landlord is no longer required to perform its contractual obligations under the lease. This of course can present a number of issues for the tenant, especially in leases where the landlord is obliged to perform maintenance on the property, provide utilities to the tenant’s premises, and/or provide the tenant with certain concessions, such as a tenant improvement allowance for the build-out of the tenant’s space.
Section 365(h) of the Bankruptcy Code deals directly with a tenant’s options in the event of a landlord bankruptcy. Under Section 365(h), if a landlord in Chapter 11 reorganization elects to reject a lease, the tenant has two options. First, if the landlord’s rejection of the lease would constitute a breach of the lease giving the tenant the right to terminate in accordance with applicable state law or pursuant to the terms of the lease, the tenant may elect to treat the lease as terminated and bring a claim for damages resulting from the breach. Second, the tenant may opt to retain its rights under the lease for the remainder of the term and for any renewal or extension of the term. In the case of shopping center leases in particular, tenants who elect to retain their rights under leases retain the benefit of lease provisions dealing expressly with “radius, location, use, exclusivity, or tenant mix/balance.” If a tenant chooses to continue operations in its premises under the existing lease, the tenant may offset against its rent the value of any damage caused by the landlord’s failure to perform its lease obligations after the date of the lease rejection. Thus, if the landlord was obligated under a lease to provide certain services, such as heat, trash removal, and maintenance of common areas, the tenant can perform or contract for the performance of these obligations and receive a credit against rent for the amount that the tenant ultimately spent for such services. This option may be more practical for tenants having their own parcels (as opposed to an in-line location) where they can control and administer maintenance and services. It should be noted, however, that once the tenant has exercised its offset right, it becomes the tenant’s sole remedy, precluding the tenant from making a claim for damages against the bankruptcy estate.
Finally, in a situation where a landlord in bankruptcy is seeking to sell its property “free and clear” of any liens, including leases, tenants need to be aware that they have certain protections under Section 363 of the Bankruptcy Code. Under Section 363(f ) of the Bankruptcy Code, a landlord can wipe out a tenant's lease during a sale only where certain limited conditions are met. Generally, the landlord cannot sell its property in bankruptcy free and clear of all leases unless the tenants are given adequate protection. Tenants that receive a notice from their landlord stating that the landlord is selling its property as a result of bankruptcy should consult with their attorneys to ensure that their lease rights are properly protected under the requirements of the Bankruptcy Code.
During the next few years, the commercial real estate industry could witness an unprecedented number of landlord bankruptcies and foreclosures. A landlord’s financial difficulties, however, should not necessarily result in hardships for its tenants. Provided that tenants know their rights and options and take preventive measures to protect themselves and their investment, they can be more confident that their businesses will weather this storm and remain successful in the years to come.