In recent years, the New York City real estate market has seen an uptick in the frequency of sale-leaseback transactions. A number of these transactions involve related entities and some lease negotiations are yielding increasingly tenant-friendly provisions. While a tenant-friendly lease is not necessarily unfriendly to the landlord, such leases can create other issues down the road. Both tenants and landlords should be mindful of this and should anticipate that some tenant-friendly provisions will need to be subordinated to a future mortgage or ground lease with respect to the property. In this article, we point out a number (though, by no means all) of the potential pitfalls in negotiating a lease without properly contemplating future subordination of the lease.
To successfully negotiate a lease, the parties involved must recognize their best interests while simultaneously navigating a path through unusual provisions that may raise eyebrows down the road. 1 Tenants want to protect their leasehold interests while landlords, among other things, want all leases for space at their properties to be automatically subordinate to existing or future mortgages. Sale-leaseback tenants or other large, profitable or anchor tenants (“Major Tenants”) can have significant negotiating clout, resulting in lease provisions which can, among other things, handicap the landlord’s ability to finance the property or enter into a superior ground lease in the future, particularly if such tenants are unwilling to subordinate those provisions to a mortgage or ground lease or, at the very least, engage in a meaningful back-and-forth with the lender or ground lessor, as applicable, to obtain a mutually agreeable Subordination, Non-Disturbance and Attornment Agreement (an “SNDA”).
Of course, where leases are automatically subordinate to existing or future mortgages or superior ground leases, SNDAs are unnecessary. But in some sale-leaseback transactions and other cases, tenants have been successful in negotiating automatic subordination provisions out of their leases. In these cases, the subordination provisions often contain a contingency that the tenant obtain an SNDA from any future lender or ground lessor. However, if the lease contains provisions that may not be considered market by a lender or ground lessor, language that the tenant shall accept the lender’s then-current form of SNDA, while helpful, may not be sufficient to address certain negotiated provisions of the lease. Accordingly such provisions may require specific attention during the lease negotiation process. Some examples of these lease provisions are as follows:
- Treatment of casualty proceeds and condemnation awards. Many standard form leases provide that the landlord controls the adjustment and distribution of such proceeds and awards. While it is beneficial for a landlord to control insurance proceeds and condemnation awards, thus allowing them to control how such funds are applied to the restoration and repair of the property, some Major Tenants may want this power. Major Tenants tend to invest their own money into significant improvements to their leased spaces. In these cases, it may be more important to the tenant to control proceeds and awards than it is to the landlord. Depending on the size of the tenant and the type and quality of the improvements, these scenarios may suit some landlords as well.
- Control of rebuilding and restoration. Similar to the treatment and allocation of insurance proceeds and condemnation awards, standard provisions dealing with rebuilding and restoration of damaged property tend to vest control over these processes with landlords. Again, though, Major Tenants may negotiate provisions giving them control of rebuilding and restoration, enabling such tenants to restore their own improvements. While some landlords prefer to maintain control of the repair and restoration processes, others may be content to cede control where the property will be restored to the specifications of a top-flight, desirable tenant. Some potential lenders, however, may insist that a tenant’s right to control rebuilding and restoration be subordinated to the lender’s rights; however, other lenders may acquiesce to tenant-controlled restoration, provided that the tenant’s use of any insurance proceeds is conditioned on the lender’s control of disbursements.
- Rights of first offer (“ROFOs”) and rights of first refusal (“ROFRs”). Major Tenants sometimes negotiate ROFOs or ROFRs in order to protect their investment in the leased space. While a tenant may be comfortable with the landlord with whom the lease was negotiated, the tenant may not be comfortable with a new landlord following the sale of the property or the tenant may simply desire to purchase the property for its own use. Most landlords are more likely to grant a ROFO rather than a ROFR as the former simply grants the tenant the right to negotiate with the landlord before the landlord goes to market. A ROFR, which typically allow the tenant to purchase the property on the same terms as a third party, is more restrictive and less desirable from the landlord’s point of view as it is far more difficult to market a property and get potential buyers to negotiate if there is a ROFR.
- Tenant’s right to cure defaults under a mortgage. While this is an unusual provision, Major Tenants may think it beneficial for a variety of reasons. Landlords, too, may think such a provision is beneficial as it seemingly allows the landlord a reprieve from what would otherwise be a default under a mortgage. However, the most significant issue with such a provision is that any future lender will not have agreed to a tenant cure right and may not want to allow it.
These examples of tenant-friendly lease provisions can create real problems down the road when the landlord attempts to finance the property or enter into a superior ground lease. For example, most loan documents and ground leases provide that the lender or ground lessor, as applicable, will control insurance proceeds, condemnation awards, and rebuilding and restoration to ensure that the value and character of the property is maintained. In this case, the tenant will likely be asked to subordinate its rights to such proceeds to those of the lender or ground lessor, particularly where these provisions hamstring the landlord’s options (e.g., where the lease terms require the landlord to rebuild or restore the property regardless of when during the term of the lease (or the loan) the casualty or condemnation event occurs). The same is true for ROFOs and ROFRs, particularly where the tenant’s rights arise following a casualty or condemnation, or in the event of foreclosure. A tenant’s right to cure defaults under a mortgage, however, can cause other problems because, for example, the lender will likely not have performed all due diligence required by federal regulations and the specific lender’s internal policies, including the lender’s “Know Your Client Policy”, with respect to the tenant.
During lease negotiations, both tenants and landlords should contemplate the effect these provisions may have on future financeability of the property as well potential concessions that will be necessary in an SNDA with respect to certain lease provisions. Landlords should also be prepared to provide additional assurances to lenders or ground lessors where tenants hold fast to their negotiated provisions, such as an additional guaranty for losses suffered as a result of those provisions. Maintaining this kind of flexibility and practicality beyond the signing of the lease will facilitate the landlord’s ability to obtain financing or enter into superior ground leases while at the same time preserving (to a certain extent) the tenant’s rights under the lease.