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.