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Real Estate Update

It’s Complicated: Leasehold Mortgages and the Relationships Between Tenants, Landlords and Their Lenders

Thursday, October 13, 2011

A leasehold mortgage is an encumbrance or lien on a tenant’s interest in a lease conveyed to a lender as collateral for a loan to the tenant. Often a leasehold mortgage is used by a tenant under a long-term ground lease in order to secure financing for construction or major renovations to the leased premises. The most obvious benefit of a leasehold mortgage arrangement is that it allows a tenant to proceed to develop the leased premises without spending some or all of its on-hand assets. Once the improved leased premises begins generating income, the tenant may pay both the rent under the lease and the debt service on the loan secured by the leasehold mortgage.

The use of a leasehold mortgage for financing creates unique relationships among the tenant, the tenant’s lender or leasehold mortgagee, the landlord and the landlord’s lender or fee mortgagee. The obligations of the tenant to the leasehold mortgagee are governed by the leasehold mortgage and related loan documents, and, likewise, the obligations of the landlord to the fee mortgagee are governed by the fee mortgage and related loan documents. The relationships among all four parties, however, are controlled generally by the lease, which may have been negotiated and executed by the tenant and the landlord prior to the creation of either mortgage interest. In addition, a landlord consent to the leasehold mortgage and a subordination, non-disturbance and attornment agreement (often referred to as an SNDA) by and among some or all of the parties provide guidance in determining the parties’ rights in the event of a foreclosure by either mortgagee.

Prior to the creation of a leasehold mortgage, the tenant must be certain that the lease permits the tenant to encumber its leasehold interest. A commercial ground lease will typically include a provision that specifically allows a tenant to encumber all or any portion of its interest in the lease and the leasehold estate by mortgage, deed of trust or other security instrument upon obtaining the prior written consent of the landlord. This section of the lease will probably also state that any leasehold mortgage granted by a tenant is subject and subordinate to all rights and interests of the landlord, and the leasehold mortgage shall be an encumbrance or lien only on the tenant’s interest in the lease and leasehold estate and not on the landlord’s fee interest in the property. The landlord will want to be certain that the leasehold mortgage is subject to the terms of the lease and that the leasehold mortgagee does not acquire any rights greater than those of the tenant. Many commercial leases other than ground leases will specifically prohibit a tenant from entering into a leasehold mortgage, so if a tenant wants the option to do so, it should make this known early in the negotiating process (preferably when negotiating the term sheet or letter of intent).

The above-mentioned lease provisions permit a tenant to grant a leasehold mortgage so long as the landlord’s interest in the leased premises is not compromised. The financiability of a leasehold interest, which is the real issue for the tenant and the leasehold mortgagee, may depend on the provisions dealing with the tenant’s default and the landlord’s obligation to provide the leasehold mortgagee with notice of such default and adequate opportunities to cure. For example, if the landlord may immediately terminate the lease due to the tenant’s default, and in turn the tenant’s leasehold estate, and without notice to the leasehold mortgagee, the leasehold mortgage is rendered valueless. Instead, if the lease requires the landlord to provide the leasehold mortgagee with notice of the tenant’s default and an opportunity to cure the default on behalf of the tenant, the leasehold mortgagee’s interest in the leasehold may survive. Similarly, a leasehold mortgagee will want the lease to provide the tenant with the ability to assign its leasehold interest freely. That way, should the leasehold mortgagee take possession of the leased premises following foreclosure, it may market and sell the leasehold interest in order to recoup the unpaid amount of the underlying loan.

As mentioned above, if a leasehold mortgage is permitted under a lease, the lease will often require a separate written consent of the landlord prior to the tenant’s conveyance of a leasehold mortgage to its lender. The consent of the landlord will often include a subordination of the landlord’s rights to the tenant’s personal property kept on the leased premises such as equipment, machinery, tools and inventory. The underlying loan from the leasehold mortgagee to the tenant most likely names these items of personal property as collateral, with the security interest being perfected by the filing of a UCC-1 with the state in which the tenant entity was formed. Since many states provide a landlord with statutory remedies against a defaulting tenant that include the right to possess and sell the tenant’s personal property located at the leased premises (such as the rights of levy and distraint for rent), it is important to a leasehold mortgagee that the landlord’s statutory rights are subordinate to the leasehold mortgagee’s rights to the tenant’s personal property.

The relationship between the tenant, leasehold mortgagee and fee mortgagee is often controlled by a SNDA.1 The tenant must have a right to non-disturbance of the lease following foreclosure and sale of the fee interest by the fee mortgagee, which would be set forth in a SNDA. Without such a right, the value of the leasehold interest is greatly impaired because the fee mortgagee may be able to terminate the lease in the event of foreclosure after the landlord defaults on its obligations to the fee mortgagee. If the SNDA has been executed by the tenant, landlord and fee mortgagee prior to the grant of the leasehold mortgage, the leasehold mortgagee may wish to amend the SNDA to name the leasehold mortgagee as a party to the SNDA and provide for greater non-disturbance rights.

In sum, a leasehold mortgage is a very useful financing tool for a tenant. Nonetheless, due to the complicated relationships they create, care must be taken in the review of the lease and related documents to assure that the leasehold mortgage has value to secure a loan.

Endnotes

1 The topic of SNDAs was examined in an earlier edition of Leasing Corner, "SNDAs: An Important Aspect in Commercial Leases" (January 13, 2011).

David J. Tshudy and Hannah Dowd McPhelin

Written by

David J. Tshudy
Phone: 717.255.1127
Fax: 717.238.0575
tshudyd@pepperlaw.com

Hannah Dowd McPhelin
Phone: 717.255.1128
215.981.4597

Fax: 717.238.0575
215.981.4750

mcphelinh@pepperlaw.com


"Leasing Corner" – a series of articles focusing on commercial real estate leasing. While the Pepper Hamilton Real Estate Practice Group handles all matter of real estate transactions, development, land use and litigation, one area in which we regularly provide legal services to our clients is commercial leasing. We have assisted many clients in connection with varied types of leases including, for example, ground leases, big-box and in-line retail leases, large headquarters-office leases, and laboratory, industrial and warehouse space leases.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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