Interaction of Mortgages and Leases

1
Interaction of Mortgages and Leases
2
Why would a mortgagee want possession of income
property prior to foreclosure?

• To stop waste or to make repairs.
• To rent out the premises (if vacant)
• To intercept the rents and apply them to the debt
  and repairs.

3
How does a mortgagee get possession?

• Title theory state on demand at any time
  (theoretically)
• Intermediate theory state on demand if there is
  a default
• Lien theory state only upon
• voluntary relinquishment by the mortgagor.
• mortgagor abandons.
• mortgage authorizes it upon default.
• (Nearly all lien theory states accept this.)

4
Is it wise for a mortgagee to take direct
possession?

• Very strict (fiduciary) duty of accounting.
• Duty to care for the property.
• Duty to 3d parties in tort.
• Duty to comply w/running covenants.
• Duty to pay association assessments
• Statutory duties (asbestos, implied warranty).
• Doing so may terminate junior leases (in title
  theory states).

5
What acts might result in possession by a ME?

• Collecting rents
• (No)
• Entering into a new lease with a tenant
• (Probably yes)
• Evicting a tenant for nonpayment
• (Probably yes)
• Making repairs at a tenants request
• (Probably yes)
• Cultivating or harvesting crops
• (Yes)

6
Most lenders are reluctant to become mortgagees
in possession. As an alternative, they usually
prefer to have a receiver appointed by a court.
7
What happens to existing leases when a mortgage
is foreclosed? The answer depends on the
relative priority of the mortgage and the lease.
8
If lease has priority
Lease
MR Tenant MR ME
Forecl.
Mortgage
Purch.

• Foreclosure purchaser has no right to terminate
  lease.
• Tenant has no right to terminate lease.
• Tenant must attorn to foreclosure purchaser (just
  as if MR had sold the property).

9
If mortgage has priority
Forecl.
Mortgage
Purch.
MR ME MR Tenant
Lease

• If T is made a party to foreclosure, Ts lease is
  destroyed.
• If T is made a party, even if the foreclosure
  purchaser wants to keep T on the lease, T can
  walk (terminate)!
• Texas agrees Med Center Bank v. Fleetwood, 854
  S.W.2d 278(Tex.App.-Austin,1993)

10
If the tenant doesnt want the lease terminated

• Would the tenant have a claim against the
  landlord-mortgagor for damages, for its failure
  to make the mortgage payments?
• What theory would the tenant use?
• Texas denied such a tenants claim, where the
  lease expressly stated that it was subject to
  existing mortgages. See HTM Restaurants, Inc. v.
  Goldman, Sachs Co., 797 S.W.2d 326
  (Tex.App.1990)
• Was this correctly decided?

11
If mortgage has priority
Forecl.
Mortgage
Purch.
MR ME MR Tenant
Lease

• Suppose ME wants to keep the lease in effect
  (because its advantageous to the landlord, and
  hence will bring a better foreclosure sale
  price).
• So ME intentionally omits making the Tenant a
  party to the foreclosure? Will this work to
  preserve the lease?

12
If mortgage has priority
Forecl.
Mortgage
Purch.
MR ME MR Tenant
Lease

• In half the states, T is deemed a party and
  automatically wiped out or can intervene and
  insist on becoming a foreclosure party. (The
  so-called Automatic states)
• In the other half of states, T cant intervene
  so ME can pick and choose.

13
In a judicial foreclosure, Texas is a pick and
choose state

• Where suit is brought to foreclose a prior
  lien on land, which prior lien was in existence,
  and of which constructive notice was given by the
  record of such lien to the tenant who afterwards
  acquired the lease, and the tenant is not made a
  party to the foreclosure proceedings, such tenant
  is not bound by the decree rendered or by the
  subsequent proceedings in such suit.
• Kennerly v. B.F. Avery Sons Plow Co., 300 S.W.
  159 (Tex.Civ.App. 1927), reversed on other
  grounds, 12 S.W.2d 140 (Tex.Com.App.1929)

14
Query Whats the effect of a foreclosure by
power of sale?

• Many power of sale statutes dont even require
  notice to junior tenants (e.g., TX, MO).
• (See the Texas statute on the next slide.)
• Are they therefore cut off automatically by a
  power of sale foreclosure? (Probably so).
• If notice to them is required, can the ME
  preserve them by not giving them notice?
• Or does that make the foreclosure void?

15
Texas notice of nonjudicial foreclosure sales by
trustees (V.T.C.A. 51.002(b))
Notice of the sale, which must include a
statement of the earliest time at which the sale
will begin, must be given at least 21 days before
the date of the sale by (1) posting at the
courthouse door of each county in which the
property is located a written notice designating
the county in which the property will be
sold (2) filing in the office of the county
clerk of each county in which the property is
located a copy of the notice posted under
Subdivision (1) and (3) serving written notice
of the sale by certified mail on each debtor who,
according to the records of the mortgage servicer
of the debt, is obligated to pay the debt.
16
Old Town Fiber Form Old Town Saratoga Dove
r
Lease
D/T
Fcl
17
Priorities
What would the priority between the lease and
mortgage have been, absent any lease
clause? What was the effect of the lease clause
dealing with priority?
18
Tenant agrees that this Lease shall be
subordinate to any deeds of trust that may
hereafter be placed upon the premises. Any
beneficiary, at its option, may elect to have
this Lease superior to its deed of trust.
19
Old Town Fiber Form Old Town Saratoga
Lease
D/T
Fcl
Dover

• Who could have elected to make the lease
  superior? How? When?
• Should it have done so?

20
Old Town Fiber Form Old Town Saratoga
Lease
D/T
Fcl
Dover

• Could Saratoga have preserved the lease by
  omitting FiberForm from the foreclosure?
• Could they in a Texas D/T nonjudicial
  foreclosure? (Apparently not theres no
  mechanism for doing so.)

21
Old Town Fiber Form Old Town Saratoga
Lease
D/T
Fcl
Dover

• Was it wise of Fiber Form to pay rent to Dover
  after the foreclosure?
• However, the purchaser at the sale and the
  tenant may continue the lease if the tenant
  offers and the purchaser accepts rent payments
  after the foreclosure, they have impliedly done
  so. See Twelve Oaks Tower I, Ltd. v. Premier
  Allergy, Inc., 938 S.W.2d 102(Tex.App.-Houston
  1996).

22
Any of three different (but similar) types of
clauses might have let Saratoga keep FiberForms
lease

• Optional unsubordination (the actual case)
• (Could ME unsubordinate without a clause? See
  Mortgages Restatement 7.7)
• Attornment clause.
• New Lease clause.
• Must the clause be in the lease? What about
  putting it in the mortgage?

23
Most printed form commercial leases contain one
of these clauses.

• Why?
• They give the lender (existing or future) all the
  marbles.
• Hence, they make the landlords interest highly
  financible.
• But a powerful tenant would never sign one of
  these forms!

24
Assume that the mortgage has priority over the
lease how does the mortgage keep the tenant?
Pick and choose states
Automatic termination states
Judicial foreclosure Omit junior tenants from
service.
Judicial foreclosure Junior tenants can
intervene.
Nonjudicial fore-closure Dont give junior
tenants notice
Nonjudicial fore-closure junior ten-ants are
terminated.
25
Assuming they have a choice, how do foreclosing
mortgagees (and foreclosure purchasers) evaluate
whether a lease should be preserved?

• 1. Characteristics of the tenant and the lease.
• 2. Debt service coverage ratio.
• 3. Estoppel statements from the tenants.

26
Characteristics of the tenant and the lease

• Ts financial condition rent payment record
• Rent and rent escalation clauses
• Landlords financial duties
• Casualty loss/rebuilding
• Renewals extensions
• Exclusive clauses
• Assignment/subletting rights
• Duty to operate (lights on)

27
The lender may also consider the debt service
coverage ratio

• Net rents (after paying operating expenses, but
  before payment of debt service) (also called net
  operating income or NOI) must be at least (say)
  120 of debt service.

Debt service
Net rent
28
An example from which to compute the debt service
coverage ratio Gross Rent..............
100,000 Maintenance
6,000 Mngmt, insur., etc.
27,000 Property taxes 15,000 Net rent
before debt service (NOI).. 52,000 Debt
service............. 40,000 Net cash
flow............ 12,000
29
Debt service coverage ratio Net rents before
debt service Debt service
52,000 40,000
130
30
Tenant estoppels

• When lending on a building with existing tenants,
  why does a lender require estoppel statements
  from the tenants?
• The lender may refuse to loan without estoppels
  from a percentage (say,75) of all tenants, and
  from all the major tenants.

31
What do estoppel statements say?

• Lease is valid binding.
• No modifications have been made.
• Rent is as stated.
• No prepaid rent or rent concessions have been
  made.
• Amount of security deposit.
• Term renewal options.
• T has no claims against Landlord for breach,
  except ?

32
A lender may also want estoppels from the major
tenants before deciding whether to terminate them
in foreclosure.(But they can behard to obtain.)
33
The SNA A three-cornered agreement
Landlord
Lender
Tenant
34
If the parties have an express agreement, what
would the mortgagee like (especially in
automatic states)?

• Subordination of the lease.
• Attornment agreement by T
• (or new lease clause)
• (or optional unsubordination).
• This is just what most small tenant form leases
  say.

35
If the parties have an express agreement, what
would the tenant like (especially in a pick and
choose states)?

• A nondisturbance agreement, promising T wont
  be kicked out upon foreclosure (provided, of
  course, that T is in compliance with the lease).
• Powerful tenants always insist on this.

36
In the real world

• Strong Landlord Subordination and Attornment
• Strong Tenant Nondisturbance
• Balanced bargaining Subordination, Attornment,
  and Nondisturbance (SNA)

37
What does the SNA achieve?

• 1. Technical priority for the lender.
• 2. Fairness between lender and tenant (neither
  can break the lease on account of foreclosure).

38
Why would L want a subordination from T, if L is
going to give T a non- disturbance clause anyway?

• The lenders regulators may limit the lender to
  1st liens.
• The lease and mortgage may have conflicting
  clauses on fire insurance proceeds, condemnation,
  etc. The document with priority will prevail,
  and the lender wants that to be the mortgage!

39
Now lets look in detail at the wording of the
SNA agreement
40
Clause 1. Nondisturbance Provided that T is not
in default, Ts rights and privileges under the
Lease shall not be terminated or interfered with
by Lender in the exercise of Lenders rights
under the Mortgage.
41
Clause 2. Attornment If mortgage is
foreclosed, or deed in lieu is given, T shall
attorn to Lender or purchaser. Ts rights under
the lease shall not be impaired, or Ts
obligations increased.
42
Clause 5. Subordination T agrees that the
Lease shall be subordinate to the lien of the
Mortgage, and all other documents securing the
debt, and all extensions, modifications, and
renewals.
43
Clause 3. Lenders rights and obligations In
event of default by L, Lender (or foreclosure
Purchaser) shall have same rights as Landlord,
and shall be bound to T by all covenants in the
lease .... except
44
Clause 3. Exceptions to Lenders obligations (T
will resist these may be negotiable)

• Prior Ls defaults
• Prior Ls acts or omissions
• Offsets against prior L
• Rent prepaid to prior L for more than 1 month
• Amendments to lease made without Lenders consent
• Construction of improvements promised by prior L

45
A few more exceptions to Lenders obligations
which lender may demand

• Not bound by any radius or exclusive clauses
  in the leases
• Not bound by warranties given by Landlord (e.g.,
  regarding zoning)
• Not bound by options held by T to lease
  additional space
• Not bound to use fire insurance proceeds to
  rebuild

46
And yet a few more possible exceptions to
Lenders obligations

• Lender not bound to refund security or reserve
  deposits
• Alternatively, Lender can require deposits be
  escrowed with Lender, and pledged so Lender can
  take them over upon borrowers default
• T agrees to give Lender notice of any Landlord
  default, and opportunity to cure it.

47
The end
All of these exceptions to the lenders
obligations are negotiable, and a powerful tenant
may be very resistant to them.