What is a Landlord Subordination Agreement?
In any real estate purchase agreement, there is bound to be some discussion of the leasing process. Often times there is a need to have approval from an existing landlord on a property, where an entity is already operating on a site. In many cases, there will be an assumption of the current lease in conjunction with the new lease, or perhaps there is a need for the new tenant to be placed in a situation where they take over the existing lease. This would be the case when negotiating assignment language with an existing landlord. In many situations, an existing Landlord may not want to negotiate on assignment language, and may simply want a new lease to be executed that will replace all existing leases. Or of course a tenant could merely enter into an amendment to the existing lease to address a new tenant, where the subordination issue is merely an afterthought. In a situation where the assignment language is more difficult to make happen, you may need a Landlord subordination agreement.
In simple terms, a landlord subordination agreement is a document signed by a Landlord, which subordinates the rights of the Lender to the existing documents. That is a mouthful, but let’s break it down. When a property is leased, there is likely a mortgage placed on property . A subordination essentially pushes things back, and gives up the higher priority position that lenders generally have. In the hierarchy of property rights, a Lender that holds a mortgage has an interest that will trump anything else (except tax lien holders and the like), like lease obligations and tenant rights. The subordination agreement works in a way to keep the tenant rights ahead of the lenders and holders of senior/more powerful interests. Without this agreement, if a lender forecloses on a property, the Lease ordinarily terminates. Thus the Landlord may, or may not want to have the Lease still survive with a new owner of the property. And thus the agreement is born. The Landlord, in lieu of that interest in a potential re-negotiation of a lease, grants the tenant a mere right to priorities its rights ahead of the lender. These commonly occur in the purchase process but they are very well understood for situations where the lender holds a smaller value on the property, and where the lender will gain title to the property on the terms of the existing lease. Thus the Landlord agrees to subordinate its control over the property, whereas the Tenant now stands in front, to control the outcome – in the event there is foreclosure.
Essential Components of a Subordination Agreement
The three key elements of a subordination agreement are (i) the hierarchy of claims, (ii) the parties’ consent to the priority of these conflicting claims, and (iii) an enforceable contract that includes adequate consideration. In effect, the agreement subordinates the party that would most likely prevail in the event of a bankruptcy.
The first element is the relative status between competing claims. The status of a claim is the legal right that a creditor has to attach, take possession of, or sell a debtor’s property. Priority means that this interest is higher on the list of competing interests. The second element is the parties’ consent to this priority. The third element is a contract that includes adequate consideration – the promise to do something, or more commonly, not do something, which is legally sufficient to support an agreement. Subordination agreements generally must be in writing to satisfy the Statute of Frauds.
For example, a subordination agreement may recognize the priority of a mortgage lender’s debt that is senior to the right of the landlord to reclaim possession of a property. In such cases, the subordination agreement would prohibit the landlord from reclaiming the property for unpaid rent until the mortgage lender is satisfied. A landlord subordination agreement is a specific type of subordination agreement commonly used in commercial real estate lending.
Why Do Landlords Employ Subordination Agreements?
Depending on the particular strategy and goals of any given landlord, the decision to use or ignore subordination can vary. While there are both benefits and potential complications to entering into a subordination agreement, any commercial landlord looking to keep their investment profitable would be wise to seriously consider the situation. Having an abstract plan for the future of the property is one way that a subordination agreement can be used effectively. It also protects against disaster with creditors, particularly in the commercial setting. Foreclosure on an encumbered property can be devastating to a tenant’s interest in the property as they may lose the right to occupy the space if it is captured by a creditor. Without a formal agreement in place, a landlord may have trouble convincing a creditor that the tenant is low priority, if at all. Subordination essentially creates a formalized chain-of-title and allows creditors to see which parties might have higher priority in a court-of-law scenario. It is essentially a guarantee that any other parties involved will be secondary to those who are officially subordinate. Even still, the extent of subordination will determine how far down the chain a tenant will fall in a foreclosure scenario. Full Subordination means that the tenant gives up its rights to the property entirely. Partial Subordination allows the tenant to retain some rights but in most cases, some of the tenant’s rights will be sacrificed. However, by giving up some minor interests, a tenant may be able to secure critical rights for the duration of the lease.
Effects on Tenants and Creditors
Tenants, having entered into binding lease agreements with their landlords, must be informed about the subordination of their rights. Signed subordination agreements require a tenant to become subordinate to the deed of trust, including the express waiver of its lien claim for personal property against the property alone. The subordination agreement also gives the lender the right to terminate the tenant’s lease after default of the loan and sell the leased space as part of a foreclosure. Post-foreclosure, the lender will assume responsibility for the leased space, stand in the shoes of the landlord and continue to operate the space under the existing lease terms. A tenant’s rights to occupy the leased space is reduced to that of a licensee who may not count upon the continued existence of the lease because the lender may, in its discretion, terminate the lease. The most significant right and protection lost by the tenant is the ability to claim a landlord’s lien on the leased space on real property.
As mentioned above, subordination allows a financial institution making a loan secured by real estate to have priority over pre-existing liens. Lenders recognize that tenants pose risks to the hierarchy of interests created by the use of their real property as collateral for loans. For instance, rental agreements create a risk that tenants may not pay rent due under their lease after the lender takes possession of the property. Tenants can make claims against a leased property that decrease its equity value and mitigate a lender’s return on their investment. There also may be cases where a tenant has rights to property that the lender inappropriately expects to take as well. Subordination agreements also assist lenders in marketing the property after foreclosure by ensuring the lender can sell the property free and clear of all liens and interests, including those of tenants.
Drafting a Subordination Agreement
When negotiating a subordination agreement, the following tips may help to ensure that the agreement contains appropriate provisions:
- Set forth in the Subordination Agreement all of the pertinent terms of the lease, including the name of the tenant and landlord, the location, size and other pertinent information about the property, parties’ rights and obligations and any contingencies, including the right to receive notice of the landlord’s default, an opportunity to cure, and other rights as the parties may agree.
- Set forth in the mortgage loan documents all the pertinent terms of the loan, including the name of the borrower, lender, property, description of the encumbered properties, parties rights and obligations and any contingencies, including the right to receive notice of a borrower’s default, an opportunity to cure, other rights and remedies available to the lender, and any other matters of importance to the lender.
- Avoid making the wording stronger against the landlord or tenant than is necessary . For example, in the sale of bank foreclosed property, the bank will require that the outstanding mortgage be paid off prior to closing and the borrowing buyer therefore should not have to pay off the outstanding mortgage debt in order to close the sale of the property which is being sold at an amount less than the amount of the outstanding indebtedness.
- Carefully draft and review the legal description of the real property to be encumbered, as well as the list of fixtures, zoning and other municipal requirements or restrictions affecting the property. Include, where applicable, a description of easements, lease provisions, restrictions, purchase options, rights of first refusal and other matters the landlord or tenant may have with respect to the property. The more issues that the parties can agree upon sooner in the transaction’s life cycle, the easier it will become for all interested parties to settle their interests and the less costly the transaction will be for all involved.
- Review the lease, and each lender’s proposed subordination agreement, to determine if any significant changes have been made in the terms of the lease by either party after the lender has approved the lease.
Legal Considerations and Best Practices
As with any agreement, there are certain legal implications that a landlord should consider when deciding whether to enter into a subordination agreement. The most important concern should be whether they are restricting their rights as landlord. In some states, subordinate agreements must be recorded to be enforceable against purchasers for value and in some instances, a recorded mortgage may be superior to a lien of an unrecorded subordination agreement. Failure to follow statutory requirements may prevent a landlord from enforcing their rights as lessor under a lease in bankruptcy proceedings after the tenant files.
In a commercial setting, it is a best practice to have counsel not only review lease provisions dealing with subordination but also counsel should be involved in drafting the subordinating agreement. The subordination agreements should take into account the entirety of the deal. For example, are there guarantees associated with the lease? Does the lender need to consent to those guarantees yet be willing to subordination the lender’s rights under the mortgage to those guarantees? Additionally, who is going to bear the cost of the recording of the subordination agreement? While all these issues should be anticipated by the parties, sometimes this will not happen and as stated above, counsel should be involved in the drafting of the subordination agreement.
Case Studies and Illustrative Scenarios
The leasing world is replete with case studies of landlords and tenants entering into subordination agreements. For instance, when a retail tenant signed a subordination agreement three days after the mortgage lender took title to the property, the Pennsylvania Superior Court held that a substantial delay in the performance of the default provisions of the mortgage, after the subsequent lessee had entered into possession, was insufficient to vitiate the subordination agreement. Roderick v. EMF 64/7 Avenue Property, Inc., 474 A.2d 1155 (Pa. Super. Ct. 1984).
On the other hand, the Delaware Supreme Court has applied the "four corners" rule for contract interpretation, holding valid when the subordination clause in a lease states that the lease will be subject and subordinate to all mortgages and deeds of trust, regardless of the time of execution or recordation, whether or not the lender decides to subordinate the lien of the mortgage to the lease , and whether or not the lease is subordinated to the lender’s lien at all. Wilmington Trust Co. v. AIG Baker Sterling Sq. 1, LLC, 2008 Del. Lexis 205 (Del. July 7, 2008).
In other cases, state courts have deemed subordination clauses invalid when they intend to give the creditor a superior lien to the property without formally executing a land contract, mortgage, or deed of trust. In Roderick, the landlord attempted to give secured creditor status to a subsequent lessee by means of subordination clauses in its lease agreement with the subsequent lessee. The Pennsylvania Supreme Court invalidated the subordination clauses where the lessee did not pay value to the landlord.
In Washington, a trial court granted a landlord summary judgment against a tenant based on a defective subordination clause. In First Leasing & Inv. v. Sailboat Point Of F.V., 535 P.2d 801 (Wash.App. 1975), the trial court entered judgment in favor of the landlord because the subordination clause relied upon by the landlord was deemed ineffective.