Commercial mortgage lenders of non-owner occupied property need to be adept at reviewing leases to protect themselves from risk. Although the rent roll is a useful tool, some lenders learned during the economic downturn that it was a mistake to rely solely on the rent roll for a picture of the future income stream of a commercial property. Lease agreements of retail space, in particular, carry some unique terms that could impact the lender in ways a typical office or industrial lease may not. A thorough review of the lease agreements not only helps to protect the lender from risks in the borrower’s ability to meet its debt service, but also can help identify provisions that might negatively impact the lender in the event of a default. A lender should be wary of the following:
Self-Help and Off-Set Rights. When a landlord fails to make certain repairs to a property, self-help and off-set rights allow the tenant to make the repairs and off-set its costs against the rent. Self-help and off-set rights interfere with the predictability of the property’s income stream. This affects the borrower’s ability to pay under the loan and the value of the lender’s security. Property maintenance and upkeep can also become a problem when properties go into foreclosure or become the subject of a distressed sale. As such, it is a prime time for tenants to exercise self-help and off-set rights. A tenant’s exercise of self-help rights while property is in foreclosure or receivership can become a burden on a receiver in foreclosure proceedings. Lenders should be wary of any self-help or off-set rights and may want to consider requiring the borrower to enter into a lease amendment with the tenant, removing those rights from the lease.
Co-Tenancies. Some tenants, such as those in retail shopping centers, would prefer to condition their lease upon the operation of another tenant in the center or upon certain occupancy thresholds. But when a key tenant leaves or the occupancy threshold isn’t met, like dominoes, tenants with co-tenancy agreements or lease provisions can leave in succession without breaching their lease agreements. Unfortunately, this occurred during the economic downturn, leaving many landlords with empty shopping centers, no recourse against vacating tenants, and no new tenants to fill the vacancies. With no income stream, landlords defaulted on their loans and lenders inherited empty centers. A co-tenancy agreement may entice a desirable tenant to move into a center, but it can also be a precursor to a rapid decline of the property. All co-tenancies should be considered in underwriting risk analyses.
Kick-out Clauses. Under a kick-out clause, if a retail tenant fails to meet a certain minimum sales threshold over a period of time, the tenant has the option to terminate the lease. The early termination could interfere with the income stream of the property and make it more challenging for the landlord to meet its debt service.
Seasonal or Temporary Leases. In the economic downturn, owners of shopping centers and office buildings were willing to take on seasonal and temporary tenants to fill space that had previously been filled by more reliable tenants. Seasonal and temporary tenancies can be deceiving to lenders looking primarily at vacancy rates. They are also less likely to be renewed and could be an indication that the borrower is having difficult filling the space. Lenders may not miss a “Halloween Store” but less obvious seasonal or temporary tenants could be missed if the leases are not carefully reviewed. A lender should protect itself by reviewing the entire lease term of each lease, rather than just the termination dates of the leases, in connection with the overall vacancy rate of the building.
Best practice calls for a full review of all existing leases so that lending institutions can factor these and other lease provisions into their underwriting decisions.