Office leasing in 2011 is on the rise, but it remains a tenant’s market. Landlords are granting reduced rent and large concession packages to keep existing tenants and attract new ones.

However, it is important to realize that there is a third party to consider in most commercial leases: the landlord’s mortgage holder. In a year when thousands of properties are falling into distress and potential foreclosure, understanding the mortgagee’s role is critical to both landlord and tenant.

Leasing safeguards

Landlords who take steps to maintain long-term flexibility in leases can position their properties to increase rental income quickly once the market shifts in their favor. Before agreeing to a reduced rental rate or other incentives, a landlord should retain the right to relocate a tenant to substitute space within the building, or to terminate the lease.

These terms will be valuable to the landlord if the market improves because the space can be leased to a larger, longer-term user. The right to terminate is handy in cases where the landlord may have been compelled to give away generous deals to tenants in leaner times.

For tenants, it is prudent to require a subordination, non-disturbance and attornment agreement (SNDA) between the tenant, the landlord and the landlord's mortgagee. This is especially true today, when the market is filled with examples of tenants who are performing their lease obligations but the landlord is in default under its mortgage. Remember, the mortgagee, as the successor owner through a foreclosure, may not be obligated to honor any agreements made between the landlord and the tenant unless the terms are in writing.

An SNDA will prevent termination of the lease by the mortgagee through the foreclosure, so long as the tenant is not in default. In consideration, the tenant agrees to attorn to a new owner, meaning it will welcome the lender as landlord in the event of a foreclosure, and will subordinate its leasehold estate to the lien of the mortgage.  

Additionally, the tenant should request in the SNDA that the mortgagee be bound by any allowances or rent concessions that the landlord agreed to in the lease. This can be a difficult task, however, because mortgagees do not want to become liable for the landlord’s monetary obligations to third parties.

We recently required that a client’s large office lease be contingent on a mutually satisfactory SNDA. The lease had a significant allowance and rent abatement, as well as an option for the client to expand its space and receive an additional improvement allowance during the lease term.

The lender refused to execute the SNDA, however, because it wouldn’t agree to be responsible for the tenant improvement dollars if the client expanded its premises. This resulted in additional negotiations between the owner and its lender, and the ultimate modification of my client's original deal with the landlord.

To avoid a similar conflict, a tenant should require that the landlord escrow any tenant allowance or build-out funds and have the mortgagee agree that the monies will be available if the landlord goes into default.

Due diligence and communication

Today, landlords need to remember that major leases and lease amendments often require lender approval. Mortgage loans often establish criteria for leases that do not require the lender's consent if they meet thresholds for rents or lease terms.

But in today's economy, as landlords and tenants right-size leases for tenants' needs, terms may fall below the required thresholds and therefore necessitate the lender's consent. Therefore, the landlord could be in breach of mortgage covenants simply by trying to lease vacant space or retain a tenant.

Often a tenant that terminates its lease must pay a termination fee. It is a good idea to review the mortgage loan documents before paying the landlord, however, because such fees are often payable to the lender.

Finally, with new leases or renewals, it is smart to review the provisions regarding the condition of the premises to be delivered back to the landlord. Many leases require the space to be returned in its original condition. It is advisable to include in the lease a provision that, at the time the improvements are made, the landlord must notify the tenant whether or not the improvements must be removed upon expiration or termination of the lease.

The bottom line is that it is important to review leases and the underlying loan documents in order to best understand the respective rights, duties and obligations of all parties, including the mortgagee. Despite today’s numerous economic challenges, lease transactions can be completed satisfactorily if each party does its due diligence, is willing to be creative and communicates clearly with everyone involved.

Harold S. Dembo co-chairs the real estate practice group at Chicago-based law firm Much Shelist. He can be reached at hdembo@muchshelist.com.