Special Blog Post By John Clark: Non-Distrubance Agreements

Today we have our first ever guest blog post. John Clark, Partner at Clarks Barristers & Solicitors in Windsor, Ontario, will provide us with a post from a legal prespective, as part of our leasing series:

In negotiating leases for commercial landlords, clients often ask me about non-disturbance agreements. They are often after-thoughts for those in the process of purchasing commercial rental properties. They shouldn’t be.

Take this scenario:
Akim has agreed to purchase a 5 unit commercial plaza. To finance the purchase he arranged a new first mortgage with Easy Money Mortgage Co. Three of the units in the development were rented with written leases in place when Akim bought, and he knew that he had two prospects wanting to rent from him once he took ownership and possession. The Easy Money mortgage made no reference to the leases, and none of the old or new leases made any reference to the Easy Money mortgage. All tenants paid their rents on time each month and honoured the terms of their leases.

Akim later runs into financial difficulty with another investment. He uses the rent from this development to pay off his other obligations and as a consequence defaults under the Easy Money mortgage. Easy Money puts the matter into the hands of its favourite receiver, Stripette, Bayer and Sellit, and foreclosure proceedings are begun. In that case, what of Akim’s tenants? In the absence of any agreement between the tenants and Easy Money, here’s what happens:

1. The leases that were in place before Akim purchased, and therefore before Easy Money took a mortgage, have priority over the mortgage. Easy Money has to honour the leases whether they like the tenants or not. And the tenants have to stay, whether or not they like Easy Money. In most cases, the tenants would also have to stay after the sale to the new purchaser that Stripette, Bayer and Sellit finds for the property on behalf of Easy Money.

2. There is a different result for the two leases put in place after the purchase, and therefore after the Easy Money mortgage. And, it’s a double-edged sword, both for Easy Money and for the tenants. As the mortgage has priority, Easy Money can instruct Stripette, Bayer and Sellit to terminate the leases and offer the property to prospective purchasers with those two units vacant. This may be attractive to a prospective purchaser if the market has improved since the time the two leases were entered into, allowing a new purchaser to negotiate higher rents than the displaced tenants were paying. Obviously, this improves the price that Stripette, Bayer and Sellit can command on behalf of Easy Money. From the tenants’ point of view, they stand to lose the cost of remodeling and other changes they put into the units other than improvements that might be considered fixtures in law.

The other edge of the sword is this: if the tenant wants, in circumstances where he has not invested a lot in improving the premises, he can flee. He can look for a more stable development, which might be very attractive if the market has softened, as he may be able to secure premises at a lower rental rate.

To bring more certainty and perhaps to enhance the marketability and value of the development, Akim and Easy Money should have considered subordination agreements and non-disturbance agreements at the time Akim purchased the development. These are contracts entered into between mortgage companies and tenants, who otherwise have not contracted with each other (ie, the mortgage or the leases).

A non-disturbance agreement typically provides that a tenant may remain in possession of the rental premises, despite any power of sale or enforcement actions taken by a mortgage company upon a landlord’s default, so long as the tenant keeps paying the rent and honouring the other terms of the lease.

A subordination agreement typically provides that a mortgage company would have priority over a lease. Often in subordination agreements there is a specific attornment provision. Under that provision the tenant recognizes and acknowledges the mortgage, the mortgagee’s rights upon default, and agrees to pay rent to the mortgagee regardless of the landlord’s default.

As you might imagine, there is a lot of room for negotiation in these agreements, and in some cases the mortgage companies or tenants would rather not enter into these agreements, and for good strategic reasons.

For example, in our scenario, the three original tenants already have priority over the mortgage, and a non-disturbance agreement would be redundant. It is already secure in its possession rights. You might ask why a tenant would ever agree to subordinate. Here’s why. Recall that if neither the mortgage or a lease references each other, and there is no non-disturbance or subordination agreement, both parties are stuck with each other. From Easy Money’s perspective, it has to honour the lease so long as the tenant keeps paying rent. And, if the tenant attempts to flee, or refuses to pay rent, Easy Money can sue to recover any unpaid rent, and may also be in a position of terminating the lease and suing the tenant for the rent that otherwise would have been payable during the balance of the term.

In the absence of a mutually acceptable settlement, each of the parties has the option to look for better lease terms. If the parties negotiate subordination and non-disturbance agreements at the time the mortgage is being put into place, the tenant may include provisions (which mortgage companies tend to avoid) that the mortgage company will honour all terms of the lease; not just those permitting further possession if the rent is paid. If in our scenario, Akim had agreed to repave the parking lot within 4 years, one of the original tenants whose lease had priority over the mortgage, might require Easy Money to assume that responsibility; otherwise, it might have no other incentive to sign. Mortgage companies typically resist such requirements, unless the tenant is a very strong one whose continued presence in the development would improve the market value of the development. Bear in mind, that the improved market value would also have worked for the benefit of Akim himself, had he not defaulted.

In most cases, Easy Money would not agree to these extra terms, and would prefer to negotiate with tenants if and when there is default, based on the economic circumstances of all parties and the marketplace at that time. From the tenant’s prospective, it would likely, depending on its strength in the marketplace, also prefer not to enter into any specific subordination or non-disturbance agreements.

In retrospect, Akim should have sought the consent of his vendor to speak to the original three tenants and determine their wishes so far as subordination and non-disturbance agreements are concerned. That would have led to early negotiations between Easy Money and the tenants, which may have improved the mortgage terms that Akim received from Easy Money.

If the new tenants were informed by Akim and Easy Money that Easy Money would extend non- and your lender. The time you invest early may save you in terms of interest rate, and enhance market value.disturbance agreements to them, Akim may have been able to secure better lease rates from them. The tenants, in turn, recognizing that they were protected, would have been more inclined to invest in improvements to the premises. The overall market value of the development may have increased as a result.

So, when considering the purchase of a commercial rental property, consider the relationship between the tenants.

Special thanks to John for his contribution. To learn more about his legal services, visit his website at www.clarkslaw.com.