As the San Diego commercial real estate market continues to struggle, foreclosures are becoming more and more common. The prevailing wisdom is that it’s going to get worse before it gets better. While this writer cautiously takes a more optimistic view, there can be little doubt that many San Diego businesses are being and will be confronted with landlord foreclosures. Businesses invest more than just lease payments in the premises they occupy. They make tenant improvements, invest in advertisements and marketing materials using the premises address, build customer loyalty and benefit from a well known and popular location. Under these circumstances, being forced out as a result of a landlord’s default would be disastrous.
So what does happen to a business when a landlord defaults on its loan? The answer depends on the terms of the lease, when it was executed and whether or not it was recorded. Senior commercial leases will generally survive foreclosure sales, especially where the commercial lease is recorded prior to the recordation of the third party encumbrance. Tenant possession of the premises may also serve as constructive notice of the senior lease to third party encumbrancers. However, where a trust deed or other encumbrance is recorded prior to the execution of the lease, the lease is subordinate to the trust deed. In such circumstances, a foreclosure will extinguish the lease. A foreclosure purchaser may then evict the tenant as an unlawful occupant.
Experienced commercial landlords and tenants, savvy business owners and those represented by commercial lease attorneys look to address these potential consequences before entering into long term leases. Whatever the terms, it is sound business practice to record all leases including amendments and other related instruments. If the parties are concerned with confidential terms, they may record a “memorandum of lease” which identifies the unrecorded lease, the parties, the property and the lease term.
Where a trust deed or other encumbrance is senior to the lease interest, tenants may request that the landlord cooperate in obtaining a non-disturbance agreement with the lender. In leasing, “non-disturbance” clauses are generally accompanied by a subordination clause (agreement that leasehold interest is secondary to lender’s lien) and an attornment clause (obligating tenant to “attorn to” a new landlord in the event of foreclosure by a senior encumbrancer). Whether a landlord will agree to a non-disturbance clause depends on the parties’ relative bargaining power. If the tenant is a small boutique in a large commercial mall, it is unlikely that the landlord will agree to a non-disturbance agreement. If the tenant is an anchor store in that same mall (say a national department store), it can insist on a non-disturbance agreement. There are of course many variations between these two extremes and prospective tenants should work closely with their attorney towards this goal.
From the landlord’s perspective, obtaining the cooperation of the lender may sometimes require extraordinary effort but otherwise provides tenants peace of mind which in turn is good for the long term operation of the property. In addition, lenders and foreclosure purchases are unlikely to move forward with wholesale evictions where the real estate benefits from established and reliable tenants. With this in mind, the failure to negotiate a non-disturbance agreement shouldn’t necessarily be a deal breaker. However, by raising the issue, tenants at least understand the risks.