The Top Questions Every Lender Should Ask When Reviewing Commercial Leases
You are tasked with handling the due diligence for a commercial real estate loan. The dollar amount of the loan is based on the rental stream from leases on the property. Sitting on your desk is a pile of leases – some longer than a hundred pages. On top of that pile is a rent roll given to you by the borrower. What do you do with the pile of leases?
Reviewing several hundred-plus pages of leases can be daunting, but the importance of this review cannot be understated. Not only does the review need to substantiate the cash flow presented on the rent roll, but it also needs to red flag certain provisions that impose extraordinary obligations on the landlord – remember, the lender could someday step into the shoes of the borrower/landlord.
Many lease reviews start and stop with the review of the financial terms of a lease to ensure such terms match the rent roll provided by the borrower. But a lease review needs to be much more. Many terms past the first two pages of a lease can affect rental stream and the landlord’s obligations. The reviewer must delve into a lease to assess adequately the risks the lease poses to the Lender. Different loans require a different level of lease review. A low loan to value will not require as much an in-depth review as a loan that just squeaks in under the underwriting requirements. The riskier the loan, the more important the leases become and often counsel is brought in to do a more comprehensive review.
Lenders, Complete Your Due Diligence
The list below, although not exhaustive, contains much of the information the lender needs to the perform its due diligence.
1. Is the lease complete?
Often copies of leases are missing exhibits, amendments or addendums. These missing documents could affect the financial terms of the lease, the length of the lease, and other important matters.
2. Who are the parties to the lease? Is the lease signed by the tenant and is the tenant’s name correctly listed?
3. What is the term of the lease? When does the lease expire? Are there any renewal options that the tenant has not yet exercised? What are the terms for notice, for renewal rent, and the length of the renewal period?
4. What is the rent under the lease? What is the base rent? Percentage rent? Additional rent for operating expenses, taxes, and insurance?
5. Is the tenant entitled to the abatement of any rent in the future under the lease?
6. Does the landlord have obligations under the lease for tenant improvements/ tenant allowances? Has the landlord delivered the premises? If not, what are the tenant’s rights if the landlord fails to deliver timely? Can the tenant then terminate the lease? Are there any ongoing landlord obligations for tenant improvements/allowances?
7. Does the tenant have the right to certain exclusive uses under the lease? If the tenant has exclusive rights, what are the remedies if an exclusive is violated? Can the tenant terminate the lease? Can it reduce the rent?
8. When can the tenant terminate the lease? In a casualty? After a certain period of time if sales are not sufficient? If other tenants vacate the building/shopping center? Is there a termination fee due to the landlord?
9. Does the tenant have self-help rights under the lease if the landlord does not perform its obligations?
10. What are the restrictions for assignment and subletting? Does the tenant have any assignment or subletting rights that do not require the landlord’s consent? Does the tenant remain liable if an assignment occurs or subletting?
11. Is the lease self-subordinating? Does the tenant require a specific form Subordination and Non-Disturbance Agreement that places obligations on the lender?
12. Is the tenant obligated to provide an estoppel to the lender or a purchaser?
When reviewing leases and answering the above questions, the reviewer must remember that the review is not only for items that may affect the ability of the borrower to pay the loan, but also for obligations imposed on the lender if and when it becomes the landlord.
Ann Marie Mehlert is a real estate attorney at Lerch, Early & Brewer in Bethesda, Maryland who works with real estate developers, investors and owners on all aspects of commercial real estate. For more than 25 years, she has negotiated and documented transactions from acquisition and financing through development, leasing and sales. For more information on reviewing commercial leases, contact Ann Marie at (301) 907-2803 firstname.lastname@example.org.