Tenant's Overlooked Risk: Landlord Default

In the balance of power between landlords and tenants, the risk of default is usually higher for the tenant. While many landlords have accrued wealth and invested in low-risk assets, many tenants are embarking on a new business venture with the hopes of starting the next billion-dollar enterprise. Conventional wisdom holds that 9 out of every 10 of these ventures will fail. Commercial leases reflect this imbalance, providing a laundry-list of protections for the landlord to address a potential tenant default without giving as much attention to the risk of a landlord default.

The risk of a landlord default, however, is not zero. More prevalent in times of market tumult, landlords can run into performance issues if they have taken on too much debt, invested in assets with underlying defects in the condition of the property, or have not reserved enough liquidity to address unanticipated issues. These issues can plague landlords large and small.

How a Landlord Default Can Affect a Tenant

Tenants don't often consider the potential impact of a landlord default, but this approach could lead to disastrous results. Most landlords acquire their property using a mortgage or other debt instrument. Under California law (and subject to some exceptions), if a landlord defaults on its mortgage and the lender forecloses on the property, leases that were entered into after the mortgage was recorded are subject to automatic termination by the lender. In other words, if the landlord loses the property, the lender can kick out the tenant as well – regardless of whether the tenant is in good standing under the lease. The tenant may have a claim against the landlord, but a landlord that recently experienced foreclosure is unlikely to have assets against which to collect.

The Lifeline Tenants Need: The SNDA

To avoid this risk, tenants who want to preserve their lease and/or are investing significant resources into their premises should insist on receiving a Subordination, Non-Disturbance and Attornment agreement (SNDA) at the time their lease is executed (or immediately thereafter). These agreements, entered into by the landlord, tenant, and landlord's lender, will provide, among other things, that if landlord's lender forecloses on landlord's interest in the property, the lender cannot terminate the tenant's lease and must recognize the tenant's continued right of occupancy pursuant to the terms of the lease as long as the tenant is not in default. SNDAs can be beneficial to the landlord as well, as they will typically provide protections for the lender that strengthen the loan, such as (a) the lender's interest in the property is superior to the lease and (b) the tenant will attorn to (i.e., recognize) the lender if a foreclosure occurs. 

A Real-Life Example: When the Lack of an SNDA has a BIG Impact

We recently worked with a tenant whose landlord lost the property to foreclosure. Because the tenant did not obtain an SNDA, the tenant could not force the lender to honor the lease. This tenant had invested hundreds of thousands of dollars remodeling the space for its new business, but since the lender believed a different use would be more profitable, the lender refused to permit the tenant to continue occupancy of the space. As a result, the tenant that had duly performed its obligations under the lease and was building a strong business had no options and was forced to move on.

Recognizing When an SNDA is Essential and Reasonable

Landlords may resist a tenant request for an SNDA. The administrative burden of obtaining an SNDA can be disruptive for a landlord, and the lender may charge for their cooperation. For a small tenant in a large office building, this risk of a landlord default may be so low that the tenant may be willing to proceed without an SNDA. In such cases, it is not unusual for a lender to cooperate with the tenant rather than be forced to re-lease the building, further minimizing the risk to the tenant. But for retail and industrial tenants who devote substantial time and expense in building out the space for their occupancy, obtaining an SNDA should be non-negotiable. 

Don't Sign a Lease Without Considering This Risk Landlord default may not be common, but when it happens, the consequences for tenants can be severe and irreversible. For tenants entering a commercial lease, especially one that requires significant investment, insisting on an SNDA is a smart way to protect their business.

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