Interaction of
Mortgages
and Leases
Why would a mortgagee want
possession of “income property”
prior to foreclosure?
To stop waste or to make repairs.
 To rent out the premises (if vacant)
 To intercept the rents and apply them to
the debt and repairs.

How does a mortgagee get
possession?
●Title theory state: on demand at any time
(theoretically)
●Intermediate theory state: on demand if there
is a default
●Lien theory state: only upon
• voluntary relinquishment by the mortgagor.
• mortgagor abandons.
• mortgage authorizes it upon default.
•(Nearly all lien theory states accept this.)
Is it wise for a mortgagee to take
direct possession?
● Very strict (fiduciary) duty of accounting.
● Duty to care for the property.
● Duty to 3d parties in tort.
● Duty to comply w/running covenants.
● Duty to pay association assessments
● Statutory duties (asbestos, implied warranty).
● Doing so may terminate junior leases (in “title
theory” states).
What acts might result in
“possession” by a ME?
● Collecting rents
• (No)
● Entering into a new lease with a tenant
• (Probably yes)
● Evicting a tenant for nonpayment
• (Probably yes)
● Making repairs at a tenant’s request
• (Probably yes)
● Cultivating or harvesting crops
• (Yes)
Most lenders are reluctant
to become “mortgagees in
possession.” As an
alternative, they usually
prefer to have a receiver
appointed by a court.
What happens to existing
leases when a mortgage is
foreclosed?
The answer depends on the
relative priority of the
mortgage and the lease.
If lease has priority:
Lease
MR
Tenant
Forecl.
Mortgage
MR
ME
Purch.
● Foreclosure purchaser has no right to
terminate lease.
● Tenant has no right to terminate lease.
● Tenant must attorn to foreclosure purchaser
(just as if MR had sold the property).
If mortgage has priority:
Mortgage
MR
Forecl.
ME
Purch.
Lease
MR
Tenant
● If T is made a party to foreclosure, T’s lease
is destroyed.
● If T is made a party, even if the foreclosure
purchaser wants to keep T on the lease, T
can “walk” (terminate)!
● Texas agrees: Med Center Bank v. Fleetwood, 854 S.W.2d 278
(Tex.App.-Austin,1993)
If the tenant doesn’t want the
lease terminated…
Would the tenant have a claim against the
landlord-mortgagor for damages, for its
failure to make the mortgage payments?
 What theory would the tenant use?
 Texas denied such a tenant’s claim, where
the lease expressly stated that it was
“subject to” existing mortgages. See HTM
Restaurants, Inc. v. Goldman, Sachs &
Co., 797 S.W.2d 326 (Tex.App.1990)
 Was this correctly decided?

If mortgage has priority:
Mortgage
MR
Forecl.
ME
Purch.
Lease
MR
Tenant
● Suppose ME wants to keep the lease in effect
(because it’s advantageous to the landlord, and
hence will bring a better foreclosure sale price).
● So ME intentionally “omits” making the Tenant
a party to the foreclosure? Will this work to
preserve the lease?
If mortgage has priority:
Mortgage
MR
Forecl.
ME
Purch.
Lease
MR
Tenant
In half the states, T is deemed a party and
automatically wiped out or can intervene
and insist on becoming a foreclosure
party. (The so-called “Automatic” states)
 In the other half of states, T can’t
intervene; so ME can “pick and choose.”

In a judicial foreclosure, Texas is
a “pick and choose” state:
“[W]here suit is brought to foreclose a prior lien on land,
which prior lien was in existence, and of which
constructive notice was given by the record of such lien
to the tenant who afterwards acquired the lease, and the
tenant is not made a party to the foreclosure
proceedings, such tenant is not bound by the decree
rendered or by the subsequent proceedings in such suit.”
Kennerly v. B.F. Avery & Sons Plow Co., 300 S.W. 159
(Tex.Civ.App. 1927), reversed on other grounds, 12
S.W.2d 140 (Tex.Com.App.1929)

Query: What’s the effect of a
foreclosure by power of sale?
● Many power of sale statutes don’t even
require notice to junior tenants (e.g., TX, MO).
●(See the Texas statute on the next slide.)
● Are they therefore cut off automatically by a
power of sale foreclosure? (Probably so).
● If notice to them is required, can the ME
preserve them by not giving them notice?
● Or does that make the foreclosure void?
Texas notice of nonjudicial
foreclosure sales by trustees
(V.T.C.A. 51.002(b)):
Notice of the sale, which must include a statement of the earliest time at
which the sale will begin, must be given at least 21 days before the date of
the sale by:
(1) posting at the courthouse door of each county in which the property is
located a written notice designating the county in which the property will be
sold;
(2) filing in the office of the county clerk of each county in which the
property is located a copy of the notice posted under Subdivision (1); and
(3) serving written notice of the sale by certified mail on each debtor who,
according to the records of the mortgage servicer of the debt, is obligated to
pay the debt.
Old Town
Lease
Old Town
Fiber Form
Saratoga
D/T
Fcl
Dover
Priorities:
What would the priority between the
lease and mortgage have been,
absent any lease clause?
What was the effect of the lease
clause dealing with priority?
“Tenant agrees that this Lease shall
be subordinate to any deeds of
trust that may hereafter be placed
upon the premises.”
“Any beneficiary, at its option, may
elect to have this Lease superior to
its deed of trust.”
Old Town
Lease
Old Town
D/T
Fiber Form
Saratoga
Fcl
Dover
Who could have elected to make the lease
superior? How? When?
Should it have done so?
Old Town
Lease
Old Town
D/T
Fiber Form
Saratoga
Fcl
Dover


Could Saratoga have preserved the lease by
“omitting” FiberForm from the foreclosure?
Could they in a Texas D/T nonjudicial
foreclosure? (Apparently not; there’s no
mechanism for doing so.)
Old Town
Lease
Old Town
D/T
Fiber Form
Saratoga
Fcl
Dover
 Was it wise of Fiber Form to pay rent to
Dover after the foreclosure?

“However, the purchaser at the sale and the tenant may continue the
lease; if the tenant offers and the purchaser accepts rent payments
after the foreclosure, they have impliedly done so.” See Twelve
Oaks Tower I, Ltd. v. Premier Allergy, Inc., 938 S.W.2d
102(Tex.App.-Houston 1996).
Any of three different (but similar)
types of clauses might have let
Saratoga keep FiberForm’s lease…

“Optional unsubordination” (the actual case)
 (Could
ME unsubordinate without a clause?
See Mortgages Restatement § 7.7)
“Attornment” clause.
 “New Lease” clause.


Must the clause be in the lease? What about
putting it in the mortgage?
Most printed form commercial
leases contain one of these
clauses.




Why?
They give the lender (existing or future) all the
“marbles.”
Hence, they make the landlord’s interest highly
“financible.”
But a powerful tenant would
never sign one of these
forms!
Assume that the mortgage has priority over the
lease; how does the mortgage keep the tenant?
“Pick and choose”
states
“Automatic
termination: states
Judicial foreclosure:
Omit junior tenants
from service.
Judicial foreclosure:
Junior tenants can
intervene.
Nonjudicial foreclosure: Don’t give
junior tenants notice
Nonjudicial foreclosure: junior tenants are terminated.
Assuming they have a choice,
how do foreclosing mortgagees
(and foreclosure purchasers)
evaluate whether a lease should
be preserved?
1. Characteristics of the tenant and the
lease.
 2. Debt service coverage ratio.
 3. Estoppel statements from the tenants.

Characteristics of the tenant and
the lease:








T’s financial condition & rent payment record
Rent and rent escalation clauses
Landlord’s financial duties
Casualty loss/rebuilding
Renewals & extensions
Exclusive clauses
Assignment/subletting rights
Duty to operate (“lights on”)
The lender may also consider the
“debt service coverage ratio”:
● Net rents (after paying operating
expenses, but before payment of debt
service) (also called “net operating
income” or NOI) must be at least (say)
120% of debt service.
Net
rent
Debt
service
An example from which to compute the
debt service coverage ratio:
Gross Rent..............$ 100,000
Maintenance
6,000
Mngmt, insur., etc.
27,000
Property taxes
15,000
Net rent before
debt service (NOI)..$ 52,000
Debt service.............$ 40,000
Net cash flow............$ 12,000
Debt service coverage ratio:
Net rents before
debt service
Debt service
$52,000 = 130%
$40,000
When lending on a
building with existing
tenants, why does a
lender require
“estoppel statements”
from the tenants?
 The lender may refuse
to loan without
estoppels from a
percentage (say,75%)
of all tenants, and from
all the “major” tenants.

Tenant estoppels
What do estoppel statements say?
● Lease is valid & binding.
● No modifications have been made.
● Rent is as stated.
● No prepaid rent or rent concessions have
been made.
● Amount of security deposit.
● Term & renewal options.
● T has no claims against Landlord for
breach, except [?]
A lender may also want estoppels
from the major tenants before
deciding whether to terminate
them in foreclosure.
(But they can be
hard to obtain.)
The SNA: A three-cornered
agreement:
Landlord
Lender
Tenant
If the parties have an express
agreement, what would the
mortgagee like (especially in
“automatic” states)?
●Subordination of the lease.
●Attornment agreement by T
• (or “new lease” clause)
• (or optional “unsubordination”).
• This is just what most “small tenant” form
leases say.
If the parties have an express
agreement, what would the tenant
like (especially in a “pick and
choose” states)?
● A nondisturbance
agreement, promising T
won’t be kicked out
upon foreclosure (provided,
of course, that T is in
compliance with the lease).
● Powerful tenants always insist on this.
In the “real world”:
● Strong Landlord:
Subordination and Attornment
● Strong Tenant:
Nondisturbance
● Balanced bargaining:
Subordination, Attornment, and
Nondisturbance (SNA)
What does the SNA achieve?
● 1. Technical priority for the lender.
● 2. Fairness between lender and tenant
(neither can break the lease on account of
foreclosure).
Why would L want a subordination
from T, if L is going to give T a nondisturbance clause anyway?
● The lender’s regulators may limit the
lender to 1st liens.
● The lease and mortgage may have
conflicting clauses on fire insurance
proceeds, condemnation, etc. The
document with priority will prevail, and the
lender wants that to be the mortgage!
Now let’s look in detail at
the wording of the SNA
agreement…
Clause 1. Nondisturbance:
Provided that T is not in default, T’s
rights and privileges under the Lease
shall not be terminated or interfered
with by Lender in the exercise of
Lender’s rights under the Mortgage.
Clause 2. Attornment:
If mortgage is foreclosed, or deed
in lieu is given, T shall attorn to
Lender or purchaser. T’s rights
under the lease shall not be
impaired, or T’s obligations
increased.
Clause 5. Subordination:
T agrees that the Lease shall be
subordinate to the lien of the
Mortgage, and all other
documents securing the debt, and
all extensions, modifications, and
renewals.
Clause 3. Lender’s rights and
obligations:
In event of default by L, Lender (or
foreclosure Purchaser) shall have
same rights as Landlord, and shall
be bound to T by all covenants in
the lease .... except:
Clause 3. Exceptions to Lender’s
obligations (T will resist; these may
be negotiable):






Prior L’s defaults
Prior L’s acts or omissions
Offsets against prior L
Rent prepaid to prior L for more than 1 month
Amendments to lease made without Lender’s
consent
Construction of improvements promised by
prior L
A few more exceptions to Lender’s
obligations which lender may
demand:
● Not bound by any “radius” or “exclusive”
clauses in the leases
● Not bound by warranties given by
Landlord (e.g., regarding zoning)
● Not bound by options held by T to lease
additional space
● Not bound to use fire insurance proceeds
to rebuild
And yet a few more possible
exceptions to Lender’s obligations:
● Lender not bound to refund security or
reserve deposits
• Alternatively, Lender can require deposits
be escrowed with Lender, and pledged so
Lender can take them over upon borrower’s
default
● T agrees to give Lender notice of any
Landlord default, and opportunity to cure it.
All of these exceptions to the lender’s
obligations are negotiable, and a powerful
tenant may be very resistant to them.
The end