Due Diligence of Real Property Financing Complicated when Tenant Leases Are Involved

By Brett L. Hayes and Maura B. O'Connor

In today's real estate market, time is the most priceless commodity. Clients, more than ever before, insist that their counsel close real estate transactions quickly and inexpensively. The result is that lawyers have less time to investigate the real property that drives these transactions. Under these circumstances, a due diligence review that misses a key fact might become a malpractice trap for the unwary lawyer.

This may be particularly true for lawyers who represent lenders financing real property loan transactions that involve tenants. When these lawyers undertake a due diligence review for their clients, they face unique problems that will be neglected unless the lawyers know what to look for during the review. The primary problem is the lender's reluctance to foreclose on the real property. Most lenders are not equipped to manage rental properties, and the last thing any lender wants to do is spend more money on foreclosed property. Thus, most lenders have a lower tolerance for risk than most landlords borrowing money. Lawyers should ensure that the lender's due diligence review is expansive enough to determine:

The financial terms of the tenant leases. Lawyers should inquire whether there is sufficient cash flow to service any debt and create a profit.

The areas of the leases most likely to cause legal problems. Lenders should know about the risks of disputes that could interrupt the flow of rentsand how and if they can limit these risks.

The provisions that would apply to the lender as successor landlord if it were to foreclose upon the property.

When a lender's due diligence review involves tenant leases, the lender's lawyer should review each lease, together with all lease amendments, side letters, work letters covering construction of tenant improvements (commonly referred to as TIs), and any other documents outlining the obligations of the landlord and the tenant. This review should be done as early as possible in order to correct or address any problems in the leases before the transaction closes. The documentation for the planned transaction should include representations and warranties from the current owner/landlord and the tenants. The lender or its counsel should review all parts of each lease. Ideally, the lender should also receive confirmation from the borrower/landlord in the loan documents and from each tenant in the tenant estoppel certificates that there are no oral or written understandings between the landlord and any tenant other than those provided to the lender in writing. (See "Tenant Estoppel Certificates" box story on page 3.)

Basic Terms

The lawyer's review of the existing leases should cover the basic terms of each lease, the name of the tenant, the space covered by the lease, the amount of the rent, and the method by which it is calculated. In a retail lease, it is important for lenders to learn whether percentage rent (usually based on retail sales) is paid. In an office lease, lenders need to know whether the tenant must pay any other charges, such as utilities; taxes; common area maintenance (CAM) charges; heating, ventilation and air conditioning (HVAC) services during business hours or on weekends; or part of the cost for any TIs. The lawyer also typically evaluates the credit enhancements for each tenant - including lease guaranties, letters of credit, or other mechanisms that secure the tenant's obligations - to determine if there are alternative sources of recovery for the lender if the tenant defaults.

The due diligence review should clearly identify the circumstances that allow tenants to terminate their leases. Usually lenders want leases to state that a tenant can terminate its lease only if a casualty or condemnation destroys most or all of the leased premises and the damage will not be repaired for a significant period of time. Most leases also should provide that a tenant cannot terminate its lease for reasons beyond the landlord's control. For example, a shopping center tenant should not be able to terminate its lease due to the failure of an anchor tenant to operate during required mall operating hours because the anchor tenant has filed for bankruptcy protection. The lawyer should check the insurance provisions of the leases as well to determine...