The subordination provision in a lease is very important. From a tenant's standpoint, if a lease is subordinate to a deed of trust granted by the landlord, the lease is generally terminated upon a subsequent foreclosure of the deed of trust. The buyer at a foreclosure sale might, under certain circumstances, attempt to continue the lease regardless of whether it is subordinate, but if the lease is not a favorable lease (e.g., the lease provides for a rental that is substantially below-marke, or contains other unfavorable provisions), a new owner may instead elect to have the tenant vacate the property after the foreclosure, rather than continuing the lease.
Sometimes the course of action could result in a ratification of a lease. For example, a lender forecloses on property on which there is a lease executed after execution of the deed of trust. The deed of trust is clearly superior to the lease, but if the tenant, after foreclosure, continues to pay rent under the lease and the lender continues to accept such rent, there may be a good argument that the lease has been affirmed and ratified. This could be either good or bad for a particular party. For example, if a lease is deemed ratified, a new owner/landlord might be subjected to certain unwanted obligations and liabilities under the lease.
A lease can be subordinate either by way of its later date of execution (relative to the execution date of the deed of trust) or by way of agreement of the parties. For example, if a lease is executed after a deed of trust is filed, then the lease is subordinate to the deed of trust. Even if the lease is executed before the deed of trust, it may still be subordinate by way of a subordination provision contained in the lease itself or by way of a separate subordination agreement executed contemporaneously therewith or anytime thereafter.
If a lease is subordinate, a tenant could obtain some protection by requesting and receiving a subordination and non-disturbance agreement. An SNDA basically could say that, regardless of whether a foreclosure occurs, the new owner agrees to recognize the tenant as its tenant. Whether a landlord will agree to pursue an SNDA for a particular tenant depends on various factors, including the willingness of the landlord (or mortgage lender) to cooperate and the tenant’s bargaining power. It is entirely possible that a landlord may not want to bother its lender for an SNDA if the tenant is leasing a small space or because the landlord does not want to incur any costs because it and the lender have previously agreed on a charge for the lender’s granting SNDAs. And, of course, there may be lenders who just won't agree to execute an SNDA unless specifically required by the deed of trust.
It should be noted that, with reference to foreclosures occurring after May 20, 2009, there is a new federal statute (“Protecting Tenants at Foreclosure Act of 2009”) that may allow certain bona fide “dwelling or residential real property” tenants (who are current in their lease obligations) to remain in possession for at least 90 days after a notice to vacate is given even if their lease is subordinate to the deed of trust. This new federal law, which contains various exceptions, is scheduled to sunset on December 31, 2012.
Sometimes a deed of trust will contain a provision allowing the lender to unilaterally subordinate the deed of trust to a subsequent lease. A provision of that type grants a lender some flexibility. For example, if the lender desires to foreclose and not cause a termination of a favorable lease, the lender could by separate instrument (or perhaps in the notice of the foreclosure sale and trustee’s deed) unilaterally subordinate the deed of trust to the subsequent lease — with the effect of the lender’s foreclosing and accepting the property “subject to” a lease. There is some risk associated with a lender taking “subject to” an existing lease. The lender may be bound by lease amendments of which the new owner has no prior notice, including, for example, amendments changing the rental or otherwise modifying other terms of the lease or requiring monetary payments to the tenant. In addition, a new owner could be liable for damages arising out of a prior landlord’s conduct. Proper advance planning could reduce, eliminate or at least alert the lender of some of these risks.
— Vincent Marino is a shareholder in Winstead's Houston Office, working in the Real Estate Development & Investments practice.