Landlord Subordination Agreements: What Small Businesses Need to Know
Many small businesses operate out of leased commercial spaces like office buildings, warehouses, or retail locations. When these businesses seek financing, such as an SBA 7(a) loan, their business assets like equipment and inventory are often used as collateral for the loan. However, since the business does not own the building, the landlord must agree to subordinate their rights to this collateral in case the business defaults on the loan. This is accomplished through a landlord subordination agreement.While these agreements are usually only 1-2 pages long, negotiating the terms can be tricky for both landlords and lenders. We’ll break down what small business owners need to know about these agreements when seeking financing for their business.
What is a Landlord Subordination Agreement?
A landlord subordination agreement is a contract where the landlord agrees to subordinate their rights to collateral located on their property in favor of the lender providing financing to the business tenant.In plain English, this means if the business tenant defaults on the loan, the lender has a superior claim to the collateral – like equipment or inventory – compared to the landlord. The lender can seize and sell this collateral to recover their losses from the defaulted loan.Landlord subordination agreements are common requirements for SBA 7(a) loans and other small business financing when the collateral is located at a leased property. The SBA actually mandates these agreements.
Why Do Lenders Require Landlord Subordination Agreements?
Lenders require landlord subordination agreements to protect their interests when lending to businesses that operate out of leased spaces.Here are some key reasons these agreements are required:
- Access to Collateral – With a subordination agreement, the lender can enter the property and seize collateral if the loan defaults. Without it, the landlord could prevent access.
- Prevents Landlords from Seizing Collateral – Landlords also cannot seize and sell collateral like equipment or inventory to satisfy unpaid rent. The lender has priority over this collateral.
- Notice of Lease Default – The agreement can require the landlord to notify the lender if the business tenant defaults on their lease. This allows the lender to take action and protect their interests.
- Cure Lease Defaults – Lenders can negotiate the right to cure any lease defaults, preventing eviction or other adverse actions against the tenant business.
- Protects Loan Collateral – Overall, the agreement protects the lender’s collateral and interests when lending to a business without real estate assets.
So in summary, these agreements give lenders recourse if the tenant business defaults on the loan by guaranteeing access and rights to the collateral.
What Do Landlords Need to Know?
While lenders benefit from subordination agreements, landlords should understand the implications before signing:
- Lien Priority – The lender will have a superior claim to any business assets or improvements on the property over the landlord.
- Access for Lender – Signing may grant the lender access to the property to seize and remove collateral in a default.
- New Tenant – The lender may be able to assign the lease to a new tenant, subject to approval.
- Limits on Landlord’s Rights – Landlords give up certain rights, like restricting access or seizing collateral for unpaid rent.
- Negotiate Provisions – Landlords should negotiate notice requirements, time limits, and assignment rights.
- Consult an Attorney – Have an experienced real estate attorney review the agreement before signing.
While subordination can benefit landlords by helping tenants secure financing, they should understand the potential downsides. With good legal advice, landlords can negotiate agreements that protect their interests.
Key Provisions in Landlord Subordination Agreements
There are several important provisions that are typically included or negotiated in landlord subordination agreements:
Notice of Default
The agreement usually requires the landlord to notify the lender if the tenant defaults on their lease. This allows the lender to take action like seizing collateral before the landlord terminates the lease.The notice requirements should clearly define what constitutes default and set time periods for notification. Lenders should ensure adequate notice is required.
Lender’s Right to Cure Defaults
Lenders often negotiate the right to cure any defaults under the lease, such as paying past due rent. This prevents the landlord from terminating the lease or taking action against the tenant.Landlords may want to limit the number of times a lender can cure defaults before terminating the lease. Lenders obviously want more flexibility to protect their collateral.
Access to the Premises
The agreement grants the lender access to the property to inspect, seize, and remove collateral after a loan default. Lenders will want adequate time frames, like 60-90 days.Landlords may want to limit the access to business hours or shorten the time period. Local property laws may also dictate access rights.
Occupancy and Rent
If the lender occupies the property to remove collateral, they are typically required to pay rent for that period. Clearly defining the rent amount and occupancy period is important.Rent is usually set at the amount owed under the lease. Lenders want to limit rent to the time they actually occupy the space.
Assignment of the Lease
Lenders often want the ability to assign the lease to a new tenant who assumes the loan. Landlords usually want consent rights for any assignment.Strongly negotiated issue as landlords want to control who becomes the new tenant. Lender flexibility helps attract a replacement tenant.
Best Practices for Lenders and Landlords
To smooth the negotiation process and secure favorable agreements, lenders and landlords should follow certain best practices:For Lenders
- Provide the agreement early in the closing process for review
- Understand internal policies and SBA requirements
- Carefully consider time needed to access and remove collateral
- Review rent obligations and minimize when possible
- Seek maximum rights for assignment of the lease
- Review agreement with an experienced real estate attorney
- Negotiate notice provisions to protect your interests
- Seek to limit lender cure rights and access periods
- Control consent rights for any assignment of the lease
- Limit rent obligations to time lender occupies premises
Following these best practices allows both parties to negotiate and finalize an agreement that meets their needs in financing the small business tenant.
Alternatives to Subordination Agreements
In some cases, landlords and lenders may consider alternatives to a full subordination:
- Non-Disturbance Agreement – Landlord agrees not to disturb tenant’s possession so long as tenant is not in default. Lender protects their interest in the lease.
- Attornment Agreement – Tenant agrees to recognize new landlord, such as if property is sold or foreclosed on. Provides lease continuity.
- Collateral Access Agreement – Landlord gives lender access to seize collateral upon default. Does not subordinate landlord’s rights.
However, the SBA requires a subordination agreement for 7(a) loans, so these alternatives won’t work in that case. But they can provide more flexibility outside of SBA lending.
The Bottom Line
Securing a landlord subordination agreement is often a key hurdle for small business owners seeking financing secured by assets on leased property. While generally short in length, negotiating favorable terms for landlords and lenders can be challenging.Following the best practices outlined above allows both parties to craft an agreement that meets their core needs – landlords preserve key rights and lenders protect their collateral. By understanding the implications and key provisions, small business owners can be prepared to facilitate this important process in securing financing for their company.