White Paper: Critical Risks in Lease Terms

As the CMBS market returns, borrowers would do well to ensure their lease documents are structured appropriately and they are familiar with the most critical elements.

As the CMBS market returns, borrowers would do well to take special care to ensure their lease documents are structured appropriately and they are familiar with the most critical elements when entering into a deal or managing a property. That’s the advice from Zenobia Tambuvala, executive managing director of due diligence and underwriting, and Cheryl Clark Esq., director of lease and loan abstracting at Situs, providers of commercial real estate and loan advisory services and solutions.

“I think sometimes there’s a disconnect between what the borrowers think is important and what the lender thinks,” Tambuvala observed. The biggest risk is to midsize or smaller borrowers, she noted, since in the recent economy they have been financing property investments through local and regional banks, which require recourse. As loans are securitized through non-recourse CMBS pools, the priorities are different—in large part because they are driven by the all-important B-piece tranche buyer. And if a recourse loan is sold into a CMBS pool, the terms may be renegotiated in favor of the B-piece buyer.

When performing due diligence on a property, borrowers would do well to pay special attention to some particularly important areas of any tenant’s lease. The most critical areas where issues can be overlooked include the termination option, the ground lease if there is one, and in relevant states, taxation under Proposition 13. In the case of ground leases, for instance, most people know if one exists, Tambuvala noted; what they may not take into account is how rental rate increases can impact it. The ground rent on a 10-year loan in Hawaii, for instance, would reset to market rate—which could have a significant impact on income, she observed.

To help borrowers protect against such unpleasant surprises that can undermine their proceeds, Tambuvala and Clark produced a white paper delineating the most critical issues to consider and risks that can be incurred.