Balancing Act: How SNDAs and Recognition Agreements Can Keep Your Lease or Sublease from Collapsing

Publication

The COVID-19 pandemic brought challenges to many commercial real estate asset classes, and downtown office properties were no exception. For example, the downtown Chicago office market showed a record 18% vacancy rate at end of 2020.[1] These vacancies have encouraged landlords to find creative ways to make up for lost rent and to attract new tenants. For example, some building owners and investors are seeking to designate their building or surrounding area as a Class L historic landmark or are exploring the benefits of properties located within an Enterprise Zone so that they can take advantage of tax credits, regulatory exemptions, and other incentives. Yet, while these programs and designations may help reduce the strain on landlords and potentially result in lower rents to tenants, new and existing tenants should also assess and proactively manage the risk of a landlord’s potential insolvency.

As vaccines continue to roll out and companies prepare to return to the office, tenants will have the option of leasing office space directly from landlords, or through the sublease market. In this tenant-friendly market, a tenant should consider requesting that a landlord and the landlord’s lender enter into a subordination, non-disturbance and attornment agreement, commonly referred to as an “SNDA,” and subtenants may want to request that prime landlords enter into recognition agreements.

SNDA

A Quick Overview

An SNDA is a tri-party agreement between a tenant, landlord, and landlord’s mortgagee under which the tenant agrees to subordinate its lease to the mortgagee’s lien in exchange for the mortgagee’s agreement to honor the terms of the lease if mortgagee forecloses on the property. In addition, the tenant also agrees that in the event the mortgagee forecloses on the property, the tenant will recognize the mortgagee as landlord and pay such mortgagee rent and any other amounts tenant is required to pay to landlord under the lease. In Illinois, an SNDA does not need to be recorded, but tenants should consider requesting that the SNDA be recorded because it provides constructive notice to third parties of the existence of the lease and therefore affords the tenant an additional layer of protection.

If the mortgage predates the lease and the lender forecloses without an SNDA in place, the lender can either reject the lease and require the tenant to vacate the property, or recognize the lease and perform as landlord. An SNDA eliminates this uncertainty for tenants.

I am a Tenant and this Sounds Great – How do I Get One?

Existing tenants should dust off their lease files to determine if an SNDA was negotiated and obtained at the time of execution of their lease, or if a landlord is required to obtain an SNDA pursuant to the terms of the lease. New tenants should attempt to negotiate into their term sheet with a potential landlord an obligation for a landlord to obtain an SNDA from their lender in connection with tenant executing the new lease. This request should be made when tenant is negotiating its term sheet and lease because landlord’s mortgagee has little incentive to agree to one after a lease has been fully executed.

Note, however, that lenders may be reluctant to enter into an SNDA with tenants leasing only a small space because the SNDA could make it harder for the lender to sell the property after foreclosure. Generally, tenants that lease more space will have more success convincing a potential landlord to obtain an SNDA for them in connection with a new lease.

Can Tenants Negotiate a Lender’s Form of SNDA?

Yes, but the question is to what extent. Lenders will typically negotiate their form SNDA depending on the importance of the tenant to the overall asset (based on factors such as the length of the lease term and size of the premises). Typical negotiated provisions include whether mortgagee will be required to complete any outstanding construction, recognize a tenant’s ability to offset rent pursuant to the terms of the lease, pay any remaining improvement allowance, pay casualty proceeds, or recognize tenant’s security deposit.

Recognition Agreements

A Quick Overview

Just as an SNDA provides certainty to a tenant that a tenant may remain in its premises after a landlord has failed to perform under its loan, a recognition agreement provides assurance to a subtenant that it may continue to operate in its premises if its sublandlord defaults under its lease with the owner of the building. More specifically, a recognition agreement is a contract between a subtenant and a prime landlord under which the prime landlord agrees to recognize the subtenant and the sublease if the tenant/sublandlord defaults under the prime lease and the prime landlord terminates the prime lease. If triggered, the sublease effectively replaces the prime lease for the duration of the sublease’s term. Importantly, while a recognition agreement will protect the subtenant if the tenant/sublandlord defaults, it will not protect the subtenant if the prime landlord defaults under its mortgage. Lenders rarely agree to enter into SNDAs with subtenants, but for a subtenant with enough negotiating leverage, an SNDA would provide an added layer of security to protect against this risk.

Who Benefits?

A recognition agreement benefits both subtenants and tenants/sublandlords. A tenant/sublandlord may appreciate a recognition agreement because, in many cases, if the tenant/sublandlord defaults under the prime lease, their liability is mitigated once the landlord finds a new tenant. Entering into a recognition agreement serves to effectively cap the tenant/sublandlord’s potential exposure by ensuring that another tenant will immediately take over the space if the prime lease is terminated.

Prime Landlord Considerations

While recognition agreements are an important tool for subtenants, a prime landlord may be reluctant to agree to one, particularly if the sublease is for less than the tenant/sublandlord’s entire space as the prime landlord may lose some flexibility in reletting the space. This is especially true if the landlord needs to reconfigure the floor plan or provide alternate access to accommodate both the subtenant and any new tenant. Further, if the prime landlord agrees to a recognition agreement, it will be required to honor the negotiated sublease terms. If a tenant/sublandlord agrees to under-market terms (which is especially possible given the ongoing pandemic), the landlord is stuck with those terms. If the prime landlord believes it could lease the subleased space on better terms, it may be less inclined to enter into a recognition agreement. On the other hand, a recognition agreement gives a landlord some additional certainty that if its tenant defaults, it will continue to have a revenue stream.

Thus, whether leasing or subleasing new office space or renegotiating existing arrangements, tenants should consider seeking SNDAs and/or recognition agreements as important protections in this challenging and uncertain market.

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[1] Danny Ecker, COVID pushes downtown office vacancy to record high, Crain’s Chicago Business (January 13, 2021).