FRIDAY, MAY 01, 2009
by William Cotter |
| William Cotter |
In these turbulent economic times, we have seen professional real estate investors face many challenges - a shriveled market of property buyers, commercial lenders vacillating from the wary to the disinterested and previously strong tenants struggling with new financial instability. All of these factors are interrelated, and owners have grappled with new strategies to buttress their investments. Clients realize that properties with cash flow deficiencies are subject to irregularities, both in pricing and in loan underwriting.
Nonetheless, properties with a strong and steady cash flow are always saleable and bankable, especially where lending on a project is based primarily on its income stream. Conversely, shortfalls or irregularities in that rental stream result in financing difficulties. Those shortfalls could exist for any number of factors, such as vacant space in the shopping center, looming terminations of office leases, or the burn-off of promised tenant concessions (such as free rent). Regardless of cause, any deficiency in the rent stream will be carefully weighed during a lender's underwriting analysis.
Where a project does have a shortfall, creative owners might offer, or a lender or buyer might require, a "master lease." In general terms, the master lease is simply a lease of all or some portion of a commercial project by a creditworthy "master tenant." This legal structure provides supplemental or secondary rent stream for the project. The master tenant will usually be the project owner, or an affiliate of the project owner (for example, a member in the owning LLC, or a subsidiary company). The obligations under a master lease are assigned to the lender as collateral.
Master leases are used in a couple of scenarios. The first uses the master lease as a credit enhancement for a property owner seeking to finance a commercial project. The second uses the master lease as a financial inducement to a buyer. In this second case, the master lease will naturally be assigned to the buyer's lender as additional collateral to support the buyer's acquisition financing.
Master leases come in many different shapes and flavors, but their common end-goal is to provide the rent stream necessary to support project financing. Some common variations on the master lease include:
- The master lease might cover premises that are the subject of a soon-to-expire lease. In this case, the master lease will only become effective if that expiring lease is not renewed by the existing tenant or let to a new tenant.
- Sometimes the master tenant leases the entire commercial property, and is then deemed to be subleasing space to tenants in occupancy of their space. In this way, the master tenant is the prime tenant as to the entire project.
- Alternatively, the master tenant may lease only the vacant space in the project. In this configuration the master lease typically terminates when the master-leased space is subsequently leased to third party tenants.
- Where a current tenant is still enjoying the benefits of a lease concession (e.g., free rent), a master lease can be formulated to cover only the rent abatement.
- Sometimes a "floating master lease" is used. This version covers only the project's vacant space but for a specific term (say, three or five years), so that the master-leased premises may change to cover the project's real vacant space at any time during the term.
- In the context of a property sale, a master lease can be used to fill the gap between actual rent and the rent that was used to establish the purchase price. In this case, the parties anticipate that the seller's rent subsidy should result in an enhanced or stabilized appraised value since the prevailing "cap" rate is applied to the property's subsidized net operating income.
In a project sale in which a master lease is a component, it will ordinarily be addressed in the purchase agreement. The agreement will require the seller (or its affiliate) to enter into the master lease at closing, and the form of master lease agreement is negotiated at that time. Sometimes the master lease is negotiated during the buyer's contractual due diligence period once it becomes apparent that credit enhancement may be required by the buyer's lender. A portion of the purchase price may be held back at closing and placed in escrow in order to secure the master tenant's payment obligations, with the remaining escrow funds being disbursed to the master tenant (or the property seller) if and when certain leasing or rental benchmarks are met.
Logically, the master lease gives the master tenant the right to procure commercially reasonable third-party tenants for the master-leased space. Accordingly, the master lease will often contain minimum leasing terms for such proposed leases, or will set forth a workable mechanism for the master tenant to present commercially reasonable lease proposals to the buyer. If the proposal meets the agreed economic and credit criteria, the buyer will be obligated to enter into a lease with the proffered tenant, and the master lease will abate or terminate.
Master leases usually create all of the rights, remedies and defenses provided to tenants under local landlord-tenant statutes. While a master lease in typical form creates a standard landlord-tenant relationship, the master tenant does not take possession of the master-leased space, and does not have responsibility for maintenance, repair or maintaining insurance. In the event of a master tenant default in its payment obligations, the owner would be required to institute eviction or similar proceedings in order to regain possession of the leased premises. This may be coupled with an action for the acceleration of rent or other damages under the master lease or as allowed by local law.
Furthermore, the owner may be bound by certain legal duties to mitigate damages or defenses requiring that sums owed to the owner be reduced by some discount factor. In addition, a master tenant could declare bankruptcy and take advantage of the lease rejection mechanism and the limitations on rental damages available under bankruptcy law.
All of this is obviously more complicated than simply requiring the seller (or owner) to provide a guarantee. Recognize that there have been cases in which courts have recast master leases as guarantees - specifically to honor the intent of the parties at the onset of the transaction. In those cases, the rights and remedies of the parties shift; advice of counsel in this regard is important.
A master lease is simply another tool for the creative property investor to consider when trying to put the best face on their project. Careful understanding of this strategy with the parties' counsel (and their accountants to understand the tax implications of their use) is important before finalizing the transaction.
William Cotter is a partner in the law firm Coman & Anderson, PC, in Lisle, Ill. The firm practices real estate law, tax and business law, and wealth transfer planning. You can reach Cotter by e-mail at WCotter@comananderson.com.More Articles
