Real Estate Lenders’ Credit Analysis of the Leases


  1. Project Analysis. Prior to looking at specific leases, a real estate lender will review the rent roll, the condition of the property and the ease with which space can be leased in the project. The analysis of the project will focus on, among other things, the project’s location, related market conditions and, with respect to retail projects, the viability of the anchor tenants and the tenant mix.
  2. Lease Analysis
  3. Summary. While lenders have differing concerns for different types of projects, the following is a summary of the provisions in a lease which tend to concern lenders. Therefore, a landlord should keep these concerns in mind when negotiating leases to maximize the owner’s ability to finance (and/or sell) the project.   In addition, an owner should strive to maintain the overall consistency of the leases throughout the project, and if possible, confine all changes from the form to either interlineation or a typed addendum to enable the leases to be reviewed on an expedited basis.
  4. Term of Lease. A lender’s analysis of the value of a project will be based upon, in part, the existence of leases for minimum lease terms. First, the tenants’ obligation to pay rent must commence on an objectively determinable date (preferably as soon as possible). Second, if any lease has an early cancellation right, such early cancellation right will be taken into account by the lender in determining the value of the project. In some instances, this termination right can be exercised by the tenant upon the payment of a termination fee. In other instances, such a termination right may be granted in a shopping center lease if a certain percentage of the shopping center’s tenants close or if certain anchor tenants close. Termination rights are also often granted if the landlord fails to cure a breach of the lease within a specified period or fails to meet certain conditions with respect to: (i) the construction of tenant improvements, (ii) the construction of project improvements, or (iii) project lease up. In any event, a landlord should avoid granting early termination rights in order to preclude a lender from making “deductions” from the value of the project based on such early termination rights.
  5. Rent. Since a lender’s valuation of income producing property is largely determined by the rental income of the project, a lender will focus on the nature of the difference, if any, between the nominal rent and the effective rent payable under a lease. The effective rent payable under a lease will be less than the nominal rent if the landlord grants the tenant concessions such as: (i) free rent (which may be granted at the beginning of the lease term or at intervals throughout the lease term), (ii) tenant improvement allowances (at commencement and sometimes also at intervals throughout the term), (iii) reimbursement of moving expenses, or (iv) a buyout or assumption of the tenant’s pre-existing lease.

In a retail project, a lender will analyze the expected percentage rents payable under the leases. Such an analysis will include a review of: (i) the percentage rent rate, (ii) the breakpoint, (iii) the definition of gross income, and (iv) the exclusions from the definitions of gross income.

If the loan is long term, lenders like to see increases in base rent over time (typically step increases or increases based on the Consumer Price Index), and a pass-through of operating costs/common area maintenance expenses and real estate taxes. A lender will carefully review such clauses (especially the exclusions from operating expenses and whether the computation of the tenant’s percentage share is based upon the total leaseable square footage of the project or the total square footage of the project leased and open for business) to be sure that the landlord has the ability to pass through to the tenant all costs and expenses the landlord may incur in connection with the operation, maintenance, repair and replacement of the project, irrespective of any increases in inflation. This can be achieved in a net lease by having the tenants of a project pay all taxes and operating expenses. In a gross lease, the landlord can shift the inflation risk to the tenant by including an escalation clause which requires the tenant to pay increases in operating expenses and taxes over a defined base year.

A lender will frequently object to a provision which allows a tenant to cure defaults by a landlord and deduct from rent the costs incurred by the tenant in effecting such cure due to the effect on cash flow. In some limited instances, a lender may allow offsets with respect to required material repairs or the correction of building code violations so long as the lender has had prior notice of the need for such repair and a reasonable opportunity to effect such repair.

A lender will also object to a tenant’s ability to prepay more than one month’s rent. A lender does not want a troubled borrower to accept a year’s rent in advance at a discounted rate from a tenant only to have the borrower thereafter go into default.

  1. Use of Premises. In multi-tenant projects, a lender will pay particular attention to the use clauses to determine if any exclusive rights have been granted to any tenants of the project and, if so, whether there is a possible conflict with the other leases of the project. Even if there is no conflict, the existence of an exclusive use clause is troublesome due to the potential for defaults by the landlord and the additional scrutiny required with respect to new leases.

Some tenant oriented leases impose covenants on the landlord not to lease to a competing use or otherwise compete with the tenant within a specified distance of the tenant’s premises. Such provisions are often unacceptable to a lender.

  1. Tenant Alterations. A lender may object to a lease provision which allows a tenant to make any alterations without the consent of the landlord to the project’s structural elements, the project’s mechanical systems or any other material alterations to the project. Where a lease provides that alterations are subject to the landlord’s prior consent, the lender can protect the lender’s interest in the project by including a provision in the assignment of leases which gives the lender the right to have input on tenant alteration requests. A lender will also want the alterations clause of the lease to include provisions: (i) requiring the tenant’s contractors to maintain insurance, (ii) requiring the tenant to obtain lien waivers from the tenant’s contractors, and (iii) prohibiting alterations to one portion of the project which trigger code compliance work in other portions of the building.
  2. Landlord Covenants. Landlord covenants can be troublesome to lenders. First, the existence of an affirmative covenant of the landlord may increase the risk of a default by the landlord under the lease. Second, lenders do not want to have affirmative performance obligations in the event the lender forecloses and steps into the shoes of the landlord. Common landlord covenants include: (i) the obligation to make initial tenant improvements or tenant improvements at various intervals throughout the lease term, (ii) expansion space tenant improvement obligations, (iii) exclusive use provisions, and (iv) clauses setting forth prohibited uses in the project.
  3. Assignment and Subleases. Lenders want the leases to require the landlord’s consent to an assignment or sublease. The lender can protect the lender’s interest in the project by including a provision in the assignment of leases which requires the landlord to obtain the lender’s consent before the landlord approves any assignment or sublease. Generally, a lender will consent to an assignment where: (i) the assignor is not released from liability, (ii) the assignee will occupy the project for a use which does not violate an exclusive use granted to another tenant of the project, (iii) the assignee’s use is consistent with the other uses of the project, and (iv) the assignee has the financial strength, business reputation and managerial skill to be successful.
  4. Casualty and Condemnation. Perhaps the most important concern of a lender when reviewing the casualty and condemnation provisions of leases in a multi-tenant project is that these provisions must be consistent. If the lender takes over the project, it cannot be in a position of being obligated to repair the premises for only half the tenants upon the occurrence of a casualty while the other tenants’ leases terminate.

Most lenders include provisions in their loan documents which allow a lender either to use casualty insurance proceeds to pay down the debt or to disburse such insurance proceeds to the borrower to rebuild. In any event, a lender will rarely allow insurance proceeds to be used for rebuilding unless the lender is certain that the project will be substantially occupied after the completion of the reconstruction. Therefore, tenant termination rights under a lease upon the occurrence of a casualty or minor partial condemnation must be narrowly limited. With respect to a condemnation, a lender will want to be able to apply all of the proceeds to pay down the debt.

  1. Options. A lender will rarely loan on property which is subject to a prior option to purchase unless the tenant’s option rights are subordinated to the lien of the lender’s loan documents. Lease renewal or expansion options generally do not concern lenders unless a landlord has granted inconsistent option rights.
  2. Lender Modification Rights. Some leases contain provisions pursuant to which the tenant agrees to modify the terms and provisions of the lease upon reasonable request from the landlord’s lender. While it is difficult to convince a tenant to accept such a provision in a lease, such a provision enables the landlord to modify a lease to the extent necessary to secure financing.
  3. Limits on Landlord/Tenant Lease Modifications. A lender will be concerned that a landlord may: (i) modify a lease to reduce the tenant’s obligations under such lease, (ii) waive an obligation of the tenant, or (iii) accept more than one month’s advance rent. To protect itself, the lender will require, as condition of making the loan, that each tenant of the project execute a subordination agreement in which the tenant covenants to the lender that it will not engage in any of such actions without first obtaining the lender’s prior written consent.