December, 2006

Master Leases In Financing Transactions


Financing a commercial real estate project based on its rental stream brings many challenges for a property owner. Deficiencies in that rental stream only increase these challenges, whether the deficiencies arise from vacant space, scheduled lease expirations, tenant concessions (such as free rent) or other lease attributes that are scrutinized in the lender’s underwriting process. Some lenders seek to have perceived rental deficiencies covered by requiring a “master lease”.

A master lease is a lease of all or some portion of a commercial project signed by a creditworthy master tenant to provide an additional or back-up rental stream for the project. The master tenant is typically a principal or affiliate of the borrower entity owning the project, which is the landlord. The master lease is assigned to the lender as collateral.

Master leases can be structured in many ways, but their common purpose is to provide the income stream necessary to support project financing. Some common structures include:

The master tenant leases the entire project, and is deemed to be subleasing space to tenants in occupancy of their space;

The master tenant leases specific vacant space only, and the master lease terminates with respect to space later leased to tenants in occupancy;

The master lease covers only the vacant space in the project from time to time, so that the master premises “float” to coincide with actual vacant space;

The master lease covers specific space covered by a lease with an upcoming expiration, and takes effect only if that lease is not renewed or the space re-leased;

The master lease covers space leased to a tenant currently paying no rent due to a rent abatement period, but only during such period.

If the master lease was given as credit enhancement for the loan, in the event of the owner’s default, the master lease performs the same function as a guaranty. The lender is looking to the master tenant as a secondary source of recovery after the lender has foreclosed on the project. At that point, the new landlord – the lender or other successful bidder at foreclosure – would seek to collect rent payments due under the master lease as a source to recover its investment.

As explained below, upon court scrutiny a master lease may be treated as a disguised guaranty of the loan. Whether a master lease is treated as a true lease or a guaranty will have significant implications to both the master tenant and the lender.

Recharacterizing a Master Lease

Under certain circumstances, courts will not honor the form in which a transaction has been documented if the true intent of the parties was a different type of transaction with different legal results. The decisions in these types of cases rely very heavily on the individual facts of each case, and the analysis applied by courts varies from state to state.

However, legal scholars widely believe that courts in many states would have no trouble coming to this result if requested by the master tenant. Questions a court must address include:

Was the master lease a condition to the lender making the loan?

Is the master tenant a party who might otherwise have given a guaranty?

Does the rent called for under the master lease produce just the amount of project income necessary to meet the lender’s underwriting standards?

Did the master tenant never occupy the property?

Did the lender treat space leases as direct leases to the borrower rather than as subleases?

If the answer to some of these questions is “yes” the master lease may be treated as a guaranty. Alternatively, if these facts do not appear and there is an independent business purpose for the master lease which is on market terms, the master lease should be treated as a true lease. Many master leases will fall into the gray area between these extremes, and it is hard to predict how they will be treated.

Master Lease as a True Lease

The difference between treating a master lease as a true lease and a disguised guaranty can be very significant. When a master lease is viewed as a true lease, the lender’s recourse to the master tenant is analyzed in the same way as its recourse to any project tenant. The lender’s collateral will include an assignment of all project leases and rents. Following the borrower’s default, in many states the lender will be entitled to appoint a receiver to run the project and collect rents until the lender can hold its foreclosure sale. Prior to foreclosure, the receiver may enforce the master lease, and after foreclosure the successful foreclosure bidder becomes the new landlord under the master lease, entitled to enforce its terms. If the master tenant does not pay its rent upon demand by the receiver or new landlord, it will be in default under the master lease.

In many states, the remedy for landlords to collect rent from tenants in default is to terminate the lease and sue the tenant for delinquent rent and future rent through the end of the lease term. Each state has its own rules for determining what the landlord may collect for delinquent and future rent, and the duty of a landlord to mitigate its damages by seeking a replacement tenant.

Assuming the master tenant is in default under the master lease, a lawsuit against the master tenant seeking to collect these amounts generally could be commenced any time after a receiver is appointed or a foreclosure sale is held.

Master Lease as a Disguised Guaranty

If a court determines the master lease should be recharacterized as a guaranty, it will rewrite the master lease to follow what it believes was the true intent of the parties. The first question the court must face is determining the amounts guaranteed. Assuming the master lease was signed to provide sufficient income to service the loan, a natural conclusion would be that the master lease constitutes a guaranty of debt service up to the amount of rent called for under the master lease. The guaranty might also cover payment of taxes, insurance and any common area maintenance charges at the project.

The lender would be entitled to demand the master tenant pay the guaranteed amounts, and if not paid the lender would bring a lawsuit to enforce the “guaranty.” Guarantors generally have various defenses to guarantees, known as “suretyship defenses.” While most guaranty documents provide waivers of these defenses, a master lease would not normally contain these waivers. The master tenant may be able to raise suretyship defenses, which generally include the right to require the lender to first exhaust the lender’s remedies against its collateral (the project) and the borrower before seeking recovery against the master tenant.

Some lenders attempt to address this problem by including suretyship waivers in the master lease document. This should assist in enforcing the master lease if it is recharacterized as a disguised guaranty. However, this language in a master lease would clearly show that the parties were cognizant of this risk and may be used as evidence that the parties intended a guaranty rather than a true lease. Both the benefits and risks of including guarantor waivers in a master lease should be carefully considered.

Effective Use of Master Leases

A master lease can be an effective tool for a commercial property owner to enhance its financing opportunities. Whether this legal obligation should be structured as a master lease or a guaranty of cash flow or debt service should be carefully considered by the borrower and lender, with the advice of counsel. In most cases there will be a structure that meets the needs of both parties, and this can be implemented while minimizing the risk of later recharacterization by a court and the unintended results that follow.