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September 28, 2016

Best Practices: Existing Third Party Tenants and EPC/OC Leases

by Victor A. Diaz

Generally, SBA loans are made to operating businesses. An exception are loans made to Eligible Passive Companies (“EPCs”), those that use loan proceeds to acquire, and/or improve or renovate real or personal property (“Project Property”) leased to one or more Operating Companies (“OCs”) for conducting the OC’s business. (13 CFR 120.111). The EPC/OC rule, which allows loans to finance assets held for passive income, requires the existence of a lease between the EPC and the OC.

In the abstract, the requirements of the lease are simple and straightforward. There must be a lease between the EPC and the OC. The lease must be in writing, subordinated to the lender’s lien instruments for the term of the loan, and it must be for 100% of the Project Property. SOP 50 10 5(H), Subpart B, Chapter 2, Paragraph III.F. and Subpart C, Chapter 2, Paragraph III.F. In reality, this last requirement (that the lease be for 100% of the Project Property) can be difficult to achieve when the loan is for the acquisition of improved real property with existing third party tenants. While the SOP provides guidance when there are existing mineral leases, there is an absence of similar guidance when dealing with existing third party tenants who have the right to occupy a portion of the Project Property.

In those cases, as part of the conveyance of real property, the seller must also assign all interests in existing third party leases to the buyer. When the buyer is an EPC, the assignment of an existing third party lease to any EPC would violate the EPC/OC rule, making the SBA loan ineligible! Accordingly, the best practice is to convert the existing third party tenant lease into a sublease of the EPC/OC lease with the consent of the tenant and its affirmative subordination of the lease to the lender’s lien instruments. The sublease goes directly from the OC to the third party tenant.

Although in the majority of cases third party tenant leases are assignable without the consent of the tenant, convincing a tenant to convert its existing lease into a sublease and subordinate it to the lender’s lien is a different matter altogether and no simple task. It can become a lengthy, complicated negotiation process and may come at a price, for example, the promise of non disturbance from the lender. From my experience, existing tenants who are asked to subordinate and convert their leases into subleases will invariably want the lender to ensure that their tenancies will not be disturbed. Under a subordination, non-disturbance and attornment agreement (“SNDA”), the lender recognizes the sublease and agrees to refrain from disturbing the tenancy if the subtenant is not in default; at the same time, the third party tenant agrees to attorn (acknowledge) the lender’s superior rights in its lien instruments and thereby subordinates its interest in the sublease to the lender. This is significant because, when coupled with other occupancy requirements of SBA loans, the lender may be saddled with undesirable tenants occupying up to 49% of the project property who it has promised not to disturb.

For the foregoing reasons, it is incumbent upon the lender to identify existing third party tenants early in the loan underwriting process and begin negotiations promptly in order to avoid last minute delays and hasty decisions at the time of closing.

For more information on existing third party tenants and EPC/OC leases, contact Victor at 407-667-8811 or via email vdiaz@starfieldsmith.com.