Landlords Beware: Subordination Agreements

In the recent Arizona Court of Appeals case Earle Investments, LLC v. Southern Desert Medical Center Partners, 762 Ariz. Adv. Rep. 12 (2017), the Court of Appeals addressed the question of the scope of a subordination agreement signed by the property owner (Lessor/Landlord) at the request of the Lessee/Tenant and Lessee/Tenant’s Lender.  In general, by subordination, Party No. 1 with a higher/better lien priority agrees to allow Party No. 2 (usually a lender providing construction funds for the overall betterment of the property) to get a lien position in front of Party No. 1.  Party No. 1 presumably believes the switch of lien position in return for someone else paying for the property improvements will benefit Party No. 1 in the long run by resulting in an increase in the value of Party No. 1’s position.

The crux of the dispute was what rights the owner had subordinated to the Lender (i.e. giving the Lender priority above the owner).  The owner argued that it had only agreed to give the Lender priority over the owner to receive the rents from the Lessee if the Lessee defaulted on the loan.  The purchaser at the foreclosure sale (aka Trustee’s Sale) argued that the owner had subordinated its ownership rights (meaning that if the Lender foreclosed, the Lender would not only have first priority to receive the rents, but could foreclose on the owner’s entire fee ownership interest).  Although the document signed by the owner was entitled “Subordination Agreement,”  the court held that the Subordination Agreement effectively served as a Deed of Trust whereby the owner provided its fee title interest to the Lender as security for the loan made by the Lender to the Lessee.  As a result, the court held that when the Lessee defaulted, and the Lender foreclosed, the Lender not only foreclosed on the owner’s right to receive the lease payments, but foreclosed on the owner’s fee title interest altogether, thus wiping out the owner’s entire interest in the property.  So the lesson is this – beware of the precise language in a subordination agreement.