Trap Doors Lead to Experience

They say when a business person makes a mistake or loses money they gain experience. I can attest to that during my 30+ years in commercial real estate. Fortunately, most of my experience has come from being a keen observer of other’s mistakes; although I’ve had some hands-on ‘experience makers’ too.

In our MasterguideTM lease negotiation training program we talk about a fairly common error built into leases. We call these Trap Door TM clauses/issues. That said, Trap Door issues are not confined to leases, as you’ll see.

A Trap Door issue occurs because of one or more of the following:

  1. An assumption made,
  2. A direct intent to deceive, and
  3. An industry ‘given’ when circumstances have evolved.

The last one is related to the first. It happens when a material evolution has occurred but common practice lags behind. Here is a perfect example contained in many commercial mortgage documents.

I became involved in a property comprised of a number of separate buildings with an existing, long-standing mortgage. Unfortunately, one of the buildings was completely destroyed by an arson fire. Financially, the building represented about 16% of the property income.

Although the owner had both replacement insurance on the building and income interruption insurance – effectively replacing the lost rent from the one building , a Trap Door issue arose due to the wording in the mortgage documents. The lender was an additional payee on the insurance. In the mortgage document, the lender could apply all insurance proceeds against the outstanding balance of the mortgage.

The mortgage wording seems reasonable when dealing with a total loss and by all accounts, that boilerplate wording hadn’t been reviewed for many years. It shouldn’t apply with the rise of the number multiple building projects, because it can cause a Catch 22 situation.

In this case, the debt service and the mortgage covenants were fully covered by the rental income from the property before the fire and could be sustained by the remaining income after the fire. The income interruption insurance further covered the payments until the planned rebuilding was complete. Notwithstanding this, the lender wanted to lay claim to all the insurance proceeds from both the income interruption insurance and the replacement value proceeds to pay down the mortgage principle; effectively, creating a double dip.

The money the owner was expecting to receive to rebuild was going to the lender instead and the income interruption proceeds would also go to the lender, pursuant to the mortgage wording. The lender’s solution to the issue was to offer to lend the amount needed to rebuild the affected building. This was not a good situation as the insurance proceeds would be interest free, whereas a new loan would increase the overall cost of debt on the investment. And the new loan was at a higher interest rate than the existing mortgage.

Additionally, the income interruption proceeds included the amount of the affected tenants’ prepayment contributions to operating expenses. Having all that go to pay down the mortgage would result in one of two things:

  • the balance of the tenants would see a substantial increase in their costs (simple math says 16%), or
  • To keep the existing tenants at the same cost level, the owner would be out of pocket for the same amount.

While we eventually resolved the issues with the lender, this was an experience builder.

Here are some take-aways:

Negotiate mortgage documents to mitigate similar issues in the future recognizing issues around partial destruction, multiple buildings and income replacement insurance.

Recognize that just because ‘it has always been thus’, doesn’t mean that the world is static. Build in as much future-proofing as possible into all contracts, documents and leases.

Issue resolution, such as this, is one of the services we provide. In addition we provide extensive lease and asset management training based on global best practices. Use the Contact Us form to learn more.

Posted in Asset Management, Landlord Related.