In legal terminology, subordination gives one legal arrangement priority over another. When a property has two mortgages, for example, the second mortgage usually is subordinate to the first. This means that in foreclosure, the first lender has priority to be paid. Commercial leases often contain a subordination clause stating that the rights of the tenant are subordinate to the rights of any lender whose mortgage affects the property.
At any one time, multiple people may have the right to own and use a property in various ways. So, a landlord may own real estate and at the same time a bank may have a mortgage over it and a tenant the right to live in it pursuant to a lease or rental agreement. Each party has a slightly different interest in the property. Usually, these different interests co-exist without difficulty.
First Come, First Served
The problem comes when one party tries to enforce his rights, such as when the bank tries to foreclose. Broadly, real estate law applies a first-come, first-served principle. Whichever party records an interest in the property first has priority over the other parties. So a tenant whose lease came before the mortgage could argue that his right to live in the property takes priority over the bank’s right to foreclose. In theory at least, a pre-existing tenant could block a foreclosure.
Subordination clauses, like the one commonly found in commercial leases, protect the bank's interests. Tenants who sign them agree that the landlord may refinance the property at some future date and that the refinance lender has first call on any claims affecting the property. Consequently, if the landlord does not pay the mortgage, the bank can terminate the lease and sell the property. A subordination clause might lead to a tenant being evicted before the end of the lease term.
Do Not Disturb
Tenants concerned about eviction may refuse to sign a subordination clause. However, such a refusal may be counterproductive. Many lenders won't refinance a property if there's a chance they'll be stuck with an unprofitable lease -- and a landlord who can't refinance may lose the property to foreclosure anyway, causing all sorts of problems for the tenant. One alternative is signing a subordination and non-disturbance agreement. This states that a foreclosing lender will let the tenant stay in the property for the remaining lease term, as long as the tenant continues to observe the lease.
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer specializing in finance and tech. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.