What a Waste! what’s a Prudent Lender to do?

• Author: Marsha Baumgarner; Michael Hentrel
• Position: Vice President and Deputy General Counsel to Fannie Mae/Associate General Counsel to Fannie Mae
• Pages: 05

The views presented in this article are the views of the authors and are not necessarily the views of Fannie Mae or its Conservator.

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In the midst of the deepest housing and credit crisis in decades, multifamily lenders and owners must equally face some tough decisions. In a typical multifamily mortgage transaction, the lender has two equally important, but sometimes competing, issues to manage: timely payment of the debt, and maintenance of the revenue producing property as collateral, the primary driver for multifamily loan transactions. In a perfect world, landlord/borrowers would be able to pay debt service and maintain the property in pristine condition thereby maintaining or increasing the value of the lender’s collateral. How ever, in a down market with less capital available, borrowers must often choose between servicing the debt and maintaining the property.

Some examples are helpful in illustrating this dilemma. First, consider the effects of a property owner in a cash-flow crunch tearing out functioning appliances from vacant units to replace non-functioning appliances in occupied units. What happens if that property owner never replaces the non-functioning appliances and subsequently defaults, causing the lender to foreclose? How does the lender get the cannibalized appliances replaced? Now, imagine a property owner bulldozing buildings in preparation for redevelopment of a property and the redevelopment sputters before anything is built. Is the lender stuck with a bulldozed lot at foreclosure?

These are just two examples of the real challenges faced by multifamily lenders. How does a typical nonrecourse lender protect both its income stream (debt service on the loan) and the value of the collateral that generates that stream (the property) when waste has been committed on the property? The fact that most multifamily borrowers are single asset entities (mostly limited partnerships or limited liability companies) with the property being the only asset adds to the challenge. The first part of this note will discuss the general concept of waste. The second part will discuss some of the various approaches regarding a mortgagee’s standing to sue for waste and the remedies associated. The third part will discuss specific issues in nonrecourse transactions and possible contractual solutions that protect the lender’s standing and remedies.

I Waste defined

“Waste” is defined as any act or omission that causes lasting damage or permanent loss of the fee or that destroys or lessens the fee’s value.¹ More specifically, waste is an act or omission by one in rightful possession of land who has less than a fee simple interest in the land, which decreases the value of the land or the owner’s interest or the interest of one who has an interest in the estate that may become possessory at some future time.² There are three elements essential to a cause of action for waste: (1) there must be an act or omission constituting waste, (2) the act must be done by someone legally in possession of the property, and (3) the act or omission must harm the estate or the interest of another in the property.³

Under the law generally, there are three kinds of waste: voluntary waste, ameliorative waste, and permissive waste. Voluntary waste is a deliberate and intentional change made to thePage 11 property that harms the property or diminishes its resources, unless such use is a continuation of a current use.⁴ Under generally established common law principles, owners have a duty to avoid committing waste and an obligation to surrender the premises in the same condition as when the tenant took possession of the premises, normal wear and tear excepted.⁵ In the United States, it is generally accepted that a tenant may “make changes in the physical condition of the leased property which are reasonably necessary in order for the tenant to use the leased property in a manner that is reasonable under the circumstances.”⁶ In other words, the reasonableness of the use is determined by the agreement between the parties and the prior use of the property. To the extent that the parties contemplate a particular use of the property, the presumption is that they are implicitly agreeing that all of the ordinary incidents of that use are reasonable.⁷ For example, if the property contains a coal mine and the parties agree to this use, a tenant can continue to mine the property for all of its coal without committing waste. Conversely, if the land was leased as a goat pasture, the tenant’s use as a coal mine would constitute waste.

“Waste” is defined as any act or omission that causes lasting damage or permanent loss of the fee or that destroys or lessens the fee’s value. More specifically, waste is an act or omission by one in rightful possession of land who has less than a fee simple interest in the land, which decreases the value of the land or the owner’s interest or the interest of one who has an interest in the estate that may become possessory at some future time.

Ameliorating waste is an improvement or modification to the property that changes the nature or character of the property. In most cases, such an improvement or modification actually increases the current value of the property.⁸ In the United States, a landlord cannot generally recover damages for ameliorating waste as the common law seeks to promote improvements to unproductive property.

Under the definitions provided above, it is obvious that an “act” by the owner or tenant can constitute waste. For example, if a tenant rips out appliances and fixtures upon vacating the premises, it is a clear act of waste. However, common law and some states have expanded the definition and the cause of action to include instances where the owner or tenant neglected to act in such a way to preserve the property.⁹

Permissive waste is an intentional or negligent failure to maintain the property physically or otherwise—it does not require a bad act on the part of the tenant.¹⁰ Permissive waste is actionable in the same way as active waste, because both can hinder and diminish the value of the real estate.¹¹ Thus, passive situations in which the tenant is not paying expenses he or she is responsible for or is not maintaining the property in a reasonable manner constitutes permissive waste. For lenders on multifamily properties, permissive waste is the most challenging type of waste to address.

Once a tenant or owner is found liable for waste, there are three main remedies. The court may require the defendant to pay monetary damages to the injured party to compensate for the loss...