The Importance of the “Estoppel Certificate”:

Ensuring Positive Returns from the Purchase of Income-Properties

ABSTRACT

An Estoppel Certificate is a document typically used in performing due diligence prior to the purchase of tenant-occupied property.  The purpose is for a lender and purchaser to have written confirmation from tenants of certain terms.  Important amongst these are: the rental amount; security deposit; duration of lease, renewal options; and, as discussed further below, a “subordination” clause.

The subordination clause is used to confirm that the tenants have agreed, in their lease, that their interest is subordinate to future mortgages.  Without such confirmation, the tenants’ leases have priority over mortgages that are subsequently obtained.  Furthermore, only a tenant whose interest is subordinate to the mortgage can be evicted.  A purchaser (and their lender) may be stuck with tenants for an indefinite period without the ability to earn market rental values.  A tenant may be locked in for years, and potentially even forever—courts have upheld provisions giving the tenant the right to perpetual renewal of leases.

THE LAW

Prior Leases Have Priority over Subsequent Mortgages

Under CCP §1161a, only a tenant whose interest is subordinate to the mortgage can be evicted.[1]  A lease has priority over a mortgage if it was executed prior to that mortgage.

If a lease has priority over the mortgage, and there is no subordination agreement in that lease, the tenant has a complete defense to an action for eviction (as long as the tenant is not in default otherwise).[2]   In this situation, the purchaser acquires only a future reversionary interest in the land, subject to the lease.  In other words, the purchaser takes a deed of trust on leased property and acquires only a lien on the reversion.[3]  Furthermore, transfer of the interest conveys to the purchaser only the same reversion.[4]

The Bona Fide Purchaser Argument and Why to Avoid Having to Make It

If the lease was not recorded, a purchaser who subsequently records their interest could argue that the lease is not enforceable against them, as they paid valuable consideration and are a “bona fide purchaser.” A bona fide purchaser is one who pays valuable consideration, in good faith, and who records their interest.  Prior unrecorded and unknown interests are not enforceable against the bona fide or encumbrance.[5]  However, this is not an absolute defense, has a good chance of failing in the context being discussed, and the very least, leads to a messy factual dispute.

A bona fide purchaser must have purchased for value and must have purchased without knowledge or notice of prior interest.[6]  Furthermore, notice to an agent is notice to the principal.[7]

If there was any notice to the purchaser of the lessees’ interests, the lessees’ claims would be enforceable against the purchaser.  Notice can actual, implied, or constructive, making it highly likely that a purchaser did have notice of the lessees’ interests.  Actual notice, as the name implies, occurs when a purchaser was actually told that there are tenants with current leases.   Constructive notice occurs when the interests are recorded with the County.  In that situation, a purchaser need not have actually done a title search—if the interest is recorded, they are charged with knowledge of it.  As discussed below, even without actual or constructive notice, it is still likely that a purchaser will be charged with notice of all tenants’ interests.

Notice Implied by Use

Notice implied by use arises where a tenant visibly occupies a space.  A purchaser will be charged with knowledge of all information that would be revealed by a reasonable inspection of the property.[8]

Moreover, the minimum investigation under the law requires an inquiry of the occupant about his or her right to possession.[9]  Whether or not a purchaser actually questioned tenants about their rights is irrelevant.  The law requires that they to do so.

A tenant’s visible possession constitutes notice of his or her interest to a purchaser.[10]  The purchaser therefore takes the property interest subject to the possessory rights of the tenant.[11]  This includes notice of the tenant’s entire interest.  For example, in Claremont Terrace Homeowners’ Assn. v. United States (1st Dist. 1983), 146 Cal. App. 3d 3987, the Court determined that the possession of one unit in a condominium by the manager of the homeowner’s association was implied notice of the association’s unrecorded option to purchase the unit.[12]

Notice Implied by the Circumstances

Furthermore, actual use or possession of a property that is inconsistent with the record title is considered to be notice that the occupant may have some interest in the property.[13]  A purchaser is charged with knowledge of any inconsistencies between the record title and visible occupation.  In Claremont, supra, the occupation of a condominium unit by the manager of the homeowner’s association was held to be notice of the association’s unrecorded option to purchase the unit.  Claremont at 408-409.

Leases can Automatically Renew, Leaving you with Tenants Paying Less than Market Value

Leases may contain provisions which allow a tenant to renew a lease at their option (i.e., the landlord has no control over denying the renewal).  Courts have even upheld and enforced provisions giving tenants the right to perpetual renewal of leases.[14]  The preferred view seems to be that a perpetual renewal provision does not create perpetuities problems because the lease vests in all respects on its execution, and rights under it (although exercisable in the future) do not have the characteristics of a contingent or future estate.[15]  Even where courts have limited perpetual leases, they construe them to be limited to 99 years.[16]

CONCLUSION

Due diligence must be done prior to purchasing an income-property.  This includes a review of all agreements involved, including the purchase and mortgage documents.  Just as critical to ensuring that the property purchased does produce income is a thorough review of all tenants’ rights to the property.  The primary vehicle to do so is by obtaining comprehensive estoppel certificates.

[1] See, Rosenkranz v Pellin (1950) 99 CA2d 650, 222 P2d 249.

[2] See, Fahrenbaker v E. Clemens Horst Co. (1930) 209 C 7, 284 P 905.

[3] See, Fahrenbaker, supra.

[4] See, Calidino Hotel Co. v Bank of America Nat’l Trust & Sav. Ass’n (1939) 31 CA2d 295, 87 P2d 923.

[5] Civ.Code, §§ 1107, 1214, 1217 4; 2 Miller & Starr, Current Law of California Real Estate (1977) § 11:27, pp. 50–51;  4 Witkin, Summary of Cal. Law (9th ed. 1987) Real Property, §§ 205–209, pp. 411–414.

[6] See, Horton v. Kyburz, 53 Cal. 2d 59, 65 (1959).

[7] Civ. Code §2332.

[8] See, In re Weisman, 5 F.3d 417 (9th Cir. 1993).

[9] See, In re Sale Guar. Corp., 220 B.R. 660 (B.A.P. 9th Cir. 1998).

[10] Even a purchaser who does not live in the area is bound by implied notice.  See, Taylor v. Ballard, 41 Cal. App. 232, 238.

[11] See, Evans v. Faught, 231 Cal. App. 2d 698, 705-706 (1st Dist. 1965).

[12] See, Claremont at 408-409.

[13] See, Gates Rubber Co. v. Ulman, 214 Cal.App 3d 356, 366 (2d Dist. 1989).

[14] See, Fisher v. Parsons (1963) 213 CA2d 829, 29 CR 210; See also, Becker v. Submarine Oil Co. (1921) 55 Cal.App. 698, 700.

[15] See, Fisher, supra.

[16] See, Shaver v Clanton (1994) 26 CA4th 568, 31 CR2d 595.

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