Securing rental income with a lockbox agreement

Lenders routinely collateralize commercial real estate loans by taking assignment of the rents paid by property tenants to the owner. Such an assignment can be an effective tool in capturing rents and ensuring they are applied to principal, interest, real estate taxes, insurance and property expenses. They are designed to prevent an owner from stripping rents from the property and leaving the lender and tenants without resources for maintenance and repair. Lenders, however, must be cognizant of the limitations of an assignment of rents and know the best way to implement one. In Illinois, an assignment of rents should be accompanied by a lockbox agreement, which is described in greater detail later in this article.

The rental income assignment

As a general rule, when a property owner grants an assignment of rents to its lender, the owner remains in possession of the real estate and is entitled to the rental income. The owner has no obligation to preserve the rents for the lender’s benefit. By recording its assignment, the lender perfects a security interest in the rents but cannot immediately enforce the assignment to collect rents. This distinction is critical when the owner becomes financially distressed.

To enforce an assignment of rents, the lender must take “possession” of the property, which requires affirmative action culminating in court authorization, such as appointment of a receiver or entry of a possession order. Prior to the lender obtaining possession, the owner may spend rental income on anything the owner chooses, whether or not related to the property. Generally, the lender has no recourse to recover the funds.

Distressed owners often avoid service of a complaint and utilize litigation tactics that delay entry of a receiver or possession order in favor of the lender. During that time, the loan balance increases and property managers and expenses go unpaid, which results in lost tenants and property deterioration. The lender must address these issues to mitigate losses.

If a property owner is subject to a judgment by a third party, an ensuing citation by the judgment creditor creates a lien against the rents that is superior to the lender’s assignment of rents. A judgment creditor can seize the rental income in the owner’s operating account and any rents due to the owner while in possession of the property. In such a case, several months can pass before a court grants the lender possession of the property. During that time, rents are applied to the third party’s judgment, not to the mortgage loan secured by the property. 

The components of a lockbox agreement

To better preserve rents, lenders can rely on a caveat to the general “possession” rule described above. The rule only applies where the lender and owner have not agreed to “otherwise” enforce the assignment of rents. One such agreement requires rental payments to be paid directly to a “lockbox” pursuant to the assignment of rents. A lockbox agreement directs property tenants to pay the rents to an account controlled by the lender and authorizes the lender to apply the rents to the amount due under the loan. It may include a provision that releases surplus funds to the owner. When such an agreement is in place, Illinois courts consider the assignment of rents to be “enforced” just as if a receiver were appointed or possession order entered. As such, the rents are no longer in “possession” of the owner and are beyond the reach of a judgment creditor’s citation.              

When properly crafted, assignments of rents and lockbox agreements can preserve rents for the lender as originally contemplated by the loan. They can also assist lenders in monitoring a property’s cash flow, alerting lenders to potential credit quality issues before borrowers disclose them.

As with all loan documentation and collection issues, contact one of Chuhak & Tecson’s experienced banking attorneys to determine the best course of action.     

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: Michael W. Debre, Associate