This is the fourth episode in our new series dramatizing lender interference under the due-on clause in a trust deed during periods of rising interest rates. The prior episode covers triggering the due-on clause in a trust deed on entry into a lease with a term over three years, or for any term coupled with an option to buy.

This episode covers triggering the due-on clause on a lease assignment or modification which extends the lease term beyond three years, or grants the tenant a purchase option.

The next episode covers triggering the due-on clause on a further encumbrance of a property or foreclosure by a junior lienholder.

When the due-on clause is triggered on an assignment or modification of a lease

An assignment by a tenant or modification by an owner of an existing lease does not trigger the due-on clause in a trust deed encumbering fee title, unless the owner:

  • modifies the lease by extending the term beyond three years; or
  • grants the tenant a purchase option.

For example, consider an owner of commercial real estate who enters into a lease agreement granting the tenant a ten-year term. After leasing the property, the owner refinances the property, recording a trust deed containing a due-on clause.

Later, the tenant assigns the lease to a new tenant when more than three years remains on its term. The owner approves the assignment as provided in the lease agreement.

Here, the due-on clause is not triggered by the lease assignment. The mortgage holder may not call the mortgage loan due since the due-on clause is not triggered by the tenant’s assignment of a pre-existing lease.

Further, the mortgage encumbers only the owner’s interest, which does not include the leasehold interest the owner previously conveyed and was owned by the tenant. The fee owner whose interest is encumbered by the mortgage transferred nothing.

The assignment by a tenant of a leasehold , senior or previously consented to by the lender, is not a transfer of any interest in the fee encumbered by the trust deed.

Now consider a landlord who releases the original tenant from all liability under the lease as part of an assignment and assumption of the lease by the new tenant. The remaining term on the lease is greater than three years. These things happen during recessions.

Here, the release of the original tenant from liability and an assumption of the lease agreement obligations by a new tenant constitutes a novation of the lease agreement. The result is a new agreement conveying an interest in the secured property to the new tenant by the owner of the fee. Since the novation included a lease term exceeding three years, the mortgage holder may enforce a call of the mortgage. [Wells Fargo Bank, N.A. v. Bank of America NT & SA (1995) 32 CA4th 424]

Thus, a new tenant’s assumption of the lease with a remaining term greater than three years coupled with a release of the former tenant from liability constitutes a present transfer of a fee ownership interest in the real estate to the new tenant since the assumption and release of liability constituted a novation which cancelled the original lease agreement.

Accordingly, a lease novation triggers the due-on clause when the lease has a remaining term of over three years or includes an option to purchase.

Typically, an owner of commercial income property wants long-term leases which run for more than three years. Here, the leasing periods have to be held to three years each, the initial term, and any options to extend the occupancy under a lease agreement.

Unless otherwise agreed by modifying the due-on clause when a mortgage is originated, the mortgage holder may call the mortgage when the leasehold period granted to the tenant is for more than three years, either initially or on exercise of an option to extend.