Editor’s Note: Justin M. Lewis is a member of the Real Estate Practice Group at Ward and Smith, P.A.

Imagine the following scenario. You spend weeks, maybe even months, negotiating a long term lease for your new business premises. Your lawyer carefully searches the public records and determines that the landlord has a mortgage on the premises (which, if foreclosed upon, would invalidate your lease), but has not leased the premises or otherwise granted rights to the premises. You eventually reach an agreement with the owner of the premises; sign all the necessary paperwork; obtain a subordination agreement from the landlord’s mortgage company agreeing that if the mortgage is foreclosed, your lease will be honored; and settle into your new premises. You make your rental payments when due and comply with all the other terms and provisions of the lease. Then one day you receive a letter from someone claiming to be the new owner of your premises, and demanding that you vacate immediately. Are you legally obligated to vacate even though you have a lease? The answer is yes, if you don’t record your lease (or more commonly and for the reasons explained below, a memorandum of your lease signed by your landlord).

Leases for a Term of More Than Three Years Must be Recorded

Most businesses, big and small, lease their premises for many years at a time. These businesses can find themselves in a very awkward and unpleasant situation if they do not adhere to two simple rules: (1) search the public records prior to executing a lease to determine if anyone other than the landlord has rights to the premises, and, (2) immediately record the lease or a memorandum of lease in the public records if the term of the lease is for more than three years. A lease with a term of more than three years must be recorded (sometimes referred to as "registered") in the office of the Register of Deeds of the county in which the leased property is located in order to be valid against and establish priority ahead of lien creditors, subsequent tenants, or subsequent purchasers of the landlord’s property. The purpose of this rule is to give notice to such parties that the property is encumbered by a lease so that they can act accordingly.

In North Carolina, the first one to record a document in the office of the Register of Deeds that conveys, or evidences the conveyance of, an interest in the property prevails over others claiming rights in the same property, including those who may have obtained their interest in the property first but failed to record their deed or lease. Under North Carolina law, even actual notice of other interests in a certain property does not matter. All that counts is priority in recording. In this regard, North Carolina is unlike most states where a person’s actual notice of another’s interest in a property, such as a lease, prevents the person with notice from obtaining a superior interest in the property.

As a result, in North Carolina, you must record your lease or a memorandum of it as soon as possible after the lease’s execution in order to establish your priority.

What Can Happen If You Don’t Record?

If your lease has a term of more than three years and you do not record it (or a memorandum of it), and your landlord later conveys or leases the property to a person or entity who promptly records the new deed or lease, the new owner or tenant may require that you either vacate the premises or negotiate a new lease on terms acceptable to the new owner or tenant which may be considerably less favorable to your business than the terms in your original lease. The same result will apply if your landlord has a lien filed against the leased property and the property is sold to pay the lien. The purchaser at the sale will have the same right to demand that you vacate or negotiate a new lease.

The Importance of Recording in Troubled Economic Times

Recording is important in the best of times and is even more important in the worst of times. In difficult economic times, there is an increased risk that your landlord will have liens filed against the property or file for bankruptcy protection. In fact, the more favorable your lease terms are to you (perhaps because your lease was made many years ago and the rent is now below market), the more likely the landlord will experience financial difficulty. A bankruptcy trustee is entitled to the status of a lien creditor and a purchaser for value. Therefore, if you have not recorded your lease or a memorandum of it, the bankruptcy trustee can terminate your lease or force you to renegotiate it in order to increase the value of your landlord’s bankruptcy estate.

Why Record a Memorandum of Lease Rather Than the Lease Itself?

There are two reasons why recording a memorandum of lease is preferable to recording the actual lease. First, the actual lease will contain financial terms and conditions, such as the amount of rent, concessions, guaranties, and other information, that one or more of the parties to the lease do not want on the public record for all to see. Second, most well-drafted long-term leases are lengthy, and it costs money per page to record documents. For these reasons, most landlords and tenants agree in their leases that they will execute a much shorter memorandum of lease. Among other matters, a well-drafted memorandum will contain such things as the names of the parties; a legal description of the leased premises; the maximum length of the term of the lease, including extensions; provisions that affect the real property on which the leased premises is located or other real property of the parties, such as provisions that the landlord will not lease any other portion of the property on which the leased premises is located or within a set distance from that property (a so-called "exclusive" which prevents the landlord from harming the tenant by leasing adjacent or nearby property to a competitor of the tenant); and any other rights regarding real property such as an option or right of first refusal to purchase the leased property.

The Only Alternative to Recording – A Claim Against Your Original Landlord

If, unfortunately, you find yourself in a situation where your lease has been rendered invalid because of the lack of recording, you still may have a claim against your original landlord. As mentioned above, the purpose and effect of recording is to provide notice of your lease rights to third parties, but such notice is not necessary to retain your rights against the landlord with whom you originally contracted. Depending on the specific terms of your lease, it is possible that you could recover on a variety of claims against your original landlord, including a claim for damages based on the amount of additional rent you will have to pay under terms of a new lease or for business lost because you have had to relocate your business.

However, any such recovery will be reduced to the extent you do not make a sufficient effort to mitigate your damages. In this regard, one North Carolina appellate court judge has suggested recently in an opinion that not recording a lease or memorandum of lease may, in and of itself, constitute a failure to mitigate damages, or at least negatively factor into the amount of damages awarded.

Regardless, if you are reduced to seeking a monetary recovery in such an action, you will devote hours of time and a substantial amount of money to a lawsuit when you could have devoted this time to your business by simply recording your lease or a memorandum of it.

Conclusion

The lesson is simple: If you enter into a lease for a term of more than three years, make absolutely certain that your lease or a memorandum of it is recorded in the office of the Register of Deeds in the proper county. Recording will provide protection against a dishonest or financially crippled landlord and purchasers and subsequent tenants of the property you have leased. This simple action of recording a document with the Register of Deeds may save you money, time, and maybe even your business in the future.

© 2008, Ward and Smith, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Justin M. Lewis practices in the Real Estate Practice Group where he concentrates his practice in commercial real estate, leasing, and community association law. Comments or questions may be sent to jml@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.