Nancy Little a/o 7/18/2005 (00012451.DOC;1)



Financeable Ground Leases: An Overview

Nancy R. Little

McGuire Woods LLP

One James Center, 901 E. Cary Street

Richmond, Virginia 23219

Ph.: 804.775.1010

Fax: 804.698.2101

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Introduction. Most lenders will accept a ground lease as a part of the collateral package as long as the ground lease is “financeable.” A “financeable” ground lease either provides for “subordination” of the landlord’s fee interest or contains provisions to protect a leasehold mortgagee from certain risks associated with loss of the leasehold interest as a result of the termination of the ground lease. Although a “subordinated fee” is less common, there are situations in which a ground lessor will be willing to partially or fully “subordinate” or subject its fee interest in the land to the lender’s mortgage. In that case, however, there will be certain protections against loss of the fee interest that the ground lessor will want from the lender. For a leasehold mortgage, the lender will require certain mortgagee protections in the ground lease to feel comfortable that it is not at risk that the ground lessor will terminate the ground lease on which the leasehold mortgage is predicated if the ground lessee defaults in the performance of its obligations under the ground lease or the ground lease is otherwise terminated.

Perspectives.[1]

Lender. In order to lend on collateral that includes a ground lease, the lender must have a subordinated fee mortgage from the landlord or a leasehold mortgage based on a ground lease that permits the lender to foreclose on the ground lessee, including the ground lessee’s leasehold interest under the ground lease, and to manage and/or dispose of the collateral following foreclosure. The lender is at risk of losing its investment if the ground lease is terminated before the loan is repaid in full as a result of expiration or early termination of the ground lease. Therefore, the lender wants adequate protections in the ground lease, such as notice of the ground lessee’s default and cure rights, in order to avoid early termination.

Ground Lessee. The ground lessee is concerned with the ability to finance construction of its improvements and subsequently refinance the property, if necessary. The ground lessee is also concerned with financeability in the event of a sale of the property because the buyer may need or want to obtain financing secured by the property. Therefore, the ground lessee as well as the lender, wants to be sure that the ground lease is financeable.

Ground Lessor. The ground lessor is willing to entertain certain mortgagee protections in the ground lease, and possibly subordination of its fee interest, in order to facilitate the ground lessee’s development of the land from which the ground lessor expects to derive revenue. However, the ground lessor wants to minimize the likelihood that it could lose its fee interest in the property in the case of a subordinated fee. In the case of a leasehold mortgage, the ground lessor wants to limit the extent to which the lender can restrict the ground lessor’s exercise of its remedies if the ground lessee defaults under the ground lease. Consequently, the ground lessor’s concerns may be at odds with those of the lender and the ground lessee who need the ability to finance based on the leasehold.

Subordination of the fee.

General. “Subordination of the fee” is a bit of a misnomer because the concept really involves the ground lessor’s joinder in the mortgage for the purpose of subjecting its interest in the property to the lien of the mortgage and permitting the mortgagee to foreclose not just on the ground lessee’s leasehold interest but also on the ground lessor’s fee interest in the property. The ground lessor is not obligated to pay the debt or to pay or perform any of the other obligations of the ground lessee/borrower under the loan. However, in the event of a foreclosure by the lender, the ground lessor could lose its interest in the property. As a result, the ground lessor may negotiate with the leasehold mortgagee for certain rights, such as notice of default under the loan by the ground lessee/borrower and a right to cure such loan defaults.

Subordination of Fee by Ground Lessor. Certain ground lessors, such as governmental entities, may be prohibited from entering into subordinated fee mortgages. However, other lessors may be willing to do so to obtain higher rents and/or to encourage development of adjacent property in which the ground lessor has an interest, but subject to such protections as the ground lessor may be able to negotiate with the lender. Subordination of the fee may also be a possibility if the ground lessor and ground lessee are affiliates or venture partners.[2]

Enforceability of Agreement to Subordinate. Even if the ground lessor has agreed in the ground lease to subordinate the fee, there may be issues as to the enforceability of the agreement to subordinate in the event of a recalcitrant ground lessor. The intent of the ground lessor to subject its fee interest in the property to the ground lessee’s mortgage should be clearly written into the ground lease. Vague or general agreements to “subordinate” the ground lessor’s fee interest may not be enforceable.[3]

Partial Subordination. The ground lessor may be willing to “subordinate the fee” only during the construction phase or, conversely, only for a permanent loan, depending upon the circumstances. For example, the ground lessor may be willing to encumber its fee interest to facilitate the development of the property but may require a release of the fee interest upon completion of the project. Alternatively, the ground lessor may be willing to forego receipt of all or part of the ground rent for a period of time (e.g., until the lender is repaid).[4]

Conditions to Subordination of Fee. The ground lessor may also impose conditions and/or demand involvement in the development process in order to protect its fee interest. Fee owner protections, such as approval rights, may be burdensome to a ground lessee in trying to expedite development of the project. However, such rights may help the ground lessor protect itself. The ground lessor may impose a cap or limit on the amount of the loan (e.g., the ground lessor will subordinate the fee but only if the loan does not exceed some percentage of the appraised value of the project). Other conditions and/or restrictions that the ground lessor may consider including in its agreement to subordinate are budget approval, minimum equity commitment, use of consultants to oversee construction and development, a requirement for a take-out commitment, etc. In contrast, a ground lessee will want the fewest possible conditions to avoid potential delays in the development of the project.[5]

leasehold financing. A financeable ground lease provides the leasehold mortgagee with protections and rights designed to avoid termination of the ground lease during the term of the loan and to permit the lender to foreclose on the leasehold estate and dispose of the collateral. An overview of such protections follows.

Basic Terms. The leasehold mortgagee will need to be comfortable with the basic terms of the lease, including rent and term. Most lenders will want to see a fixed or predictable rent.[6] Most leasehold lenders will want the term of the ground lease to exceed the maturity date of the loan by a substantial amount of time in case the lender needs an extended period after foreclosure to recover its investment. The leasehold mortgagee may also want the right to exercise renewal options even if the ground lessee is in default, as well as the right to exercise any purchase option the ground lessee may have. The lender will not want the ground lease to unduly restrict the use of the property and will look for a fairly broad “use” clause in the ground lease to facilitate disposition of the property at or after foreclosure. The ground lease should also include a “no merger” clause providing that the leasehold and fee estates do not merge in the event that the ground lessee acquires the fee interest in the property. The lender will not want continuing liability under the ground lease in case of foreclosure and will want the ground lease to provide that, in the event the lender or its affiliate becomes the ground lessee following foreclosure, it will have liability under the ground lease only during its tenure as ground lessee and not after its further assignment of the ground lease to a third party.[7] The lender will also want to see as few “personal” covenants (i.e., covenants that can only be performed by the then-current ground lessee) as possible in the ground lease to avoid the situation in which a purchaser at foreclosure could not cure the prior ground lessee’s default. A waiver in the ground lease of any landlord’s lien is also desirable from the lender’s perspective as well as the ground lessee’s.[8] Obviously, the lender will want the ground lease to provide that the ground lessee has the right to mortgage its interest in the property.[9]

Right to Cure. The leasehold mortgagee will want to receive written notice of any default by the ground lessee at the same time any such notice is received by the ground lessee, and the lender may require that a default notice given to the ground lessee not be effective unless it is simultaneously given to the lender. A default under the ground lease should also be a default under the loan. If the lender receives notice of the default, it can monitor (and encourage) the borrower/ground lessee’s cure of the ground lease (and loan) default. The lender will also require that it be provided with an opportunity to cure the default in the event that the ground lessee does not, and the lender will want an agreement from the ground lessor to accept the lender’s cure. The amount of time given to the lender to cure the ground lessee’s default is the subject of debate in lender-ground lessor negotiations. A lender generally wants a cure period in addition to the one provided to the ground lessee to effect a cure. Most ground lessors argue that the lender should have a cure period that coincides with the ground lessee’s cure period and do not want to give the lender an additional time for cure. The obvious issue is that the lender does not want to incur costs to cure the ground lessee’s default unless and until the ground lessee defaults beyond the cure period set forth in the ground lease. Therefore, the lender wants to wait until the cure period under the ground lease has expired to see if the ground lessee cures the default. If not, the lender may want as much as an additional thirty or sixty days, for example, beyond the cure period given to the ground lessee under the ground lease. Some lenders may also require that a second or additional default notice be given to the lender before the ground lessor can exercise its remedies under the ground lease. As noted above, such provisions are subject to negotiation between the ground lessor and the lender.[10]

Waiver of Certain Defaults; No Termination Pending Foreclosure. An additional consideration is whether the ground lessee’s default is capable of being cured or only curable after foreclosure by the lender. For example, defaults based on the ground lessee’s insolvency or failure to complete construction by a required date or to deliver financial statements are not susceptible of cure by the lender. In addition, operational and/or maintenance defaults may only be curable following foreclosure and the taking of possession. The lender cannot afford to have the ground lease terminate if the default cannot be cured and will want the ground lessor to refrain from terminating the ground lease for non-curable defaults or defaults that can only be cured by a party in possession. In the latter case, the lender will want the ground lessor to be estopped from terminating the ground lease or exercising other remedies until the lender has completed foreclosure on the property. Most lenders will also require additional time, beyond the ground lessee’s cure period, to acquire title to the property. In certain jurisdictions, this time period may be quite lengthy because of the length of time it takes to foreclose. Another frequent lender request is that non-curable defaults by the ground lessee be waived following foreclosure.

Assignability. A leasehold mortgagee will require that the ground lease be assignable to the mortgagee (or an affiliate) or to a purchaser in foreclosure. In order to recoup as much of the lender’s investment as possible, the ground lease must be assignable, without the consent of the ground lessor, at or following foreclosure, including by a sale to a third party following a purchase at foreclosure or acceptance of a deed in lieu of foreclosure. However, the ground lessor may not be willing to forego all restrictions on assignment and may negotiate for reasonable restrictions on future assignments that are not likely to impair a foreclosure sale.

Subletting. In the event that the property is not sold to a third party at foreclosure or shortly thereafter, the lender may need to sublet the property. Therefore, the lender will want the ability to sublease without the ground lessor’s consent with as few restrictions on use as possible. The lender may also want the ground lessor to agree to provide non-disturbance agreements to subtenants.

New Lease. The lender may also require that the ground lease contain a provision that, upon termination of the ground lease, including termination as a result of rejection of the ground lease in bankruptcy, the ground lessor will enter into a new ground lease with the lender (or its affiliate) or a third party. Note, however, such an agreement to enter into a new lease could be treated as an executory contract or an option to lease which could present issues in the case of a ground lessor bankruptcy and/or in jurisdictions where the rule against perpetuities could apply to an option to lease.[11] Intervening liens may also affect the priority of a new lease entered into by the ground lessor and the lender.

No Amendments, Etc., Without Lender’s Consent; Right to Exercise Renewals. The lender will require the right to consent to amendments to the ground lease, as well as the right to consent to any early cancellation or termination of the ground lease. The lender will also want its mortgage to control with respect to use of proceeds of casualty and condemnation awards.

Construction Issues. Because of the uncertainty associated with construction projects, a construction lender lending on a ground leased project will have additional concerns. The ground lease may provide that the improvements must be completed within a certain time period or must comply with certain use restrictions. The lender may request additional time to complete the construction, as well as the right to change the use of the property and the ability to substitute a new ground lessee.[12]

Miscellaneous. The lender will not want any encumbrances on the fee interest in the property with priority over the lease. A recorded subordination, nondisturbance and attornment agreement may be required. The lender will also be wary of operating covenants. In addition, the ground lessor will be asked to provide estoppel certificates upon the request of the lender.[13]

RATING AGENCY REQUIREMENTS. Rating agencies have also developed specific criteria for the evaluation of leasehold mortgages. These criteria should be consulted in structuring a ground lease suitable for the securitization market.[14] To facilitate refinancing, Standard & Poor’s for example, recommends a ground lease term that is at least twenty (20) years longer than the term of the loan if the loan is not fully amortizing.[15] Many of Standard & Poor’s requirements for a financeable ground lease are comparable to those noted above, such as a requirement that a memorandum of ground lease be recorded, that the ground lease be assignable without consent, that the lender receive notice of the ground lessee’s defaults and an opportunity to cure and that the ground lessor agree to enter into a new lease. Moody’s Investors Service has also developed a sample set of ground lease representations from lenders who are selling loans into the securitized market. These representations incorporate comparable requirements and criteria.[16]

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[1] For a more detailed discussion of the parties’ interests and perspectives, see Jerome D. Whalen, “Commercial Ground Leases,” Practising Law Institute, April 2003, Chapter 4.

[2] See discussion in Whalen, supra, Chapters 4 and 5.

[3] For an excellent discussion of the issues relating to enforceability of ground lessor agreements to subordinate the fee, see Joshua Stein, “A Guide to Ground Leases (With Forms and Checklists),” American Law Institute – American Bar Association, 2005, §3.9.

[4] See Whalen, supra, §4-7.

[5] For a more detailed discussion of subordinated fee mortgages, see Whalen, supra, Chapter 5, and Stein, supra, §3.9.

[6] See Ronald H. Wilcomes, “Elements of a Financeable Ground Lease,” American Law Institute – American Bar Association, 2004.

[7] See Whalen, supra, Chapter 6.

[8] See FL Receivables Trust 2002-A v. Arizona Mills, L.L.C., 2005 WL 111807 (Ariz. App. Div. 1 2005)

[9] For a general discussion of lender concerns, see Steven R. Davidson, “Leasehold Financing: The Lender’s Evaluation of the Financeability of a Tenant’s or Landlord’s Interest in a Lease,” Practicing Law Institute, 1991.

[10] See Davidson and Wilcomes, supra.

[11] See Whalen, supra, Chapter 6.

[12] See Whalen, supra, Chapter 6. Note that a construction lender may also require that the ground lessee/borrower have a permanent take-out commitment. For a discussion of “maximum,” “minimum” and “medium” leasehold mortgage protections, see Stein, supra, §1.3, Chapter 2 (Leasehold Protections, Additional) and Chapter 6 (Model Provisions).

[13] See Davidson, supra.

[14] See Whalen, supra, Chapter 6. See also “Ground Lease Requirements in CMBS Transactions,” Standard & Poor’s Structured Finance CMBS Property Evaluation Criteria, January 2004, and Moody’s Investors Service, “CMBS: Moody’s Approach to Rating Loans Secured by Ground Leasehold Interests,” October 26, 2001.

[15] See Standard & Poor’s, supra.

[16] See Moody’s, supra, Appendix I.

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