Commercial Mortgage Insight

Understanding The Basics Of Ground Lease Financing

More lenders are considering financing properties with ground leases, but they should understand the additional layer of complexity they present.

BY ADAM F. ZWEIFLER

Many lenders today are being presented with opportunities to finance real property that is subject to a ground lease. In this competitive market, lenders are considering these "leasehold mortgage" opportunities with greater frequency.

A ground lease is typically a long-term (50 to 99 year) lease of unimproved land. The lessee/developer constructs and operates the improvements on the property and pays the lessor rent on a net basis. During the term of the lease, ownership of the improvements and the underlying land is generally split, with the developer/lessee owning the improvements and the lessor owning the land itself.

A ground lease can be conceptualized as a financing device, in that it allows the developer to control and develop a site without a large upfront cash outlay. The land owner/lessor obtains a steady cash flow, in the form of rent, without assuming all of the risks inherent in development. If the lessee defaults, the lessor's typical remedy is to terminate the lease, at which point it owns both the land and the improvements free and clear.

For a lender presented with a ground lease loan, it must first determine whether the ground lessor will "subordinate" its fee interest in the land to the lien of the lender's mortgage. In this case, "subordination" means that the ground lessor, as the holder of the fee interest in the property, will join in the mortgage such that upon foreclosure the lender will acquire fee title to the property.

Even if the lessee/borrower defaults under the lease and the lease is terminated, the lender will continue to have a security interest in the underlying fee. If this is the case, the risk of default under the ground lease is virtually eliminated from a legal standpoint because the lender will acquire fee title to the property upon the borrower's default.

The important issues

When considering a subordinated fee structure, there are two important legal issues that the lender should address. First, historically the custom has been for the ground lessor, as the fee owner of the property, to merely join in the mortgage and include a statement that the ground lessor is not personally liable for any defaults of the borrower.

However, a recent California case, Mead vs. Sanwa Bank, 61 Cal. App. 4th 561 (1998), suggests that this approach may leave the lender at risk for defenses the ground lessor may assert if the ground lessor is found to be a guarantor. How does the ground lessor become a guarantor? In effect, a ground lessor subordinating its fee interest to the lender's mortgage is offering its property as additional collateral to secure the debt of another - the lessee/borrower.

The legal definition of a guarantor is one who agrees to answer for the debt of another. In these circumstances, and as the Mead case suggests, the ground lessor, in addition to signing the mortgage, should sign a non-recourse guarantee of the borrower's obligation. The guarantee should include customary waivers of defenses that are available to guarantors under the laws of most states.

The other issue which the lender should consider in the case of the subordinated ground lease is whether the operating leases of the property, those which provide the income and cash flow from the property, provide by their terms that upon termination of the ground lease the tenants will recognize the fee owner as their landlord.

If the leases have an "attornment" provision which accomplishes this purpose, then upon foreclosure the lender will not be required to maintain the fiction of keeping the ground lease in effect and can deal with the tenants directly as the fee owner of the property. If the ground lease will not be subordinate to the mortgage, that is, if upon foreclosure the lender will succeed only to the interest of the lessee under the ground lease, then there are a host of additional risks which the lender should consider and mitigate.

The primary goal of the lender is to protect itself against termination of the ground lease. If the fee interest is not made subordinate and the lender's mortgage encumbers only the ground lease, then termination of the ground lease will result in a loss of the lender's collateral for the loan. If the loan is non-recourse, which many loans are today, then the ability of the lender to collect will be reduced to nothing.

One possible mitigant is to require that upon termination of the ground lease, the underlying debt becomes a full recourse obligation of the borrower. In our experience, lenders will have only limited success in obtaining this type of commitment from a borrower.

Financeable ground lease

Another approach for the lender is to confirm that the ground lease in question is a so-called "financeable" ground lease. A financeable ground lease is one that has terms which anticipate financing of the ground lessee's interest and provide protections for the ground lessee's lender.

The basic protections are as follows:

Extended notice and cure periods for the protection of the lender. These clauses typically provide that no notice of default to the borrower will be effective unless the lender receives a copy. In addition, if the borrower fails to cure a default within the time permitted under the lease, the lender will have an additional period to cure before the ground lessor may take steps to terminate the ground lease.

It is important that the lender have the additional period so the lender does not have to step in and commence a cure before the borrower's opportunity has exhausted itself. This will avoid confusion and potential lender liability suits where the borrower claims that it was in the process of curing when the lender stepped in and took action.

Another common protection for the lender is to provide for a "pick-up" lease.

That is, upon termination of the ground lease by the ground lessor for any reason, the ground lessor, at the request of the lender, will enter into a new lease with the lender, commonly called a "pick-up" lease, upon all of the terms of the ground lease and for the unexpired term of the ground lease at the time of termination.

It is common to agree that as a condition of the lender's right to enter into a pick-up lease, it must cure all outstanding monetary defaults under the ground lease. In addition, the lender should protect itself by requiring that the pick-up lease option be available if the borrower/lessee becomes the subject of a bankruptcy case where the ground lease is terminated as a result of being "rejected" by the trustee in bankruptcy.

The disposition and control of insurance and condemnation proceeds often present difficult issues for lenders and borrower to negotiate. Adding in a third party ground lessor only makes the problem more difficult. Therefore, it is important to review the insurance and condemnation provisions of the ground lease from the outset.

At a minimum, a financeable ground lease will require the ground lessor to allow proceeds to be held by the lender - or another mutually acceptable financial institution - and used for repair of the property. If the proceeds are not to be used for repair, then they should be disbursed first to the lender until its loan has been repaid and then divided between the ground lessor and the ground lessee.

A lease which permits the ground lessor to make the call as to whether or not to rebuild, or to receive proceeds before the lender has been repaid in full, is likely to be problematic.

Ground lease terms

Finally, the lender should be protected against termination of the ground lease upon the expiration of its term. It is obvious that a ground lease term should extend until at least the maturity date of the loan. But how much longer should the ground lease extend? A lender should require that the term of the ground lease extend beyond the maturity date of the loan by an amount of time at least sufficient to allow the anticipated cash flow from the property, as of the maturity date, to amortize the anticipated unpaid principal balance of the note over the unexpired term of the ground lease.

Accordingly, assuming the lender's mortgage will have an unpaid principal balance of $10 million, prevailing interest rates will be 8% and the net cash flow from the property as of the maturity date will be $1.5 million per year, the ground lease should extend at least 10 years beyond the maturity date of the note.

Calculating the proper term will require some long-range assumptions regarding interest rates, rents and inflation. A lender can protect itself by using high probability assumptions for these values and/or adding additional years to the required minimum term as a "fudge" factor. If the term of the ground lease is not sufficient for the lender's purposes, then the lender's options are to require that the ground lease be amended to add additional time, reduce the dollars which the lender is willing to lend on the property, or to require greater amortization over the term of the lender's loan to reduce the outstanding principal balance as of the maturity date.

Another "end-of-the-term" risk is the option to extend. If having a ground lease with a sufficient term requires that the lessee exercise an option to extend the term, then the ground lease should provide that the right to exercise the options will not lapse without notice to the lender and an opportunity for the lender to exercise the options in the place of the borrower/lessee.

Though those are the basic considerations that the lender should consider, there are other terms which should be included in a financeable ground lease. The ground lease should be freely assignable to the lender, upon foreclosure. The lender should be able to transfer its interest in the ground lease without seeking the consent of the ground lessor. The lessee should have the right to enter into subleases of the ground lease space without seeking the lessor's consent and upon termination of the ground lease.

The subleases will continue in effect (Although not strictly for the lender's protection, having such a clause in the ground lease will make it far easier to find tenants for the operating spaces on the subject property.)

If all of these provisions are adequately addressed, lenders can significantly reduce the additional legal risks presented by financing properties subject to a ground lease.

Adam F. Zweifler is a partner with the law firm of Pepe & Hazard LLP in its Hartford office.

This article was previously published in the November 2000 Issue of Commercial Mortgage Insight.