Lenders are often asked to provide financing secured by a leasehold interest in land evidenced by a ground lease. A ground lease is an agreement between the fee owner of real estate (the ground lessor or landlord) and its tenant (the ground lessee) in which the fee owner leases the land to the tenant. Ground leases are typically for a longer term than a basic space lease and allow the tenant to construct improvements on the land and operate the improvements during the term of the ground lease. Because the collateral for leasehold financing typically consists only of the leasehold rights of its borrower under the ground lease, lenders should carefully review the terms of the ground lease to ensure that it contains certain minimum lender protections.
An astute drafter of a ground lease will consider a future mortgage of the ground lease in its initial preparation of the lease, but often, critical lender protections are not included, and this is especially true of older ground leases. While a landlord is generally not interested in amending the terms of the ground lease to satisfy the requirements of a lender providing leasehold financing, a landlord should understand that the tenant's interest in the ground lease must be financeable.
In addition to the protections in a lender's leasehold deed of trust, a lender will often need to request that a ground lease be amended or that a separate agreement regarding ground lease be executed to address any lender protections that may have been omitted from the initial ground lease. Below is an overview of the minimum protections that a lender should consider when financing a loan secured by a ground lease.
- Basic Terms. The term of the ground lease should extend well past the maturity of the loan and should specifically address the tenant's right to mortgage, sublease and assign the lease. A broad list of permitted uses of the property is preferred to give the tenant, the lender and foreclosure sale purchasers the flexibility to change the use of the property should the initial concept fail. To protect the tenant's interest in the ground lease and put a third party on notice, the ground lease should be evidenced by a short form memorandum thereof recorded in the real estate records.
- Casualty/Condemnation. A key provision of any ground lease is the use of any casualty or condemnation proceeds relating to the property. Since the improvements located on the land generally belong to and have been constructed by the tenant, the ground lease should provide that any insurance proceeds relating to the destruction of any improvements be paid to the tenant. The lender should require that it be named as the "mortgagee" and "lender's loss payable" on any insurance covering the improvements and the loan documents should require that such proceeds be paid directly to the lender. Similarly, condemnation proceeds attributable to the leasehold estate and the taking of the improvements should be paid directly to the lender. In addition, the lender should have the ability to participate in any condemnation proceedings to sufficiently protect its rights.
- Notice and Right to Cure. The lender should have the ability to cure any tenant defaults under the ground lease after receiving notice from the landlord. This cure period should be in addition to the time allotted to the tenant since the lender may have to foreclose or appoint a receiver prior to curing the default.
- Acquisition by Lender; Entrance into New Lease. Upon the lender's foreclosure of its leasehold mortgage or taking of a deed-in-lieu of foreclosure, the lender or any party taking title through the lender should have the right to become the tenant under the ground lease without any further consent by landlord. Similarly, if the bankruptcy of the tenant results in a termination of the ground lease, the lender should have the right to compel the landlord to enter into an identical lease with the lender or successor owner as the new tenant.
- Liability. If the lender or another party taking title through the lender takes title to the leasehold interest, such party should only be liable for those obligations of the tenant from the time that the lender or successor owner takes title to the property. The ground lease should also provide that the landlord cannot seek recovery of any losses from the lender beyond its interest in the property. Finally, following an assignment of the ground lease by the lender to a successor owner, the lender should be released from all obligations and liability under the ground lease.
- Amendments; Fee Mortgages. The ground lease should acknowledge that the ground lease may not be amended, modified or terminated without the prior written consent of any leasehold lender that has notified the landlord of its interest. In addition, the ground lease should prohibit the landlord from mortgaging its fee simple interest in the property without the prior written consent of the leasehold lender or, in the alternative, without first getting a non-disturbance agreement in favor of the leasehold lender from the mortgagee of the fee simple interest.
- Waiver/Subordination of Liens. The ground lease should provide that any liens that the landlord has or may acquire against the property during the term of the loan will either be waived or subordinated to the lien of the leasehold lender.
- Repurchase Rights; Rights of First Refusal. Repurchase rights and rights of first refusal in favor of the landlord should be subordinated to the lien of the leasehold mortgage and specifically identified as inapplicable to a foreclosure of the leasehold interest or taking of a deed-in-lieu of foreclosure. Such a clause is helpful in avoiding the impairment or delay of a leasehold lender's exercise of its rights and remedies following a loan default.
- Environmental Concerns. A lender should treat the financing of the leasehold estate in land like the financing of a fee simple estate for purposes of environmental due diligence. Any environmental reports and questionnaires required by a lender when financing a fee simple interest in property should similarly be required when financing a ground lease. If environmental issues do exist on the property, the ground lease should clearly address the responsibilities of both the landlord and tenant.
In the event that some or all of these provisions are not contained in the ground lease, a leasehold lender should request that either the ground lease be amended to include them or that the landlord execute and record an agreement in favor of the leasehold lender in which the landlord grants the lender with these rights. In addition, it is good practice to have such agreement incorporate, or have the landlord provide an estoppel certificate as of closing, which confirms that (i) the ground lease has not been amended or modified, (ii) the tenant is not then in default under the ground lease, (iii) all agreements between landlord and tenant are contained in the ground lease, (iv) the landlord is not aware of any prior assignment of the tenant's interest in the ground lease, and (v) that the landlord has no current right to terminate the ground lease. The lender should have the right to request an estoppel certificate from time to time to confirm that the tenant remains in compliance with the ground lease during the term of the loan.
A tenant's leasehold interest in land can serve as a valuable piece of collateral, but leasehold lenders must carefully review the ground lease and take the necessary steps to ensure that certain protections are included in the ground lease or in a separately negotiated agreement between the landlord and lender.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
