Ground leases are an important mechanism for ownership and development of real estate. The motivations for wanting to ground lease rather than sell can include income tax ramifications and sentimental attachment to a property. Under a ground lease, a tenant typically leases land for a long term (such as 50 or 99 years) and has the right to develop the land. At the end of the term, ownership of the improvements the tenant made on the land reverts to the landlord. The landlord benefits from a long-term, steady income stream from a tenant. The landlord (or, more likely, the landlord’s heirs) also gains the significant additional benefit of increased property value due to the tenant’s improvements.
Ground Lease Financing
Whether a lender will provide financing secured by a ground lease depends in large part on the lender’s view of whether or not the ground lease is financeable. In order to be financeable, a ground lease must expressly allow the tenant to secure financing with the ground lease as collateral. The collateral is the tenant’s possessory interest in the land and improvements for the term of the lease, rather than the fee interest in the land itself, which, in light of the effect of the ground lease is analyzed or underwritten as the rent stream under the ground lease and the reversionary interest in the property when the ground lease expires. If the tenant’s lender forecloses because of the tenant’s default under the ground lease financing, the lender succeeds to the tenant’s rights under the lease. This arrangement raises a number of critical questions about the relationship between the tenant, the landlord as the owner of the fee interest, the leasehold lender (the Leasehold Mortgagee) and the fee lender (the Fee Mortgagee). Of primary concern for the Leasehold Mortgagee are the following issues:
- Under what circumstances can the ground lease be terminated and what protections does the Leasehold Mortgagee need in order to make sure it does not lose its collateral?
- If the Fee Mortgagee forecloses, what are the tenant’s and the Leasehold Mortgagee’s rights?
- What becomes of the ground lease if either the landlord or the tenant declares bankruptcy?
Subordinating the Fee Mortgage
One concept that has challenged practitioners over the years is securing the priority of the tenant’s (and therefore the Leasehold Mortgagee’s) rights under the ground lease over those of the Fee Mortgagee. In securitized loans, Moody’s Investor’s Service (Moody’s) has most recently taken the position that the fee mortgage must be subordinate to the ground lease in all circumstances. Therefore, to meet these securitization requirements, the ground lease should:
(i) State that every fee mortgage or deed of trust is and shall be subject and subordinate to the ground lease and any “new lease” (described in more detail below);
(ii) Require the landlord to include language in all fee mortgages stating that the fee mortgage is subject and subordinate to the ground lease; and
(iii) Require the landlord and the tenant to cause their respective lenders to state in their respective mortgages that they attach to only their respective mortgagor’s interests in the property (i.e. the leasehold mortgage attaches only to the leasehold interest and the fee mortgage attaches only to the rent and the reversionary interest after termination of the ground lease).
Therefore, if the Fee Mortgagee forecloses on the property, it takes possession of the property subject to the ground lease. The tenant’s rights (and the Leasehold Mortgagee’s collateral) remain undisturbed. This is entirely consistent with the nature of the collateral the Fee Mortgagee bargained for: the stream of rental payments under the ground lease. To structure the fee mortgage otherwise, such that there is even a remote possibility of wiping out the Leasehold Mortgagee's collateral even though all payments have been made and are being made under the ground lease, serves only to introduce the possibility of a forfeiture of the Leasehold Mortgagee's collateral and an equal windfall to the Fee Mortgagee.
Fee Mortgagees sometimes attempt to avoid subordinating their interest to the ground lease by utilizing a workaround: a Subordination, Non-Disturbance and Attornment Agreement (SNDA) in which the Fee Mortgagee agrees not to disturb the tenant should the Fee Mortgagee foreclose on the property and succeed to the landlord’s rights. Executing a separate SNDA rather than requiring the fee mortgage to be subordinate to the ground lease does not sufficiently protect the Leasehold Mortgagee’s collateral. Practitioners have long noted a significant problem with this method which has recently been emphasized by Moody’s. Should the Fee Mortgagee itself become the subject of a bankruptcy, it might be entitled to reject the SNDA as an executory contract. In such an event, the ground lease would no longer be protected by the SNDA, making it vulnerable to termination if the Fee Mortgagee foreclosed. And, as previously noted, if the ground lease is terminated, the Leasehold Mortgagee loses its collateral.
Leasehold Mortgagee Favored Ground Lease Clauses
Leasehold Mortgagees require that ground leases include certain customary (but by no means uniform) provisions protecting their collateral. These provisions may include:
(i) Unrestricted assignability rights so that if the Leasehold Mortgagee finds a replacement tenant in the event of default by the original tenant either under the lease or the leasehold mortgage, it may assign the ground lease to a new tenant;
(ii) A requirement for the landlord to give notice to the Leasehold Mortgagee of any tenant defaults and ample opportunities for the Leasehold Mortgagee to cure any tenant defaults before allowing the landlord to terminate the ground lease; and
(iii) An obligation for the landlord to enter into a new lease with the Leasehold Mortgagee on the same terms and conditions as the ground lease if the ground lease is terminated upon the tenant’s default or in the event of the rejection of the ground lease in bankruptcy (this is known as a “new lease clause”).
Some landlords may take the position that the last requirement is “belt and suspenders” and that adequate notice and cure provisions allowing the Leasehold Mortgagee to cure a tenant’s default sufficiently protect the Leasehold Mortgagee. Most recently, Moody’s has rejected this position and now considers a new lease clause essential because if the ground lease is terminated for any reason, the Leasehold Mortgagee loses its collateral. A new lease clause obligates the landlord to enter into a new lease with the Leasehold Mortgagee, thereby preserving the Leasehold Mortgagee’s collateral.