11.30.2022 | Articles

Why Do We Care About Ground Leases?

By Scott C. Altonian, Brian F. Plunkett
Estate Planning

Clients often ask us to review and advise on transactions involving the finance of ground leases, often also referred to as “ground lease mortgages.” Ground leases come in many different forms, but at its most basic, a ground lease is a long-term lease of land and any improvements thereon.

Because the lender’s primary collateral is the leasehold interest held by the borrower as tenant, keeping the ground lease “alive” (i.e., preventing any termination of the ground lease) is the most important detail for the lender. This article will explain what a ground lease is, how it is financeable by a lender and why a ground lessor estoppel and recognition agreement (an “Estoppel”) is a necessary requirement for a lender in a ground lease mortgage deal.

Most lenders are familiar with typical mortgage financing in which the borrower is the record title holder to the mortgaged property (i.e., the borrower owns the “fee simple interest” in the real estate). A fee simple interest in real estate has value that can be appraised, it can be mortgaged to a lender, and a lender can obtain a title insurance policy insuring the lien of its mortgage on the real estate, subject to whatever encumbrances have been recorded in the real estate records affecting the property. When a lender takes a leasehold mortgage as part of a financing package, the lender’s collateral is the borrower’s leasehold interest in the real property, which is the borrower’s right as tenant to occupy and use the real property for a certain number of years, subject to the terms and conditions of the written lease, rather than the real estate itself. Like a fee interest, a leasehold interest in a long-term lease of real estate also has value that can be appraised, financed and insured.

Long-term leases of land and improvements with a term of anywhere from thirty (30) to ninety-nine (99) years are often referred to as “ground leases.” Like any other lease, a ground lease is a bilateral agreement in which the tenant agrees to pay the landlord rent, typically on an annual basis, in exchange for the right to occupy and use the real estate during the term of the ground lease. The land may be vacant and undeveloped at the outset of the ground lease, and the lease may afford the tenant the right to construct improvements on the land, subject to certain approval rights of the owner, and to use the land and improvements during the term of the lease. Franchise deals often involve ground leases since the franchisee, as tenant, will typically want to build a very specific structure according to the specs of the franchisor (think McDonalds, Dunkin, Taco Bell) and needs the certainty and comfort of a long-term lease after investing significant building costs into the property.  A tenant under a ground lease will record with the registry of deeds a memorandum or notice of the ground lease, which is a short document describing the key terms of the lease.

One practical difference between financing a leasehold interest instead of a standard mortgage loan is that, as part of its “due diligence” of the underlying collateral, the lender or its counsel must do a detailed and careful review of the ground lease to determine whether the lease is “financeable.” This review is in addition to the other customary due diligence that lenders do when financing fee interests in real estate (e.g., review of title, survey, appraisals, environmental reports and the encumbrances of record affecting the property). When reviewing a ground lease, we typically look for the following provisions:

(i) Confirm that the lease term matches the term of the lease used by the lender’s appraiser in valuing the leasehold interest. There is no point in doing a leasehold mortgage if the term expires soon after (or before) the maturity of the loan. The long-term nature of the leasehold interest in a ground lease is what gives it value and makes it financeable and insurable from a title insurance point of view.

(ii) Check the termination rights of the landlord under the lease. Ideally, the ground lease should provide the owner of the real estate with no right to terminate the lease as long as the tenant is in compliance with the lease terms and paying rent.

(iii) Confirm whether the ground lease requires the landlord to provide the tenant (and the tenant’s mortgagee) with ample notice and opportunity to cure any defaults under the lease, such as non-payment of the rent, real estate taxes, or insurance or any failure to maintain the leased premises. The owner should agree that the ground lease cannot be terminated unless the owner first provides a sufficient amount of prior notice to the tenant’s lender and affords the lender the right to take appropriate action to cure any tenant defaults and thereby protect its collateral. The owner/landlord should also agree that, in the event of a bankruptcy of the tenant or other removal of the tenant from the premises, the owner will enter into a new lease with the tenant’s lender or its designee on the same terms as the ground lease originally financed.

(iv) Confirm that there are no restrictions on leasehold mortgages or assignments of the lease which may require that the owner consent to the leasehold mortgage.

(v) Ascertain whether there are any unusual provisions or restrictions in the lease. While ground leases are bilateral contracts, the owner typically has few if any obligations beyond a covenant not to disturb the tenant’s use and enjoyment of the property during the term, so long as the tenant is not in default of the lease terms. At the end of the lease term, the tenant’s leasehold interest in the land and any improvements constructed thereon typically revert to the owner. Is there any obligation of the tenant to remove (i.e., demolish) improvements? If so, this is a cost that could affect the valuation by the lender’s appraiser. Are there any restrictions on the use of the leased premises? For example, the leased premises may only be used as a fast food restaurant? If so, this restriction can also have an impact on the valuation.

In an ideal world, the ground lease will contain most if not all of the protections that a prudent lender financing the leasehold interest requires, some of which are identified above, and will have been drafted with lease financing in mind. However, if the original ground lease was first executed many years ago, or leasehold financing was never contemplated when the ground lease was executed, the ground lease may not contain any or all the protections that a lender should require.  A lender that finances a leasehold interest in a poorly drafted ground lease that does not clearly define the term of the lease, provides the owner with too many rights to terminate the lease, or fails to include appropriate leasehold lender protections, could find itself without any collateral in the event the tenant defaults under the lease and the owner terminates the lease.

So what does a lender do with a poorly drafted ground lease that lacks adequate protections for a leasehold lender? In most cases, any “deficiencies” in the terms of a ground lease can be remedied, and the “durability” of the lease term bolstered, by requiring the owner of the fee interest to execute an Estoppel.  An Estoppel is a separate agreement among the owner, the tenant’s lender and, in some cases, the tenant. In fact, even if the ground lease is well drafted and contains appropriate leasehold lender protections, the tenant’s lender should require some form of estoppel agreement from the owner as a closing requirement.

First, an Estoppel is an opportunity for the tenant’s lender to obtain crucial representations and warranties from the owner regarding the ground lease and the current relationship between the owner and the tenant, including confirmation that the lease is in full force and effect and that the tenant is not in default. In addition, an Estoppel provides contractual privity between the lender and the owner, which means that a breach by the owner of its representations, warranties and covenants in the Estoppel should provide the lender with the ability to bring claims for breach against the owner directly.  If the ground lease is well drafted and contains the appropriate leasehold lender protections, the Estoppel may be a relatively short document. If the ground lease lacks some or all of the protections that leasehold lenders typically require, the Estoppel may be crafted as a longer document that “plugs” any holes in the ground lease and obligates the owner with respect to the leasehold lender protections directly in favor of the tenant’s lender. There are also helpful bankruptcy provisions which can be added to an Estoppel, the discussion of which is beyond the scope of this article

Ground lease financing can be complicated and presents opportunities for mistakes. For example, what if the owner of the fee interest has itself financed its fee interest in the real estate through a loan from another lender secured by a mortgage lien on the fee interest? In this scenario, another lender has rights with respect to the owner’s fee interest in the real estate. If the fee owner defaults on its loan and the fee owner’s lender forecloses, it is imperative that the ground lease and thus the leasehold mortgage not be affected.  To prevent a termination of the ground lease by a foreclosing fee mortgage lender, the leasehold lender should require the tenant, the fee owner and the fee owner’s lender to execute a subordination, non-disturbance and recognition agreement.

Prudent lenders contemplating financing a leasehold interest in a ground lease should understand that there are significant differences in the diligence and documentation that a leasehold financing requires, separate from a more typical mortgage financing of a fee interest. In addition to the other customary commercial real estate diligence, a careful review of the ground lease that identifies any issues and deficiencies in the lease is crucial.  In some instances, the terms of a ground lease may simply render it non-financeable. In other instances, certain issues or deficiencies in a ground lease may be remedied through a recognition and estoppel agreement with the fee owner. Even if the ground lease is perfectly drafted from a leasehold lender’s perspective, a recognition and estoppel agreement with the fee owner is advisable.  It is best to consult with knowledgeable real estate counsel as early in the process as possible to avoid going too far down a road towards a closing only to determine that the owner, the tenant and the tenant’s lender are unable to reach agreement on how to make the ground lease financeable.

This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.

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