When determining whether to finance a ground lease, the first question most likely to be asked is "Can the fee interest be subordinated to the mortgage financing, either by the terms of the ground lease, or by the acquiescence of the fee owner?" If the answer is in the negative, i.e. the fee interest cannot be subordinated, the lender may determine not to make the loan, or will at the very least, take into account the unsubordinated nature of the fee in the course of determining the pricing of the loan, the loan-to-value ratio that is acceptable to it, and a host of other issues related to the underwriting and administration of the loan.
On the other hand, if the owner of the land determines to subordinate the fee, the lender is likely to consider the loan almost as if the fee owner was the mortgagee itselfsafter all, the concept of subordination in essence puts the mortgage on the property itself, so a default under the leasehold mortgage puts the fee owner's interest in the land at risk of all enforcement rights typically available to a creditor, including foreclosure. However, before assuming this significant risk, any fee owner is likely to insist on certain protections so that its interest in the land is not jeopardized by a third-partysthe ground lessee. A recent case in which this Firm was involved illustrates some of the protections that may be required by a ground lessor, and of which a lender must be cognizant in the documentation and administration of its loan.
In our case, the ground lessor also held a majority interest in the partnership that constituted the ground lessee. The property was operated as a shopping center by the ground lessee, which owned all the improvements located thereon. The ground lease was "triple net" and had been entered into by the parties some 25 years ago. The ground lease required the ground lessor to subordinate its interest to any financing obtained by the ground lessee, and further provided that any proceeds of such financing would be the property belong to the ground lessee. This provision seemed to make sense in that the ground lessor, as the majority partner of the ground lessee, would have some control over any financing, and the use of the proceeds derived therefrom. Thus, the determination to put the property at risk through subordination would be subject to at least some control by the party assuming that risk.
When the ground lessor/majority partner died, however, the situation changed radically. At that point, the ground lessor/majority partner's estate sought to resolve various disputes with the minority partner which ultimately resulted in litigation. The litigation was settled, and in the course of such settlement, the estate, as ground lessor/majority partner, agreed to sell the majority interest in the ground lessee to the minority partner. In order to finance the buyout, the minority partner invoked the subordination provisions of the ground leasesattempting to use the fee as collateral for the buyout, as well as to re-finance other debt then-existing on the leasehold. Although the estate argued that as the ground lessor and majority owner, it was essentially being asked to finance its own buyout by subordinating to the minority partner's loan, it ultimately agreed to do so. As noted, the subordinated ground lessor will often have some interest in the ground lessee which justifies the subordination. However, after the buyout of the estate's interest as majority partner by the minority partner, the estate would lose control over its own destiny, as far as the financing of the leasehold, and subordination of the fee. In order to add some protection, certain concessions were required of the minority partner. Three concessions negotiated, which could ultimately affect the lender, are as follows:
1. Cure rights granted to the ground lessor. Notices. It is the norm for a ground lessor to be given the right to cure a default that the ground lessee allows to occur in its financing. However, the lender must recognize that in doing so, it may be permitting a cure period that is in excess of that which it would ultimately accept. In our case, the cure period under the mortgage was ten days, but the ground lessor would be permitted an additional twenty days after receiving notice of the uncured default. Obviously, this means that the lender could be obligated to defer its enforcement activities for a period of time that may extend beyond its normal procedures.
Additionally, the lender must be vigilant in providing notices to the ground lessor in the event a default occurs. Failure to give notices promptly could also adversely effect the lender. For example, if ground lessee misses several months of debt service payment, the lender may wish to give the ground lessee the latitude to "get back on its feet" before commencing enforcement proceedings, or even transmitting a formal notice of default. On the other hand, if enforcement proceedings are later commenced, the ground lessor may argue that by letting the ground lessee fall a number of months in arrears, it made it more difficult for the default to be cured. Such a circumstance could potentially result in a challenge to the subordination. Accordingly, the lender would be prudent to monitor the loan very closely and take prompt action in the event the credit appears to be in jeopardy. Certainly, keeping the ground lessor informed of the status of the loan at all points would appear to be advisable.
2. Insurance proceeds. A typical insurance provision in a mortgage would require that insurance proceeds paid or payable after a loss would be paid to the lender to reduce the amount outstanding on the loan, or applied to the reconstruction or restoration of the mortgaged premises. The application of the insurance proceeds, in either manner, is ordinarily at the option of the lender. In our case, however, the ground lease stated specifically that such proceeds had to be applied to restoration or reconstruction of the mortgaged premises. This provision protected the ground lessor since the improvements, although owned by the ground lessee during the term of the ground lease, reverted to the ground lessor at the end of the term. The lender acquiesced in this provision, which means that the lender deviated from its normal manner of proceeding. This deviation is significant, especially as the loan nears maturity, since a lender, at the later stages of the loan, would more likely be predisposed to reduce its loan amount, rather than become involved in something akin to a construction loan as the insurance proceeds are applied in draws to restore the premises.
3. Limitations on future subordination. As noted above, in our case, as part of the settlement of the litigation, the ground lessor agreed to subordinate to financing that would be used to buy out its partnership interest in the ground lessee. However, on a going-forward basis, the ground lessor insisted that future subordinations be limited. This was a logical demand, insofar as the ground lessor, while putting its fee simple interest in the land at risk, would have little if any control as to the operation of the ground lessee's business. The parties ultimately agreed that (i) future financings would be limited to 80% of the value of the leasehold at the time of the financing; and (ii) that 85% of any excess proceeds after paying off any existing debt at the time of the financing would be utilized for the property, e.g. for renovation, tenant fit-up, and the like. The remaining 15% of any excess proceeds could be used by the ground lessee for any purpose, even if unrelated to the property. From the ground lessor perspective, these limitations help to quantify its subordination, and assure that should the property appreciate, the vast majority of any financing "pulled out" of the fee would be reinvested in the property. From the lender's perspective, however, such a provision could engender some risk based upon the fluctuations in value that are endemic to the real estate market. The 80% loan-to-value limitation, although common, could foreclose the borrower/ground lessee approaching certain refinancing sources as the loan approaches maturity, a situation that could adversely affect the lender should the value of the leasehold have diminished during the term of the loan. In making such a loan, the lender should either be satisfied as to the development of the property and its likelihood of appreciation during the term, or adjust its loan-to-value ratio downward in order to provide an adequate cushion because it may be more difficult for the ground lessee to secure replacement financing as the result of the new limitation on subordination.
In summary, the subordinated fee is a powerful enabling tool for the lender as it proceeds to finance a leasehold interest. However, in making such a loan, the lender must analyze certain provisions, some seeming innocuous, that may have a profound effect on the origination and administration of the loan.
On the other hand, if the owner of the land determines to subordinate the fee, the lender is likely to consider the loan almost as if the fee owner was the mortgagee itselfsafter all, the concept of subordination in essence puts the mortgage on the property itself, so a default under the leasehold mortgage puts the fee owner's interest in the land at risk of all enforcement rights typically available to a creditor, including foreclosure. However, before assuming this significant risk, any fee owner is likely to insist on certain protections so that its interest in the land is not jeopardized by a third-partysthe ground lessee. A recent case in which this Firm was involved illustrates some of the protections that may be required by a ground lessor, and of which a lender must be cognizant in the documentation and administration of its loan.
In our case, the ground lessor also held a majority interest in the partnership that constituted the ground lessee. The property was operated as a shopping center by the ground lessee, which owned all the improvements located thereon. The ground lease was "triple net" and had been entered into by the parties some 25 years ago. The ground lease required the ground lessor to subordinate its interest to any financing obtained by the ground lessee, and further provided that any proceeds of such financing would be the property belong to the ground lessee. This provision seemed to make sense in that the ground lessor, as the majority partner of the ground lessee, would have some control over any financing, and the use of the proceeds derived therefrom. Thus, the determination to put the property at risk through subordination would be subject to at least some control by the party assuming that risk.
When the ground lessor/majority partner died, however, the situation changed radically. At that point, the ground lessor/majority partner's estate sought to resolve various disputes with the minority partner which ultimately resulted in litigation. The litigation was settled, and in the course of such settlement, the estate, as ground lessor/majority partner, agreed to sell the majority interest in the ground lessee to the minority partner. In order to finance the buyout, the minority partner invoked the subordination provisions of the ground leasesattempting to use the fee as collateral for the buyout, as well as to re-finance other debt then-existing on the leasehold. Although the estate argued that as the ground lessor and majority owner, it was essentially being asked to finance its own buyout by subordinating to the minority partner's loan, it ultimately agreed to do so. As noted, the subordinated ground lessor will often have some interest in the ground lessee which justifies the subordination. However, after the buyout of the estate's interest as majority partner by the minority partner, the estate would lose control over its own destiny, as far as the financing of the leasehold, and subordination of the fee. In order to add some protection, certain concessions were required of the minority partner. Three concessions negotiated, which could ultimately affect the lender, are as follows:
1. Cure rights granted to the ground lessor. Notices. It is the norm for a ground lessor to be given the right to cure a default that the ground lessee allows to occur in its financing. However, the lender must recognize that in doing so, it may be permitting a cure period that is in excess of that which it would ultimately accept. In our case, the cure period under the mortgage was ten days, but the ground lessor would be permitted an additional twenty days after receiving notice of the uncured default. Obviously, this means that the lender could be obligated to defer its enforcement activities for a period of time that may extend beyond its normal procedures.
Additionally, the lender must be vigilant in providing notices to the ground lessor in the event a default occurs. Failure to give notices promptly could also adversely effect the lender. For example, if ground lessee misses several months of debt service payment, the lender may wish to give the ground lessee the latitude to "get back on its feet" before commencing enforcement proceedings, or even transmitting a formal notice of default. On the other hand, if enforcement proceedings are later commenced, the ground lessor may argue that by letting the ground lessee fall a number of months in arrears, it made it more difficult for the default to be cured. Such a circumstance could potentially result in a challenge to the subordination. Accordingly, the lender would be prudent to monitor the loan very closely and take prompt action in the event the credit appears to be in jeopardy. Certainly, keeping the ground lessor informed of the status of the loan at all points would appear to be advisable.
2. Insurance proceeds. A typical insurance provision in a mortgage would require that insurance proceeds paid or payable after a loss would be paid to the lender to reduce the amount outstanding on the loan, or applied to the reconstruction or restoration of the mortgaged premises. The application of the insurance proceeds, in either manner, is ordinarily at the option of the lender. In our case, however, the ground lease stated specifically that such proceeds had to be applied to restoration or reconstruction of the mortgaged premises. This provision protected the ground lessor since the improvements, although owned by the ground lessee during the term of the ground lease, reverted to the ground lessor at the end of the term. The lender acquiesced in this provision, which means that the lender deviated from its normal manner of proceeding. This deviation is significant, especially as the loan nears maturity, since a lender, at the later stages of the loan, would more likely be predisposed to reduce its loan amount, rather than become involved in something akin to a construction loan as the insurance proceeds are applied in draws to restore the premises.
3. Limitations on future subordination. As noted above, in our case, as part of the settlement of the litigation, the ground lessor agreed to subordinate to financing that would be used to buy out its partnership interest in the ground lessee. However, on a going-forward basis, the ground lessor insisted that future subordinations be limited. This was a logical demand, insofar as the ground lessor, while putting its fee simple interest in the land at risk, would have little if any control as to the operation of the ground lessee's business. The parties ultimately agreed that (i) future financings would be limited to 80% of the value of the leasehold at the time of the financing; and (ii) that 85% of any excess proceeds after paying off any existing debt at the time of the financing would be utilized for the property, e.g. for renovation, tenant fit-up, and the like. The remaining 15% of any excess proceeds could be used by the ground lessee for any purpose, even if unrelated to the property. From the ground lessor perspective, these limitations help to quantify its subordination, and assure that should the property appreciate, the vast majority of any financing "pulled out" of the fee would be reinvested in the property. From the lender's perspective, however, such a provision could engender some risk based upon the fluctuations in value that are endemic to the real estate market. The 80% loan-to-value limitation, although common, could foreclose the borrower/ground lessee approaching certain refinancing sources as the loan approaches maturity, a situation that could adversely affect the lender should the value of the leasehold have diminished during the term of the loan. In making such a loan, the lender should either be satisfied as to the development of the property and its likelihood of appreciation during the term, or adjust its loan-to-value ratio downward in order to provide an adequate cushion because it may be more difficult for the ground lessee to secure replacement financing as the result of the new limitation on subordination.
In summary, the subordinated fee is a powerful enabling tool for the lender as it proceeds to finance a leasehold interest. However, in making such a loan, the lender must analyze certain provisions, some seeming innocuous, that may have a profound effect on the origination and administration of the loan.