Financeable Ground Leases – They’re Not Just for Development Sites Anymore

by Cozen O'Connor
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In years past, ground leases were used primarily as vehicles for the development or redevelopment of “stand alone” real estate. The fee owner – typically an investment group that purchased an income property years ago and now realizes their investment has reached the end of its useful life due to physical deterioration or obsolescence, exhaustion of tax benefits, changes in the neighborhood or the rental market, or a combination of reasons – cannot sit still, yet does not have the expertise or risk tolerance to redevelop the site. Unfortunately, the specter of income tax recapture or other considerations make a sale of the site less than attractive. Often, a financeable ground lease is just the vehicle to tap the unexploited value in the real estate – creating a long-term income stream, preserving residual values and deferring tax liabilities.

Over the years, the uses of ground leases have expanded and evolved, turning the platform into a powerful tool in any number of new contexts. For example, shopping center developers have long used ground leases to allow others to develop anchor stores, or perhaps peripheral retail, hospitality or service facilities, ultimately to be operated in concert with the developer’s own buildings and common facilities. As our aging cities call for urban renewal, many municipalities have turned to ground leasing publicly owned land as a vehicle to influence or control its development, particularly in phased projects. Frequently, they enter into separate “phase” leases with affiliated or independent developers, tied together to promote the long-term fulfillment of the desired public purposes through reciprocal easements and restrictive covenants that survive the completion of construction and privatization of the sites. Further, the operators of many college campuses, government centers, resorts, industrial plants and other large-scale facilities are using financeable ground leases as part of their strategy to implement more efficient or greener energy production through arrangements with experienced developer/operators of co-generation or large scale alternative energy facilities.

There are two critical commonalities in the evolving uses of ground leasing. First, like their older cousin – the “simple” development lease – these ground leases must be financeable. Unless the ground tenant can give a relatively secure and stable first leasehold mortgage to a financing source, the ground tenant will be hard-pressed to find the financing necessary to develop the property. Second, unlike their older cousins, many of these new ground leases are by no means stand alone. Rather, in many ways their very existences are dependent upon interrelationships with other properties or other users.

So what makes a ground lease financeable? Clearly it is much more than including magic language that gives the lender cure rights and other protection against the loss of its collateral in the event of a lease default. That is merely the starting point. There are many factors that will go into a lender’s evaluation of whether to extend financing, most of which are extremely subjective in nature and vary from situation to situation. For example:

Will the ground rent continue to be paid, and the mortgage continue to be serviced, if the co-generation facility goes off line or if the primary purchaser of the steam and chilled water produced by the mortgaged facility ends up in bankruptcy? If the mortgage is foreclosed, will the mortgagee find a sufficient number of bidders who are competent to operate an energy plant as required by the ground lease, and, if so, will the appraisal stand up as well as more traditional brick and mortar appraisals? At the end of the lease, will the landlord have the opportunity to purchase the improvements so as to continue the plant in operation, and, if so, will the price assure the retirement of the leasehold indebtedness?

Will a mortgagee in possession, receiver or foreclosure purchaser be willing to put up with a powerful and meddlesome set of municipal bureaucrats or third parties with approval and other rights under surviving documents, whose attention has become particularly aroused due to the same circumstances that have brought the leasehold mortgage to the brink of foreclosure? How would a default by the tenant’s affiliate as to a different phase, with respect to which the leasehold mortgagee has no interest or control, impact on the lease for the financed phase?

What can a lender do about deterioration of the common facilities of the shopping center? The tenant base? Can a foreclosure sale purchaser use the financed parcel for a different, possibly more successful, but decidedly conflicting purpose?

Unlike with a stand-alone development, the lender has little opportunity, as a last resort, simply to step in, take control, staunch the bleeding, sell the asset and apply the proceeds to its debt, for doing so often requires the active cooperation and collaboration of a third party with its own agenda regarding the site. Indeed, in this complex milieu, one is never confident that a lease will be found to be in fact financeable until the leasehold mortgage has been closed and funded.

To make matters even more challenging for the developer and its counsel, typically the leasehold mortgagee has not yet even been identified, let alone brought up to speed and represented by counsel, when a supposedly financeable ground lease is being negotiated. If the developer and its counsel are lucky, the leasehold mortgagee and its counsel will appear on the scene at the very end of the process, willing to review and comment upon the final or near final draft of the ground lease. More often than not, however, at the time when the ground lease is signed, the developer and its counsel are all alone, predicting what a typical leasehold lender and its counsel will say with respect to the transaction.

In summary, developers should be aware of the expanding role of financeable ground leases in today’s real estate world, but also should be cognizant of the risks and challenges posed by a ground lease transaction. It is imperative, when structuring a ground lease transaction, that the developer remain focused on the seemingly unrelated business decisions that will bear on financeability, and retain counsel with a similar sensitivity and concern to advise on these risks and challenges, and propose viable solutions.

This Real Estate Alert was adapted by Marc Intriligator from a lecture that he recently gave in a continuing legal education webinar. To discuss any questions you may have regarding this Alert, or any other issues or topics regarding financeable or non-financeable ground leases or net leases, please contact Marc at (212.453.3801) or any other member of Cozen O’Connor’s real estate practice.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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