Qualified ground lease lenders can help borrowers save time and money.
Experience counts, particularly for commercial real estate professionals involved in ground lease development. In addition, experience counts — and can pay off profitably — when choosing a ground lease lender. If a lender with the right experience is selected, under the right counsel and the right terms, the expense of negotiating a ground lease with ground lease financing may be greatly reduced. An experienced lender also can help structure flexible leasehold mortgagee protections in the original ground lease that will work for future lenders and refinancings.
The Value of Experience
Ground leases present unique lender risks. Since the developer holds only a leasehold interest in the land, lenders risk that the collateral — the leasehold — may be lost if a lease default occurs. The lender also may have to market the leasehold if it is acquired in foreclosure.
As a result, the leasehold lender may become heavily involved in ground lease negotiations, not only focusing on the leasehold mortgagee protections, but also on other provisions it perceives will impact the lease’s value or marketability. Due to this degree of involvement, the legal fees for lenders, landlords, and tenants can mount rapidly. However, these fees can be reduced by selecting a lender experienced in ground lease financing.
Experienced lenders understand and accept the unique risks of taking leasehold security. They tend to limit negotiations to the specific, practical issues of the ground lease such as competing interests in insurance proceeds, construction deadlines, mortgagee cure periods, and the leasehold’s marketability, without attempting to change the fundamental risk allocation among the landlord, tenant, and leasehold lender.
Inexperienced lenders may add additional layers of negotiations — and therefore legal fees — to avoid risks they should accept as lenders in a competitive market. For example, an experienced lender may require mortgagee cure provisions that temporarily freeze, for a stated period, the landlord’s right to terminate the lease for a tenant default. This is customary and helps the lender reduce the risk of losing its leasehold security while proceeding to a cure and/or foreclosure within a specified time frame. Inexperienced lenders also may request that the landlord’s termination right be made subject to lender cure elections and time frames solely within the lender’s control.
However, lenders who are experienced in ground lease financing are attuned to the nuances of these transactions. For example, an experienced lender may require that the tenant’s construction deadline be extended for a stated period if the lender elects to take over construction. This provides time for the lender to engage a construction manager and take other steps to transition construction from the tenant to the lender. Inexperienced lenders may request an unreasonably long (or even an open-ended) extension period for such a transition.
A sophisticated landlord quickly sees a lender heading in a risk-shifting direction and may terminate negotiations or require the tenant to pay the landlord’s incurred legal fees to bring the lender to a more reasonable, market-competitive position. Trouble begins when the lender seeks to effectively subordinate the landlord’s rights under the ground lease to the lender’s rights under its leasehold mortgage, as opposed to modifying the ground lease to provide for reasonable cure and leasehold foreclosure provisions.
Tips for Selecting a Lender
When investigating potential lenders, determine if lenders will provide examples of the provisions they require to be included in the ground lease. This may be in the form of sample ground lease inserts the lender has developed over time or a copy of its mortgagee-protection agreement form. When this information from each potential lender is in hand early on — prior to signing a term sheet with any lender — it is easier to weed out lenders who are presenting unacceptable terms quickly, without forfeiting nonrefundable commitment or term-sheet fees.
Another investigative strategy is to determine if the lender’s attorney is experienced with ground lease financing. Even some of the best attorneys who are experienced with fee-mortgage lending are uncomfortable with leasehold-mortgage lending. Inexperienced counsel may influence a lender into an overly protective mindset, bogging down the deal and increasing legal fees.
To the extent reasonably possible, the leasehold financing provisions of a ground lease should be set forth in a separate article of the ground lease with its own heading. Consolidation promotes efficient editing during negotiations. If those provisions are scattered throughout the ground lease, attorneys must pick through multiple articles each time a change is requested, which can get expensive. If the change is broad and conceptual in nature, attorneys may have to undertake a major rewrite of the lease, which also can be expensive. Realistically, the lender’s rights will have to be referenced in more than one place, such as the insurance provisions, the casualty provisions, and the construction provisions. The key is to draft most of those rights in one article and then reference that article, when needed, in another lease provision. In a typical ground lease transaction, the non-lender-related provisions may go through three to four rounds of negotiations, while the lender provisions may go through six to eight rounds of negotiations. It is important to control these time expenditures and the resulting legal fees.
Some leasehold lenders require a separate mortgagee-protection agreement between the leasehold lender and the landlord. Additionally, if there is a mortgage on the property’s fee estate, there may be one or more separate agreements regarding the lease priority and rights of the fee mortgagee and the leasehold mortgagee. Invariably, the parties to do not focus on these documents until the latter stages of lease negotiations and, as a result, quite often the initial drafts of these documents are unmodified lender forms inconsistent with the lease terms. To prevent negotiation and legal fee déjà vu, these additional agreements should be drafted concurrently and consistently with the ground lease.
Pitfalls to Avoid
It’s important to keep in mind that the ground lease must be “financeable,” which means the ground lease must contain certain customary terms protecting the interests of future leasehold mortgagees. Experienced leasehold lenders know this requirement and will cooperate in negotiating terms with a view to future financings. An inexperienced lender may insist on protections specific to it and thus jeopardize the tenant’s ability to obtain future financing without expensive lease modifications and without assurance that the tenant will obtain the consents required for such modifications.
Ground leases are complex by nature. Choosing a lender experienced in leasehold financing can reduce associated costs and headaches for this financially intricate situation.