Alienation of Tenants' Rights: Factors to Consider to Make a Ground Lease Financeable

To truly understand one's own position, it is best to walk a mile in another's shoes. This is the starting place to reveal the secrets to drafting a financeable ground lease. If the tenant can understand the leasehold mortgagee's concerns and how they integrate with the landlord's converging interests, the battle is already half won. This article suggests some tips to consider in the negotiation of the provisions of a ground lease that will be the center of attention for the leasehold mortgagee. These tips should help to smooth the way for the tenant's leasehold financing by an institutional mortgagee. By adopting an approach that acknowledges the reasonable concerns of a current or future lender, the tenant will be better positioned to avoid protracted negotiations and redrafting.

Term of Ground Lease

Most parties are quick to acknowledge that the term of the ground lease must be coterminous with the debt, but that does not get all of the parties to their comfort zones. The leasehold mortgagee will likely be intent on having a safety net in the event that the leasehold mortgagee takes the tenant's interest in the ground lease. When dealing with an existing mortgage or simultaneous mortgage negotiations, it is wise to provide for a reasonable time buffer following the stated term of the mortgage, to enable the leasehold mortgagee to obtain the full principal and interest on the loan.

Rent

The leasehold mortgagee must be able to determine with certainty what the rent is throughout the term (including the extension terms). This ensures that the leasehold mortgagee can make a reasonable estimate as to the debt coverage ratio. This approach is gaining popularity as people start to recognize the risks inherent in formulaic determinations, such as the Consumer Price Index, in uncertain economies.

Title and Ownership

The tenant must take care to provide that the ground lease will remain a priority lien on the real property. This requires a careful reading of the lease provisions. Often a simple sentence subordinating the ground lease to the fee mortgage, or failing to prohibit the landlord expressly from granting a mortgage that will prime the ground lease, is overlooked, resulting in disaster. In the case of a ground lease, it is not equally acceptable simply to have a Non-Disturbance Agreement ('NDA') executed by the fee mortgagee; such an agreement also would need to include a clear and unequivocal subordination of the fee mortgage. There are few, if any, leasehold mortgagees willing to risk foreclosure of the fee estate without having a superior claim. The practical truth, however, is that many shopping centers are already encumbered by the landlord's fee mortgage. The fee mortgagee may not be keen on the idea of subordinating its lien, especially if the prospect of a ground lease did not factor in the original negotiations. For this reason, this topic should be at the forefront of the tenant's discussions with the landlord.

Almost as important as the ownership of the ground lease is the tenant's ownership of the improvements. The ground lease should provide that the tenant retains ownership of all improvements constructed by or on behalf of the tenant. Not only is ownership an important financing consideration, but it is also important for determining the fair market value of the ground lease, for tax reasons (if the tenant owns the improvements, then it will be entitled to take the depreciation) and for title insurance coverage. Additionally, ownership of the improvements helps to strengthen the tenant's position in the event of casualty or condemnation. Generally speaking, the stronger the tenant's position, the more comfort the leasehold mortgagee will have.

Alienation of Tenant's Interest

A major focus of the leasehold mortgagee's attention is the manner or manners in which the tenant can freely alienate its interest in the ground lease. The goal for the tenant here is to build in as much flexibility as possible on all fronts ' assignment, subletting, and mortgaging.

Assignment

This is one of the areas in the ground lease where the tenant must hold firm. Flexibility to assign is among the key factors that the leasehold mortgagee will look for when determining whether to finance the lease. Of course, the best position to be in with respect to the tenant's right to assign is to have unrestricted freedom. By having the right to assign its interest in the ground lease without consent, the tenant will appease any leasehold mortgagee on the issue and at the same time avoid difficult negotiations regarding the extent of the landlord's rights. Once the landlord's right to consent enters the equation, the question becomes: What will the leasehold mortgagee tolerate, and what will risk the financeability of the ground lease? The landlord's divergent interests further complicate the discussions at this point. In any event, the ground lease absolutely must be freely assignable to the leasehold mortgagee and its successors and assigns following a foreclosure sale or deed in lieu.

Some other considerations to be discussed, or at least kept in mind, when negotiating the assignment provision are:

1) Release of the tenant following assignment;

2) Consistency between the leasehold mortgage and the ground lease regarding transfers; and

3) What constitutes an assignment; whether transfers to affiliates or successors or a change in the control of the tenant will trigger the landlord's right to consent.

One alternative for tenants, where the landlord refuses to agree to a full release of the tenant upon assignment, is to condition the release on an assignee's having the same or greater net worth as the tenant (or putting in a fixed number).

The tenant will very often find that it has to compromise. Landlords are reluctant to permit assignment without consent or restriction. The landlord's concerns commonly run, at least in part, to its plan for future development of the center or plans for the development of adjacent property. For this reason, it is strongly suggested that the tenant have a full understanding of the landlord's plans both for the reversion and for integration with any adjacent property.

Subletting

The ability of the tenant to sublease goes directly to the economics of the tenant's interest. As a potential successor to the tenant, the leasehold mortgagee shares the same concerns. The tenant's interest is far more valuable if the tenant has freedom in determining the tenant mix of the center and being able to change that mix to reflect the then current market conditions. Not only is this flexibility also more valuable to the leasehold mortgagee, it increases the value to an assignee or purchaser. The tenant should negotiate for a provision that expressly permits subleasing, subject only to applicable laws and regulations and perhaps to noxious use limitations. This will decrease the risk of vacancy and therefore increase profitability, providing the leasehold mortgagee with comfort that the tenant will meet the debt coverage obligations and greatly adding to the financeability of the ground lease.

Other points to keep in mind when negotiating the subletting provisions of a ground lease are:

1) Landlord's option to recapture;

2) Non-Disturbance Agreements in favor of the subtenants; and

3) Additional restrictions placed on subtenants.

Very often the landlord will require that the tenant notify the landlord of its intention to sublease the leased premises. Notice alone is certainly reasonable and has no bearing on a tenant's rights or the financeability of the ground lease. It becomes an issue when the landlord wants the right, upon receipt of the tenant's notice, to recapture the leased premises. Because this type of provision raises a red flag for leasehold mortgagees, inclusion of the provision in the ground lease is not recommended. The tenant would be better served to work with the landlord in constructing reasonable parameters for subleases because such an approach would not threaten the continued existence of the ground lease, which is of paramount importance to the leasehold mortgagee.

Tenants face another challenge when landlords want to restrict the circumstances under which they will agree to execute an NDA to a subtenant. Some landlords will want to limit their obligation to those subtenants meeting certain criteria, such as term, use, or financial ability. This particular obstacle can usually be overcome by: a) suggesting more reasonable criteria that will not unduly restrict the tenant's flexibility, and b) reminding the landlord that by agreeing to provide NDAs, the property will ultimately benefit from higher quality subtenants, leaving the landlord with a more desirable outcome in the event of a tenant default. Reasonable criteria should be limited to conditions that are not specific to a particular subtenant, such as: 1) the sublease must contain commercially reasonable terms, 2) the subtenant must agree in writing to be bound by all of the terms of the lease, and 3) the subtenant may not be a subsidiary or other affiliate of the tenant.

Mortgaging

The ground lease should contain a clause expressly permitting the tenant to grant a leasehold mortgage without the landlord's consent. Statutes in most, if not all, states follow the general rule that unless expressly prohibited, a tenant is permitted to mortgage its leasehold interest. Nevertheless, leasehold mortgagees favor the affirmative approach. Tenants should be cautious about any limitations or conditions being placed on the right to mortgage, as well as subsequent rights, so as not to restrict financing options, purchase money mortgagees, and 'private' or other non-institutional lenders. There is a direct correlation between the absence of limitation or restriction on the tenant's right to mortgage and the increase in the perceived financeability of the ground lease.

Casualty and Condemnation

The leasehold mortgagee will scrutinize the ground lease for a number of protections, including the following:

1) That its loan is first in line for payment in the event of a total loss;

2) Proceeds are payable to it pursuant to a named insured as loss payee clause, and that leasehold mortgagee has the opportunity to participate in any settlement with the insurer;

3) Advance notice is provided to it prior to any cancellation of or change to the policy;

4) The allocation of proceeds in the event of a total loss is clear and must keep repayment of the leasehold mortgage in first priority;

5) There are no termination rights.

As indicated above, the tenant's ownership of the improvements will factor in to how the proceeds are allocated in the event of a casualty or condemnation. A typical allocation, provided that the ground lease states that the tenant owns the improvements, is that the tenant receives the value of the unexpired lease term and the improvements, the leasehold mortgagee receives funds sufficient to discharge the mortgage, and the landlord receives the value of the land as unimproved. Another benefit to the tenant's ownership of the improvements is the leverage to allow for ' but not require ' demolition of the improvements. Landlords often try to obligate tenants to remove the improvements at the end of the term, so they have a 'clean slate' to lease to the next tenant and can avoid the associated cost of putting the improvements into leaseable condition or otherwise demolishing them, but leasehold mortgagees do not want any such end-of-the-term obligations.

The concerns of the leasehold mortgagee should be carefully considered when negotiating and drafting these provisions, to forestall the need for later revisions. Such concerns, generally speaking, revolve around continuation of the ground lease, value and utility of the leased premises, protection of the leasehold mortgagee's investment, and the absence of obligations on the part of the tenant beyond restoration within a reasonable time. As with other provisions, the tenant must always recall that the leasehold mortgagee will be bound by the same lease terms without having the same operational benefit.

Landlord Consent Rights

Tenants must be vigilant about what control is given to the landlord. With too much control, the ground lease will be difficult, if not impossible, to finance; with too little control, the landlord may walk away. Tenants must work hard to strike a balance between the landlord's need to control operation and development of the center on the one hand, and the leasehold mortgagee's need to recoup its money on the other. Operating covenants are among the harder sells. Often, landlords negotiate co-tenancy requirements in leases in order to induce occupancy. These co-tenancy requirements ultimately require that the anchor tenants have operating covenants. While an operating covenant is never favorable to the tenant, it is often death to the financeability of a ground lease, unless the leasehold mortgagee is expressly carved out of such requirement. Although there is no room for a full discussion of those issues here, a general proposition is that wherever the landlord is given rights, give the leasehold mortgagee the same rights and remember always to include time limitations on the landlord's consent rights.

Cure Rights

Last but not least, do not forget to negotiate the leasehold mortgagee's right to cure, with sufficient time, in the event of a tenant default. While this topic, too, is broad enough for its own article, this is intended as an overall reminder of the basics. There should always be notice of default to the leasehold mortgagee, accompanied by a right and opportunity to cure. Tenants should endeavor to obtain a longer cure period for the leasehold mortgagee than is provided for a tenant default. It is easy to overlook providing for the rare but possible situation where the default is of such a nature that the leasehold mortgagee cannot cure it. The ground lease should specifically provide that in such circumstances, the landlord will not have the right to terminate the ground lease, and the leasehold mortgagee will be given sufficient time to prosecute foreclosure and taking of possession.

While the word 'financeable' makes the negotiation of a ground lease far more complex, with some forethought and an understanding of, and willingness to try to balance, the parties' positions and basic concerns, the negotiation will become a challenging yet successful endeavor.

Catherine L. Burns is a partner in the Boston office of Seyfarth Shaw LLP. She can be reached at [email protected] or 617-946-4972.

To truly understand one's own position, it is best to walk a mile in another's shoes. This is the starting place to reveal the secrets to drafting a financeable ground lease. If the tenant can understand the leasehold mortgagee's concerns and how they integrate with the landlord's converging interests, the battle is already half won. This article suggests some tips to consider in the negotiation of the provisions of a ground lease that will be the center of attention for the leasehold mortgagee. These tips should help to smooth the way for the tenant's leasehold financing by an institutional mortgagee. By adopting an approach that acknowledges the reasonable concerns of a current or future lender, the tenant will be better positioned to avoid protracted negotiations and redrafting.

Term of Ground Lease

Most parties are quick to acknowledge that the term of the ground lease must be coterminous with the debt, but that does not get all of the parties to their comfort zones. The leasehold mortgagee will likely be intent on having a safety net in the event that the leasehold mortgagee takes the tenant's interest in the ground lease. When dealing with an existing mortgage or simultaneous mortgage negotiations, it is wise to provide for a reasonable time buffer following the stated term of the mortgage, to enable the leasehold mortgagee to obtain the full principal and interest on the loan.

Rent

The leasehold mortgagee must be able to determine with certainty what the rent is throughout the term (including the extension terms). This ensures that the leasehold mortgagee can make a reasonable estimate as to the debt coverage ratio. This approach is gaining popularity as people start to recognize the risks inherent in formulaic determinations, such as the Consumer Price Index, in uncertain economies.

Title and Ownership

The tenant must take care to provide that the ground lease will remain a priority lien on the real property. This requires a careful reading of the lease provisions. Often a simple sentence subordinating the ground lease to the fee mortgage, or failing to prohibit the landlord expressly from granting a mortgage that will prime the ground lease, is overlooked, resulting in disaster. In the case of a ground lease, it is not equally acceptable simply to have a Non-Disturbance Agreement ('NDA') executed by the fee mortgagee; such an agreement also would need to include a clear and unequivocal subordination of the fee mortgage. There are few, if any, leasehold mortgagees willing to risk foreclosure of the fee estate without having a superior claim. The practical truth, however, is that many shopping centers are already encumbered by the landlord's fee mortgage. The fee mortgagee may not be keen on the idea of subordinating its lien, especially if the prospect of a ground lease did not factor in the original negotiations. For this reason, this topic should be at the forefront of the tenant's discussions with the landlord.

Almost as important as the ownership of the ground lease is the tenant's ownership of the improvements. The ground lease should provide that the tenant retains ownership of all improvements constructed by or on behalf of the tenant. Not only is ownership an important financing consideration, but it is also important for determining the fair market value of the ground lease, for tax reasons (if the tenant owns the improvements, then it will be entitled to take the depreciation) and for title insurance coverage. Additionally, ownership of the improvements helps to strengthen the tenant's position in the event of casualty or condemnation. Generally speaking, the stronger the tenant's position, the more comfort the leasehold mortgagee will have.

Alienation of Tenant's Interest

A major focus of the leasehold mortgagee's attention is the manner or manners in which the tenant can freely alienate its interest in the ground lease. The goal for the tenant here is to build in as much flexibility as possible on all fronts ' assignment, subletting, and mortgaging.

Assignment

This is one of the areas in the ground lease where the tenant must hold firm. Flexibility to assign is among the key factors that the leasehold mortgagee will look for when determining whether to finance the lease. Of course, the best position to be in with respect to the tenant's right to assign is to have unrestricted freedom. By having the right to assign its interest in the ground lease without consent, the tenant will appease any leasehold mortgagee on the issue and at the same time avoid difficult negotiations regarding the extent of the landlord's rights. Once the landlord's right to consent enters the equation, the question becomes: What will the leasehold mortgagee tolerate, and what will risk the financeability of the ground lease? The landlord's divergent interests further complicate the discussions at this point. In any event, the ground lease absolutely must be freely assignable to the leasehold mortgagee and its successors and assigns following a foreclosure sale or deed in lieu.

Some other considerations to be discussed, or at least kept in mind, when negotiating the assignment provision are:

1) Release of the tenant following assignment;

2) Consistency between the leasehold mortgage and the ground lease regarding transfers; and

3) What constitutes an assignment; whether transfers to affiliates or successors or a change in the control of the tenant will trigger the landlord's right to consent.

One alternative for tenants, where the landlord refuses to agree to a full release of the tenant upon assignment, is to condition the release on an assignee's having the same or greater net worth as the tenant (or putting in a fixed number).

The tenant will very often find that it has to compromise. Landlords are reluctant to permit assignment without consent or restriction. The landlord's concerns commonly run, at least in part, to its plan for future development of the center or plans for the development of adjacent property. For this reason, it is strongly suggested that the tenant have a full understanding of the landlord's plans both for the reversion and for integration with any adjacent property.

Subletting

The ability of the tenant to sublease goes directly to the economics of the tenant's interest. As a potential successor to the tenant, the leasehold mortgagee shares the same concerns. The tenant's interest is far more valuable if the tenant has freedom in determining the tenant mix of the center and being able to change that mix to reflect the then current market conditions. Not only is this flexibility also more valuable to the leasehold mortgagee, it increases the value to an assignee or purchaser. The tenant should negotiate for a provision that expressly permits subleasing, subject only to applicable laws and regulations and perhaps to noxious use limitations. This will decrease the risk of vacancy and therefore increase profitability, providing the leasehold mortgagee with comfort that the tenant will meet the debt coverage obligations and greatly adding to the financeability of the ground lease.

Other points to keep in mind when negotiating the subletting provisions of a ground lease are:

1) Landlord's option to recapture;

2) Non-Disturbance Agreements in favor of the subtenants; and

3) Additional restrictions placed on subtenants.

Very often the landlord will require that the tenant notify the landlord of its intention to sublease the leased premises. Notice alone is certainly reasonable and has no bearing on a tenant's rights or the financeability of the ground lease. It becomes an issue when the landlord wants the right, upon receipt of the tenant's notice, to recapture the leased premises. Because this type of provision raises a red flag for leasehold mortgagees, inclusion of the provision in the ground lease is not recommended. The tenant would be better served to work with the landlord in constructing reasonable parameters for subleases because such an approach would not threaten the continued existence of the ground lease, which is of paramount importance to the leasehold mortgagee.

Tenants face another challenge when landlords want to restrict the circumstances under which they will agree to execute an NDA to a subtenant. Some landlords will want to limit their obligation to those subtenants meeting certain criteria, such as term, use, or financial ability. This particular obstacle can usually be overcome by: a) suggesting more reasonable criteria that will not unduly restrict the tenant's flexibility, and b) reminding the landlord that by agreeing to provide NDAs, the property will ultimately benefit from higher quality subtenants, leaving the landlord with a more desirable outcome in the event of a tenant default. Reasonable criteria should be limited to conditions that are not specific to a particular subtenant, such as: 1) the sublease must contain commercially reasonable terms, 2) the subtenant must agree in writing to be bound by all of the terms of the lease, and 3) the subtenant may not be a subsidiary or other affiliate of the tenant.

Mortgaging

The ground lease should contain a clause expressly permitting the tenant to grant a leasehold mortgage without the landlord's consent. Statutes in most, if not all, states follow the general rule that unless expressly prohibited, a tenant is permitted to mortgage its leasehold interest. Nevertheless, leasehold mortgagees favor the affirmative approach. Tenants should be cautious about any limitations or conditions being placed on the right to mortgage, as well as subsequent rights, so as not to restrict financing options, purchase money mortgagees, and 'private' or other non-institutional lenders. There is a direct correlation between the absence of limitation or restriction on the tenant's right to mortgage and the increase in the perceived financeability of the ground lease.

Casualty and Condemnation

The leasehold mortgagee will scrutinize the ground lease for a number of protections, including the following:

1) That its loan is first in line for payment in the event of a total loss;

2) Proceeds are payable to it pursuant to a named insured as loss payee clause, and that leasehold mortgagee has the opportunity to participate in any settlement with the insurer;

3) Advance notice is provided to it prior to any cancellation of or change to the policy;

4) The allocation of proceeds in the event of a total loss is clear and must keep repayment of the leasehold mortgage in first priority;

5) There are no termination rights.

As indicated above, the tenant's ownership of the improvements will factor in to how the proceeds are allocated in the event of a casualty or condemnation. A typical allocation, provided that the ground lease states that the tenant owns the improvements, is that the tenant receives the value of the unexpired lease term and the improvements, the leasehold mortgagee receives funds sufficient to discharge the mortgage, and the landlord receives the value of the land as unimproved. Another benefit to the tenant's ownership of the improvements is the leverage to allow for ' but not require ' demolition of the improvements. Landlords often try to obligate tenants to remove the improvements at the end of the term, so they have a 'clean slate' to lease to the next tenant and can avoid the associated cost of putting the improvements into leaseable condition or otherwise demolishing them, but leasehold mortgagees do not want any such end-of-the-term obligations.

The concerns of the leasehold mortgagee should be carefully considered when negotiating and drafting these provisions, to forestall the need for later revisions. Such concerns, generally speaking, revolve around continuation of the ground lease, value and utility of the leased premises, protection of the leasehold mortgagee's investment, and the absence of obligations on the part of the tenant beyond restoration within a reasonable time. As with other provisions, the tenant must always recall that the leasehold mortgagee will be bound by the same lease terms without having the same operational benefit.

Landlord Consent Rights

Tenants must be vigilant about what control is given to the landlord. With too much control, the ground lease will be difficult, if not impossible, to finance; with too little control, the landlord may walk away. Tenants must work hard to strike a balance between the landlord's need to control operation and development of the center on the one hand, and the leasehold mortgagee's need to recoup its money on the other. Operating covenants are among the harder sells. Often, landlords negotiate co-tenancy requirements in leases in order to induce occupancy. These co-tenancy requirements ultimately require that the anchor tenants have operating covenants. While an operating covenant is never favorable to the tenant, it is often death to the financeability of a ground lease, unless the leasehold mortgagee is expressly carved out of such requirement. Although there is no room for a full discussion of those issues here, a general proposition is that wherever the landlord is given rights, give the leasehold mortgagee the same rights and remember always to include time limitations on the landlord's consent rights.

Cure Rights

Last but not least, do not forget to negotiate the leasehold mortgagee's right to cure, with sufficient time, in the event of a tenant default. While this topic, too, is broad enough for its own article, this is intended as an overall reminder of the basics. There should always be notice of default to the leasehold mortgagee, accompanied by a right and opportunity to cure. Tenants should endeavor to obtain a longer cure period for the leasehold mortgagee than is provided for a tenant default. It is easy to overlook providing for the rare but possible situation where the default is of such a nature that the leasehold mortgagee cannot cure it. The ground lease should specifically provide that in such circumstances, the landlord will not have the right to terminate the ground lease, and the leasehold mortgagee will be given sufficient time to prosecute foreclosure and taking of possession.

While the word 'financeable' makes the negotiation of a ground lease far more complex, with some forethought and an understanding of, and willingness to try to balance, the parties' positions and basic concerns, the negotiation will become a challenging yet successful endeavor.

Catherine L. Burns is a partner in the Boston office of Seyfarth Shaw LLP. She can be reached at [email protected] or 617-946-4972.