In the Spotlight: Leasehold Financing; It's Good to Have Options

Let's face it ' we all like instant gratification. However, as current market conditions force us to sober up from years of economic over-indulgence, there is a need to discard those practices that may previously have seemed perfectly reasonable. It is now clear that these practices were not in fact properly thought-out or sufficiently disciplined to provide for true long-term stability or future success. This article discusses one particular concept in commercial leasing, which, if properly addressed and negotiated up front, is likely to benefit both the landlord and the tenant by providing greater security and increased credit possibilities in the years to come ' namely, leasehold financing.

Leashold Financing and What It Is

Leasehold financing is secured by a mortgage on the tenant's interest under a lease. As with fee-based financing, the lender in a leasehold financing transaction will record a mortgage or deed of trust against the collateral property, but in the case of leasehold financing, should the borrower default on the loan, the lender's primary remedy will be to “foreclose” on the leasehold mortgage by stepping into the borrower's shoes and becoming the tenant under the lease.

There are several scenarios in which a lender might accept a mortgage of a tenant's interest under a lease as security for a loan. Probably the most common of these is if the rent payable under the lease has not kept up with market rates, creating a “windfall” value for the holder of the tenant's interest. Similarly, if a tenant under a ground lease for unimproved property has subsequently constructed improvements (which under a “true” ground lease, will typically belong to the tenant), not only will the improvements themselves be valuable to a lender as collateral for the loan, but depending on the assignment and subleasing provisions of the lease, the improvements might also have created additional value by increasing the amount of rent that an outside party would reasonably be expected to pay.

In the alternative, it is possible that the leasehold interest might not have any significant inherent value to lenders in general but might nevertheless be attractive to a certain “niche” lender, such as a preferred lender for a particular franchisor, with whom the lender has an ongoing business relationship and with respect to which franchise the lender has specialized experience and operational knowledge. Finally, it may be the case that the leasehold interest itself does not have significant value at all, but the lender has made a business decision to accept it as loan collateral based on the value of the tenant's personal property, a personal guaranty, or other such considerations.

As with any loan, the lender in a leasehold financing transaction will need to exercise a certain degree of oversight and control over the collateral to ensure that the value of that collateral is not impaired. While this will be accomplished primarily by means of various covenants, representations, and warranties in the loan documents, because the lease is a contractual arrangement between the tenant and the landlord, there are several fundamental assurances that will inevitably require the landlord's consent. The most common of these, and from the lender's perspective, the most important, include the following.

Nondisturbance by Creditor in Possession of Fee

To the extent the landlord has mortgaged the fee interest in the leased property as security for financing of its own, the leasehold mortgagee will need to feel comfortable that, should the landlord default on its loan and the landlord's mortgagee take possession of the property, the mortgagee in possession will not be able to terminate the lease or vacate the tenant and thereby destroy the value of the leasehold mortgagee's collateral. This will most likely be accomplished by a recorded non-disturbance agreement in favor of the tenant (typically included in a subordination, non-disturbance, and attornment agreement or “SNDA”). Ideally, the nondisturbance agreement should inure to the benefit of the tenant's successor and assigns, but if the agreement is already of record and does not so state, then depending upon the circumstances, the lender on the leasehold estate may or may not require a new agreement. Moreover, because the leasehold mortgage will run parallel to the fee mortgage and encumber a completely different piece of collateral, the landlord does not need to worry that the existence of the leasehold mortgage will adversely affect its obligations to the holder of the fee mortgage.

Landlord Acknowledgment/Acceptance of Leasehold
Financing and Tenant's Right to Assign to Leasehold Mortgagee

Inherent in the concept of leasehold financing is that the lender will need to know that it can exercise its foreclosure remedy without having to deal with the landlord. Specifically, this means that the landlord will need to have agreed to the assignment by the tenant of the tenant's interest under the lease. While a landlord might consider its customary agreement to “reasonable” consent to assignment by the tenant to be sufficiently accommodating, in the leasehold financing context, any landlord consent requirement whatsoever will prevent the lease from being financeable. This is because (even assuming that the lender can record its mortgage and have it insured by the title company), if there is a possibility that the lender will be required to obtain the landlord's consent in order to foreclose, the landlord would then have a hold-up right over the lender, the cost of which risk would be difficult or impossible for the lender to quantify at the time the loan is made. Nevertheless, it is perfectly reasonable and justifiable for the landlord to clarify that the assignment will not create any additional rights in favor of the tenant or impose any additional obligations on the landlord beyond those already contained in the lease. Furthermore, depending on controlling successor liability law, the business terms of the transaction, and other such considerations, the landlord may convince the lender to assume the obligations and/or cure the defaults of the prior tenant as well.

Leasehold Mortgagee Notice and Cure Rights with Respect to Defaults by Tenant Under the Lease

Just as a lender on a fee interest will typically reserve the right to pay taxes or other amounts on behalf of the borrower in order to prevent the value of the collateral from becoming impaired, the lender on a leasehold estate will need to know that, should the borrower become delinquent and/or default in its obligations to the landlord under the lease, the lender will be able to cure such deficiencies and preserve the value of its collateral. Since the leasehold mortgagee will only be able to cure those deficiencies of which it has knowledge, the landlord will also have to agree to give the lender notice of such deficiencies. Generally speaking, however, the lender would be hard-pressed to justify a request for any notice and cure rights in excess of what the landlord has given to the tenant under the lease, and it is not unreasonable for the landlord to put the burden onto the lender to notify the landlord in writing of any future address changes. Thus, while important to the lender, the particular leasehold financing requirement should not be especially onerous for the landlord.

Consent of Leasehold Mortgagee Required to Modify Lease Terms

Since the lender will have underwritten the transaction based on the terms and conditions of the lease as they existed at the time of the loan, the lender will want to be comfortable that the landlord and the tenant will not be able to alter those terms and conditions in a way that would jeopardize the value of the leasehold estate as collateral for the loan. A “good” leasehold financing provision, from the lender's perspective, might require the landlord to agree that the lease will not be modified, amended, terminated, or altered in any way, and that the landlord will not, without the lender's consent, terminate the lease or accept a surrender of the premises. Since the lender will already have gotten these protections from the borrower in the loan documents, the only situation in which the lender would need to rely on the cooperation of the landlord would be if things go so severely awry between the lender and the borrower that the borrower becomes completely uncooperative. Therefore, depending on the facts of the particular situation, the landlord may have a good argument that a provision which subjects all lease modifications to the lender's consent is overly broad. Indeed, as the financial climate changes and lenders are able to charge more for their services but are, in return, required to bear the risk of the loan themselves (as opposed to acting simply as intermediaries who pass that risk onto someone else), the strength of this argument by the landlord should increase. The landlord, therefore, may request that the provision be deleted in its entirety, or at the very least, that it be limited in its scope so as to apply only to lease modifications that materially and adversely affect the value of the lender's collateral.

Right of Leasehold Mortgagee to Exercise Any Extension or Similar Options in Favor of Tenant

Finally, the lender would ideally want to have the right, even prior to assuming the tenant's interest under the lease, to exercise any extension options (or options to purchase, etc.) on behalf of the tenant under the lease. Since much (or most) of the potential length of a ground lease will typically be in the form of extension options, having less-than-perfect certainty that those options will be exercised could create a significant underwriting risk for the lender. A landlord who is worried about getting in the middle of a dispute between the tenant and the lender and who is, therefore, reluctant to grant such a right to the lender should rely on the same argument described above with respect to amendments and modifications to the lease. In other words, it is the lender who is (or should be!) in the business of evaluating risk and who will be monetarily compensated for accepting such risk. Thus, the fact that not being able to exercise the options on behalf of the tenant creates a certain risk for the lender is the lender's problem ' not the landlord's. Again, the outcome of this argument will hinge on the particular circumstances, such as the timing of the extension options relative to the length of the loan, the value of the particular leasehold interest in question as part of the entire package of collateral, and the lender's overall confidence in the borrower as a credit risk.

Conclusion

As stated above, it is best to address these key items in a leasehold financing provision in the original lease. While the absence of such a provision will not necessarily preclude the tenant from obtaining leasehold financing, it will require the tenant to go back to the landlord and obtain the rights necessary for leasehold financing in an estoppel, a lease amendment, or the like. To the extent such negotiations are required at the time the loan is made, they are likely to involve significant transaction costs and inconvenience and might even render the transaction as a whole too expensive to be feasible. If, on the other hand, the leasehold financing rights are clearly set forth in the original lease, the parties should be able to avoid the vast majority of such costs and inconvenience and accomplish the leasehold financing transaction smoothly and efficiently.

Finally, it is worth mentioning that even if the lease does contain a proper leasehold financing provision, the lender most likely will still need the landlord to deliver an estoppel similar to what one might see in connection with a fee interest financing or purchase and sale transaction, in which the landlord confirms the basic lease terms, that all amounts owed by the tenant under the lease have been paid, etc. Hopefully, if the lease contains a good leasehold financing provision, the landlord's estoppel obligations will be clearly described as well ' but regardless, the landlord should keep in mind that in some ways its interests are parallel to those of the tenant.

For one thing, the landlord benefits by knowing that a lender that has just conducted its due diligence review has found the tenant to be an acceptable credit risk. Secondly, should the tenant default, having a “backup” tenant available means there is at least a chance the landlord will avoid the hassle and expense of having to find a replacement ' which remediation may be required by statute, and which, in any event, is likely to be difficult in today's market. Last, should the tenant be unable to obtain financing and default, the landlord may have to bear the costs of enforcing its remedies against the tenant; whereas, it will almost certainly be easier and less expensive for the landlord to cooperate as much as possible in helping the tenant gain access to the financing it needs to continue its operations ' and of course, to pay rent.

Jay Melnick is an associate at Seyfarth Shaw LLP, Chicago.

Let's face it ' we all like instant gratification. However, as current market conditions force us to sober up from years of economic over-indulgence, there is a need to discard those practices that may previously have seemed perfectly reasonable. It is now clear that these practices were not in fact properly thought-out or sufficiently disciplined to provide for true long-term stability or future success. This article discusses one particular concept in commercial leasing, which, if properly addressed and negotiated up front, is likely to benefit both the landlord and the tenant by providing greater security and increased credit possibilities in the years to come ' namely, leasehold financing.

Leashold Financing and What It Is

Leasehold financing is secured by a mortgage on the tenant's interest under a lease. As with fee-based financing, the lender in a leasehold financing transaction will record a mortgage or deed of trust against the collateral property, but in the case of leasehold financing, should the borrower default on the loan, the lender's primary remedy will be to “foreclose” on the leasehold mortgage by stepping into the borrower's shoes and becoming the tenant under the lease.

There are several scenarios in which a lender might accept a mortgage of a tenant's interest under a lease as security for a loan. Probably the most common of these is if the rent payable under the lease has not kept up with market rates, creating a “windfall” value for the holder of the tenant's interest. Similarly, if a tenant under a ground lease for unimproved property has subsequently constructed improvements (which under a “true” ground lease, will typically belong to the tenant), not only will the improvements themselves be valuable to a lender as collateral for the loan, but depending on the assignment and subleasing provisions of the lease, the improvements might also have created additional value by increasing the amount of rent that an outside party would reasonably be expected to pay.

In the alternative, it is possible that the leasehold interest might not have any significant inherent value to lenders in general but might nevertheless be attractive to a certain “niche” lender, such as a preferred lender for a particular franchisor, with whom the lender has an ongoing business relationship and with respect to which franchise the lender has specialized experience and operational knowledge. Finally, it may be the case that the leasehold interest itself does not have significant value at all, but the lender has made a business decision to accept it as loan collateral based on the value of the tenant's personal property, a personal guaranty, or other such considerations.

As with any loan, the lender in a leasehold financing transaction will need to exercise a certain degree of oversight and control over the collateral to ensure that the value of that collateral is not impaired. While this will be accomplished primarily by means of various covenants, representations, and warranties in the loan documents, because the lease is a contractual arrangement between the tenant and the landlord, there are several fundamental assurances that will inevitably require the landlord's consent. The most common of these, and from the lender's perspective, the most important, include the following.

Nondisturbance by Creditor in Possession of Fee

To the extent the landlord has mortgaged the fee interest in the leased property as security for financing of its own, the leasehold mortgagee will need to feel comfortable that, should the landlord default on its loan and the landlord's mortgagee take possession of the property, the mortgagee in possession will not be able to terminate the lease or vacate the tenant and thereby destroy the value of the leasehold mortgagee's collateral. This will most likely be accomplished by a recorded non-disturbance agreement in favor of the tenant (typically included in a subordination, non-disturbance, and attornment agreement or “SNDA”). Ideally, the nondisturbance agreement should inure to the benefit of the tenant's successor and assigns, but if the agreement is already of record and does not so state, then depending upon the circumstances, the lender on the leasehold estate may or may not require a new agreement. Moreover, because the leasehold mortgage will run parallel to the fee mortgage and encumber a completely different piece of collateral, the landlord does not need to worry that the existence of the leasehold mortgage will adversely affect its obligations to the holder of the fee mortgage.

Landlord Acknowledgment/Acceptance of Leasehold
Financing and Tenant's Right to Assign to Leasehold Mortgagee

Inherent in the concept of leasehold financing is that the lender will need to know that it can exercise its foreclosure remedy without having to deal with the landlord. Specifically, this means that the landlord will need to have agreed to the assignment by the tenant of the tenant's interest under the lease. While a landlord might consider its customary agreement to “reasonable” consent to assignment by the tenant to be sufficiently accommodating, in the leasehold financing context, any landlord consent requirement whatsoever will prevent the lease from being financeable. This is because (even assuming that the lender can record its mortgage and have it insured by the title company), if there is a possibility that the lender will be required to obtain the landlord's consent in order to foreclose, the landlord would then have a hold-up right over the lender, the cost of which risk would be difficult or impossible for the lender to quantify at the time the loan is made. Nevertheless, it is perfectly reasonable and justifiable for the landlord to clarify that the assignment will not create any additional rights in favor of the tenant or impose any additional obligations on the landlord beyond those already contained in the lease. Furthermore, depending on controlling successor liability law, the business terms of the transaction, and other such considerations, the landlord may convince the lender to assume the obligations and/or cure the defaults of the prior tenant as well.

Leasehold Mortgagee Notice and Cure Rights with Respect to Defaults by Tenant Under the Lease

Just as a lender on a fee interest will typically reserve the right to pay taxes or other amounts on behalf of the borrower in order to prevent the value of the collateral from becoming impaired, the lender on a leasehold estate will need to know that, should the borrower become delinquent and/or default in its obligations to the landlord under the lease, the lender will be able to cure such deficiencies and preserve the value of its collateral. Since the leasehold mortgagee will only be able to cure those deficiencies of which it has knowledge, the landlord will also have to agree to give the lender notice of such deficiencies. Generally speaking, however, the lender would be hard-pressed to justify a request for any notice and cure rights in excess of what the landlord has given to the tenant under the lease, and it is not unreasonable for the landlord to put the burden onto the lender to notify the landlord in writing of any future address changes. Thus, while important to the lender, the particular leasehold financing requirement should not be especially onerous for the landlord.

Consent of Leasehold Mortgagee Required to Modify Lease Terms

Since the lender will have underwritten the transaction based on the terms and conditions of the lease as they existed at the time of the loan, the lender will want to be comfortable that the landlord and the tenant will not be able to alter those terms and conditions in a way that would jeopardize the value of the leasehold estate as collateral for the loan. A “good” leasehold financing provision, from the lender's perspective, might require the landlord to agree that the lease will not be modified, amended, terminated, or altered in any way, and that the landlord will not, without the lender's consent, terminate the lease or accept a surrender of the premises. Since the lender will already have gotten these protections from the borrower in the loan documents, the only situation in which the lender would need to rely on the cooperation of the landlord would be if things go so severely awry between the lender and the borrower that the borrower becomes completely uncooperative. Therefore, depending on the facts of the particular situation, the landlord may have a good argument that a provision which subjects all lease modifications to the lender's consent is overly broad. Indeed, as the financial climate changes and lenders are able to charge more for their services but are, in return, required to bear the risk of the loan themselves (as opposed to acting simply as intermediaries who pass that risk onto someone else), the strength of this argument by the landlord should increase. The landlord, therefore, may request that the provision be deleted in its entirety, or at the very least, that it be limited in its scope so as to apply only to lease modifications that materially and adversely affect the value of the lender's collateral.

Right of Leasehold Mortgagee to Exercise Any Extension or Similar Options in Favor of Tenant

Finally, the lender would ideally want to have the right, even prior to assuming the tenant's interest under the lease, to exercise any extension options (or options to purchase, etc.) on behalf of the tenant under the lease. Since much (or most) of the potential length of a ground lease will typically be in the form of extension options, having less-than-perfect certainty that those options will be exercised could create a significant underwriting risk for the lender. A landlord who is worried about getting in the middle of a dispute between the tenant and the lender and who is, therefore, reluctant to grant such a right to the lender should rely on the same argument described above with respect to amendments and modifications to the lease. In other words, it is the lender who is (or should be!) in the business of evaluating risk and who will be monetarily compensated for accepting such risk. Thus, the fact that not being able to exercise the options on behalf of the tenant creates a certain risk for the lender is the lender's problem ' not the landlord's. Again, the outcome of this argument will hinge on the particular circumstances, such as the timing of the extension options relative to the length of the loan, the value of the particular leasehold interest in question as part of the entire package of collateral, and the lender's overall confidence in the borrower as a credit risk.

Conclusion

As stated above, it is best to address these key items in a leasehold financing provision in the original lease. While the absence of such a provision will not necessarily preclude the tenant from obtaining leasehold financing, it will require the tenant to go back to the landlord and obtain the rights necessary for leasehold financing in an estoppel, a lease amendment, or the like. To the extent such negotiations are required at the time the loan is made, they are likely to involve significant transaction costs and inconvenience and might even render the transaction as a whole too expensive to be feasible. If, on the other hand, the leasehold financing rights are clearly set forth in the original lease, the parties should be able to avoid the vast majority of such costs and inconvenience and accomplish the leasehold financing transaction smoothly and efficiently.

Finally, it is worth mentioning that even if the lease does contain a proper leasehold financing provision, the lender most likely will still need the landlord to deliver an estoppel similar to what one might see in connection with a fee interest financing or purchase and sale transaction, in which the landlord confirms the basic lease terms, that all amounts owed by the tenant under the lease have been paid, etc. Hopefully, if the lease contains a good leasehold financing provision, the landlord's estoppel obligations will be clearly described as well ' but regardless, the landlord should keep in mind that in some ways its interests are parallel to those of the tenant.

For one thing, the landlord benefits by knowing that a lender that has just conducted its due diligence review has found the tenant to be an acceptable credit risk. Secondly, should the tenant default, having a “backup” tenant available means there is at least a chance the landlord will avoid the hassle and expense of having to find a replacement ' which remediation may be required by statute, and which, in any event, is likely to be difficult in today's market. Last, should the tenant be unable to obtain financing and default, the landlord may have to bear the costs of enforcing its remedies against the tenant; whereas, it will almost certainly be easier and less expensive for the landlord to cooperate as much as possible in helping the tenant gain access to the financing it needs to continue its operations ' and of course, to pay rent.

Jay Melnick is an associate at Seyfarth Shaw LLP, Chicago.