Ground Lease Risks In Municipal Bond Projects

Most of the tasks include tax-exempt lessor structures. Since federal government entities and nonprofit organizations are exempt from genuine residential or commercial property taxes in most jurisdictions, a ground lease between such entities and a borrower-sponsor supplies a job the opportunity to either be exempt from residential or commercial property taxes or based on a payment-in-lieu of taxes plan, both of which can provide considerable savings over the life of a job.


In higher education, universities normally use avenue funded ground lease structures to construct trainee housing tasks. These projects consist of a ground lease between a university, as landlord, and the borrower-sponsor, as renter. The university accepts the ground lease since, since the borrower-sponsor is accountable for repayment of the bonds and the mortgage is on the leasehold, the university can develop a job on campus without incurring debt and keep the project totally free once the ground lease is terminated. During the regard to the ground lease, the arrangements of the ground lease offers a way for the university to regulate or monitor the project and receive a yearly ground lease rent.


In other industries, the provider frequently owns the land and ground rents the land on which the task is to be built to the borrower-sponsor, who constructs the project and subleases it back to the company. Such a project certifies for a genuine residential or commercial property tax exemption due to the fact that it is owned by a government entity, and given that the government entity is likewise renter under the sublease, the job qualifies for sales tax exemptions on products during construction. The issuer, as renter under the sublease, is accountable for payment of the bonds, while the borrower-sponsor establishes and runs the to terms and conditions of contracts with the provider. The borrower-sponsor typically has an opportunity to acquire the land and task once the bonds are paid.


These structures present special dangers to bond purchasers. The bonds are generally protected by mortgages on the leasehold and/or subleasehold estates. Bondholders must bear in mind the rights of celebrations to terminate the ground lease or interfere with their capability to work out treatments. If the ground lease is ended or the trustee can not take ownership of the job, the corresponding lien on the physical job is snuffed out and the collateral plan has no worth.


With that in mind, shareholders ought to seek the following defenses in any ground lease that belongs to a local bond financing:


Term - the regard to the ground lease must be at least 5 years beyond the maturity date of the bonds, and bondholders must push for more if at all possible. The additional five or more years permits an exercise and extension of the term of the bonds in the occasion it is required to enable the project to capital to cover business expenses and debt service. If the bonds on a job have a bullet maturity, the term of the ground lease should be at least double the regard to the bonds to enable a refunding of the developing bonds.


Authorization - the ground lease should explicitly license the borrower-sponsor to sustain a mortgage on the ground lease or else a court would think about the lien on the leasehold estate void.


Transfer and Assignment - the ground lease must be assignable by the trustee without constraints. Failure to consist of such arrangements could avoid a mortgagee from selling or moving the leasehold estate (by sale or otherwise) upon foreclosure or the execution of an assignment-in-lieu of foreclosure. It is necessary for the arrangements to permit for the trustee to designate another entity to take position in lieu of the trustee given that the financing structure might rely on the status of borrower-sponsor to maintain the tax-exempt status of the bonds and/or provide other tax benefits. Additionally, such designee needs to be entitled to a new lease to assist in the restructuring of the job upon foreclosure or assignment-in-lieu of foreclosure.


Notice and Opportunity to Cure - any notification of default by the occupant under the ground lease ought to be provided to the trustee, and the trustee needs to have a chance to treatment of a minimum of 1 month. An uncured occasion of default of renter under the ground lease generally grants the lessor the right to terminate the ground lease, which would get rid of the trustee's security. A notification and opportunity to cure enables the trustee to protect its collateral and later on seek reimbursement for such expenditures of debtor under the leasehold mortgage, trust indenture or other bond files.


New Lease - if the ground lease is terminated for any reason, like termination upon default, or is turned down in bankruptcy, the trustee should have the chance to participate in a new lease on the same terms.


No Modification - the ground lease must not be permitted to be modified without the permission of mortgagee, or else the property owner and debtor could modify mortgagee rights and remedies without mortgagee's knowledge or permission.


In our experience representing bondholders, the majority of the ground leases we have actually examined have consisted of the foregoing provisions. As we have come across more intricate financings, we have actually seen the following major concerns:


Cross-Default - the ground lease and sublease should not cross-default with the trust indenture, loan contract or any other bond document (Example: "A default under the Trust Indenture is a default under this Lease ..."). Any event of default under the bond documents need to offer the trustee the chance to work out remedies, not provide the property owner the opportunity to remove the leasehold estate and, as a result, the collateral, unless the trustee cures borrower-sponsor's default.


Third Party Beneficiary - the ground lease and sublease should acknowledge the trustee and any successor trustee as third-party beneficiaries. This can be done by consisting of an arrangement that designates any leasehold mortgagee as a third-party recipient that can implement the arrangement versus the property owner and the tenant. Leasehold mortgagees are not parties to the ground lease, so a third-party recipient designation is required to impose mortgagee securities in the ground lease and sublease against the proprietor and tenant in court. Additionally, if success of the job depends on the property owner and borrower-sponsor meeting particular standards or providing particular services under the ground lease or sublease, the third-party recipient classification is essential for the leasehold mortgagee to enforce those arrangements against the celebrations if they fail to meet expectations.


Borrower Notices and Consents - if the task is a lease-sublease structure where the borrower-sponsor is the occupant under the ground lease and the proprietor under the sublease, the borrower-sponsor must have no authorization rights on any mortgagee matters under the ground lease or the sublease. The borrower-sponsor as ground lease tenant and sublease proprietor is more of a passthrough entity for the task until the bonds are paid, while the borrower-sponsor as developer and manager is a true party-in-interest to the project. Just as developers and supervisors usually do not have permission rights to modifications of the security, the borrower-sponsor ought to not have those permission rights to the mortgage in the project. It grants the borrower-sponsor major leverage in a workout against bondholders. If the borrower-sponsor has authorization rights over mortgages in the sublease, for instance, it could prevent the execution of a mortgage on the subleasehold estate over overdue management and developer fees that are secondary to debt service.


Shared Parcels - the ground lease and sublease ought to be on their own subdivided plot, not part of a larger charge estate parcel. When ground lease jobs become part of a bigger fee estate parcel, the job is at danger of unrelated actions and charges on the fee estate. For circumstances, if a landlord that has actually ground leased part of the charge residential or commercial property to a job, funded by bonds and secured by a leasehold mortgage, chooses to establish the remainder of the residential or commercial property on the cost estate and secure it by a cost mortgage, a foreclosure of that charge mortgage would extinguish the leasehold and subleasehold estates. Similarly, if the proprietor's fee task sustains taxes, utility charges, house owners association costs or other costs that have the potential to end up being "extremely liens" superior to the leasehold estate, a foreclosure of those liens would terminate the ground lease and sublease. If the ground lease and sublease should become part of a larger charge parcel, the ground lease and sublease should (a) require that any mortgage or lien positioned on the cost interest is secondary to the ground lease, (b) need that the proprietor without delay pays any charges or charges that risks the leaseholds, and (c) allow for the borrower-sponsor and the leasehold mortgagee to treat charges on the fee estate and look for reimbursement from the property owner.


Multiple Mortgagees - The ground lease need to acknowledge the potential for numerous mortgagees and prioritize the most senior mortgagee. We have experienced projects with multiple mortgagees where the mortgagees do not have an intercreditor agreement. In those cases, either the secondary mortgagees are subordinate to the senior mortgagees based upon time of recording and the other bond documents, or the secondary mortgagees have a springing security interest that attaches once the senior bonds are settled. Because there is no intercreditor agreement, the offer is quiet as to settlement treatments upon an event of default. Subordinate mortgagees, who typically have a closer relationship with the borrower-sponsor and misaligned interest with the senior mortgagees, too often take the reins working out with landlords in a workout without notifying or speaking with the senior mortgagees. Either the ground lease ought to clarify that the property manager will focus on the most senior protected mortgagee in settlement and dispute resolution, and/or an intercreditor contract with clear standards should be recorded on the project.


Before buying a ground lease job, shareholders should totally comprehend the task and its dangers. While examining the official declaration and engaging with the underwriter, this customer alert must work as a thorough checklist of issues that need to be resolved. In the context of a limited offering, viewpoint buyers of the bonds have leverage to request our suggested modifications to the ground lease. In those deals, many property managers are related celebrations that straight benefit from the conduit funded task. It would generally benefit property owners for the projects to succeed, and a failure to work out in great faith or a termination of the ground lease with a leasehold mortgage would negatively affect their track record and score in the bond market. If any of these defenses are not consisted of when the bonds are issued, it is critical to get them in an exercise as a condition for forbearance or refinancing.