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Ground Lease Risks In Municipal Bond Projects

The bulk of the jobs involve tax-exempt lessor structures. Since federal government entities and nonprofit companies are exempt from genuine residential or commercial property taxes in many jurisdictions, a between such entities and a borrower-sponsor provides a project the opportunity to either be exempt from residential or commercial property taxes or subject to a payment-in-lieu of taxes arrangement, both of which can offer considerable savings over the life of a job.

In higher education, universities usually utilize conduit financed ground lease structures to build student housing projects. These tasks consist of a ground lease between a university, as property owner, and the borrower-sponsor, as tenant. The university agrees to the ground lease due to the fact that, since the borrower-sponsor is accountable for repayment of the bonds and the mortgage is on the leasehold, the university can construct a task on campus without incurring financial obligation and keep the project free of charge once the ground lease is terminated. During the term of the ground lease, the provisions of the ground lease offers a means for the university to regulate or supervise the project and get an annual ground lease rent.

In other industries, the provider typically owns the land and ground rents the land on which the job is to be built to the borrower-sponsor, who constructs the task and subleases it back to the provider. Such a task certifies for a real residential or commercial property tax exemption due to the fact that it is owned by a federal government entity, and given that the federal government entity is also tenant under the sublease, the task gets approved for sales tax exemptions on materials throughout construction. The issuer, as renter under the sublease, is responsible for payment of the bonds, while the borrower-sponsor develops and runs the project pursuant to terms of arrangements with the issuer. The borrower-sponsor typically has an opportunity to purchase the land and job once the bonds are paid.

These structures present special dangers to bond purchasers. The bonds are typically protected by mortgages on the leasehold and/or subleasehold estates. Bondholders must be conscious of the rights of parties to terminate the ground lease or interfere with their ability to work out remedies. If the ground lease is terminated or the trustee can not take possession of the project, the corresponding lien on the physical project is snuffed out and the collateral bundle has no value.

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

Term – the term of the ground lease ought to be at least five years beyond the maturity date of the bonds, and shareholders should press for more if at all possible. The additional five or more years permits a workout and extension of the regard to the bonds in the event it is needed to permit the task to money flow to cover operating costs and financial obligation service. If the bonds on a job have a bullet maturity, the term of the ground lease must be at least double the regard to the bonds to allow for a refunding of the growing bonds.

Authorization – the ground lease must clearly authorize 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 ought to be assignable by the trustee without constraints. Failure to consist of such provisions could prevent 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 the trustee to designate another entity to take position in lieu of the trustee since the funding structure may depend on the status of borrower-sponsor to preserve the tax-exempt status of the bonds and/or supply other tax advantages. Additionally, such designee ought to be entitled to a brand-new lease to assist in the restructuring of the task upon foreclosure or assignment-in-lieu of foreclosure.

Notice and Opportunity to Cure – any notice of default by the renter under the ground lease must be provided to the trustee, and the trustee ought to have a chance to cure of at least thirty days. An uncured occasion of default of renter under the ground lease generally approves the lessor the right to terminate the ground lease, which would remove the trustee’s collateral. A notice and chance to treat enables the trustee to preserve its collateral and later look for reimbursement for such expenditures of borrower under the leasehold mortgage, trust indenture or other bond files.

New Lease – if the ground lease is terminated for any factor, like termination upon default, or is turned down in personal bankruptcy, the trustee ought to have the opportunity to get in into a new lease on the same terms.

No Modification – the ground lease ought to not be permitted to be customized without the authorization of mortgagee, or else the property owner and customer might customize mortgagee rights and treatments without mortgagee’s knowledge or consent.

In our experience representing bondholders, the majority of the ground rents we have actually reviewed have consisted of the foregoing provisions. As we have actually experienced more complicated fundings, we have actually seen the following severe concerns:

Cross-Default – the ground lease and sublease need to not cross-default with the trust indenture, loan arrangement or any other bond file (Example: “A default under the Trust Indenture is a default under this Lease …”). Any occasion of default under the bond files must offer the trustee the possibility to work out treatments, not provide the property owner the opportunity to eliminate the leasehold estate and, as a result, the collateral, unless the trustee treatments borrower-sponsor’s default.

Third Party Beneficiary – the ground lease and sublease ought to recognize the trustee and any successor trustee as third-party recipients. This can be done by consisting of a provision that designates any leasehold mortgagee as a third-party beneficiary that can enforce the arrangement against the property owner and the renter. Leasehold mortgagees are not parties to the ground lease, so a third-party recipient designation is required to enforce mortgagee securities in the ground lease and sublease against the landlord and tenant in court. Additionally, if success of the project is reliant on the proprietor and borrower-sponsor meeting certain standards or using certain services under the ground lease or sublease, the third-party beneficiary designation is necessary for the leasehold mortgagee to impose those provisions versus the celebrations if they stop working to fulfill expectations.

Borrower Notices and Consents – if the project is a lease-sublease structure where the borrower-sponsor is the renter under the ground lease and the landlord under the sublease, the borrower-sponsor ought to have no permission rights on any mortgagee matters under the ground lease or the sublease. The borrower-sponsor as ground lease occupant and sublease property owner is more of a passthrough entity for the project till the bonds are paid, while the borrower-sponsor as developer and supervisor is a real party-in-interest to the job. Just as designers and supervisors typically do not have consent rights to modifications of the collateral, the borrower-sponsor needs to not have those approval rights to the mortgage in the project. It gives the borrower-sponsor severe utilize in a workout versus shareholders. If the borrower-sponsor has permission rights over mortgages in the sublease, for instance, it could avoid the execution of a mortgage on the subleasehold estate over overdue management and designer fees that are subordinate to financial obligation service.

Shared Parcels – the ground lease and sublease ought to be on their own partitioned plot, not part of a bigger cost estate parcel. When ground lease jobs are part of a bigger fee estate parcel, the task is at risk of unassociated actions and charges on the charge estate. For circumstances, if a landlord that has actually ground rented part of the fee 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 charge estate and protect it by a charge mortgage, a foreclosure of that cost mortgage would extinguish the leasehold and subleasehold estates. Similarly, if the property manager’s cost task incurs taxes, energy charges, homeowners association charges or other expenses that have the prospective to become “extremely liens” superior to the leasehold estate, a foreclosure of those liens would end the ground lease and sublease. If the ground lease and sublease need to be part of a larger cost parcel, the ground lease and sublease must (a) need that any mortgage or lien put on the fee interest is subordinate to the ground lease, (b) require that the landlord promptly pays any charges or costs that runs the risk of the leaseholds, and (c) allow for the borrower-sponsor and the leasehold mortgagee to cure charges on the cost estate and look for compensation from the proprietor.

Multiple Mortgagees – The ground lease must acknowledge the potential for multiple mortgagees and prioritize the most senior mortgagee. We have actually come across tasks with multiple mortgagees where the mortgagees do not have an intercreditor agreement. In those cases, either the subordinate mortgagees are secondary to the senior mortgagees based upon time of recording and the other bond files, or the subordinate mortgagees have a springing security interest that attaches once the senior bonds are paid off. Because there is no intercreditor contract, the offer is silent as to settlement treatments upon an event of default. Subordinate mortgagees, who usually have a closer relationship with the borrower-sponsor and misaligned interest with the senior mortgagees, too typically take the reins negotiating with property owners in an exercise without informing or speaking with the senior mortgagees. Either the ground lease ought to clarify that the property owner will prioritize the most senior secured mortgagee in settlement and disagreement resolution, and/or an intercreditor agreement with clear guidelines should be recorded on the project.

Before investing in a ground lease project, bondholders need to totally understand the task and its risks. While examining the main declaration and engaging with the underwriter, this customer alert should act as a thorough checklist of issues that need to be addressed. In the context of a limited offering, perspective buyers of the bonds have take advantage of to request our recommended modifications to the ground lease. In those deals, most proprietors are associated celebrations that directly gain from the conduit financed task. It would usually benefit property owners for the projects to succeed, and a failure to work out in excellent faith or a termination of the ground lease with a leasehold mortgage would adversely affect their track record and score in the bond market. If any of these protections are not included when the bonds are provided, it is crucial to acquire them in a workout as a condition for forbearance or refinancing.