Ground Lease Risks In Municipal Bond Projects

The majority of the jobs involve tax-exempt lessor structures. Since federal government entities and nonprofit organizations are exempt from genuine residential or commercial property taxes in many jurisdictions, a ground lease between such entities and a borrower-sponsor offers 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 significant savings over the life of a project.

In college, universities typically utilize channel financed ground lease structures to construct trainee housing tasks. These jobs consist of a ground lease between a university, as landlord, and the borrower-sponsor, as renter. The university accepts the ground lease since, considering that the borrower-sponsor is accountable for payment of the bonds and the mortgage is on the leasehold, the university can build a project on school without sustaining financial obligation and keep the project free of charge once the ground lease is terminated. During the regard to the ground lease, the provisions of the ground lease offers a method for the university to manage or the job and receive a yearly ground lease rent.

In other markets, the company often owns the land and ground leases the land on which the project is to be developed to the borrower-sponsor, who constructs the job and subleases it back to the company. Such a project qualifies for a genuine residential or commercial property tax exemption because it is owned by a federal government entity, and because the government entity is likewise occupant under the sublease, the job receives sales tax exemptions on products during building and construction. The issuer, as tenant under the sublease, is accountable for payment of the bonds, while the borrower-sponsor establishes and operates the job pursuant to terms and conditions of agreements with the company. The borrower-sponsor generally has a chance to buy the land and task as soon as the bonds are paid.

These structures present distinct risks to bond purchasers. The bonds are typically secured by mortgages on the leasehold and/or subleasehold estates. Bondholders ought to be mindful of the rights of parties to terminate the ground lease or disrupt their capability to work out treatments. If the ground lease is ended or the trustee can not acquire the project, the corresponding lien on the physical task is snuffed out and the security package has no worth.

With that in mind, bondholders must seek the following protections in any ground lease that becomes part of a municipal bond financing:

Term – the regard to the ground lease need to be at least five years beyond the maturity date of the bonds, and bondholders ought to push for more if at all possible. The extra five or more years allows for a workout and extension of the term of the bonds in case it is needed to permit the project 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 should be at least double the term of the bonds to enable a refunding of the developing bonds.

Authorization – the ground lease should clearly authorize the borrower-sponsor to incur a mortgage on the ground lease or else a court would consider the lien on the leasehold estate void.

Transfer and Assignment – the ground lease ought to be assignable by the trustee without constraints. Failure to include such provisions might avoid a mortgagee from selling or transferring the leasehold estate (by sale or otherwise) upon foreclosure or the execution of an assignment-in-lieu of foreclosure. It is necessary for the provisions to allow for the trustee to designate another entity to take position in lieu of the trustee considering that the funding structure might count on the status of borrower-sponsor to protect the tax-exempt status of the bonds and/or provide other tax advantages. Additionally, such designee must be entitled to a brand-new lease to aid in the restructuring of the job upon foreclosure or assignment-in-lieu of foreclosure.

Notice and Opportunity to Cure – any notice of default by the tenant under the ground lease need to be provided to the trustee, and the trustee must have an opportunity to treatment of a minimum of 1 month. An uncured occasion of default of tenant under the ground lease usually 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 permits the trustee to preserve its collateral and later seek compensation for such costs of customer under the leasehold mortgage, trust indenture or other bond documents.

New Lease – if the ground lease is terminated for any reason, like termination upon default, or is declined in insolvency, the trustee must have the opportunity to enter into a new lease on the same terms.

No Modification – the ground lease ought to not be permitted to be modified without the permission of mortgagee, otherwise the property owner and debtor might modify mortgagee rights and solutions without mortgagee’s knowledge or consent.

In our experience representing shareholders, the majority of the ground leases we have actually examined have actually consisted of the foregoing arrangements. As we have actually encountered more complicated financings, we have actually seen the following serious issues:

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 event of default under the bond files must supply the trustee the possibility to work out remedies, not offer the property manager the opportunity to get rid of the leasehold estate and, as a result, the security, unless the trustee remedies borrower-sponsor’s default.

3rd Party Beneficiary – the ground lease and sublease should recognize the trustee and any successor trustee as third-party recipients. This can be done by including 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 celebrations to the ground lease, so a third-party recipient designation is required to enforce mortgagee defenses in the ground lease and sublease against the proprietor and renter in court. Additionally, if success of the task depends on the property manager and borrower-sponsor meeting specific standards or providing specific services under the ground lease or sublease, the third-party beneficiary designation is essential for the leasehold mortgagee to impose those provisions versus the celebrations if they stop working to meet expectations.

Borrower Notices and Consents – if the job is a lease-sublease structure where the borrower-sponsor is the occupant under the ground lease and the property manager under the sublease, the borrower-sponsor should have no authorization rights on any mortgagee matters under the ground lease or the sublease. The borrower-sponsor as ground lease occupant and sublease proprietor is more of a passthrough entity for the job until the bonds are paid, while the borrower-sponsor as designer and supervisor is a true party-in-interest to the task. Just as developers and supervisors usually do not have permission rights to modifications of the collateral, the borrower-sponsor should not have those authorization rights to the mortgage in the project. It gives the borrower-sponsor serious take advantage of in a workout against bondholders. If the borrower-sponsor has approval rights over mortgages in the sublease, for example, it might prevent the execution of a mortgage on the subleasehold estate over unpaid management and designer fees that are subordinate to debt service.

Shared Parcels – the ground lease and sublease should be on their own partitioned plot, not part of a larger fee estate parcel. When ground lease jobs are part of a larger fee estate parcel, the project is at danger of unassociated actions and charges on the cost estate. For instance, if a property manager that has ground rented part of the charge residential or commercial property to a job, funded by bonds and protected by a leasehold mortgage, chooses to establish the rest of the residential or commercial property on the charge estate and protect it by a charge mortgage, a foreclosure of that charge mortgage would extinguish the leasehold and subleasehold estates. Similarly, if the property owner’s charge job sustains taxes, utility charges, property owners association fees or other costs that have the prospective to end up being “extremely liens” exceptional to the leasehold estate, a foreclosure of those liens would end the ground lease and sublease. If the ground lease and sublease should belong to a larger fee parcel, the ground lease and sublease must (a) require that any mortgage or lien put on the charge interest is secondary to the ground lease, (b) need that the proprietor without delay pays any charges or fees that risks the leaseholds, and (c) allow for the borrower-sponsor and the leasehold mortgagee to cure charges on the cost estate and look for reimbursement from the property owner.

Multiple Mortgagees – The ground lease should acknowledge the capacity for multiple mortgagees and prioritize the most senior mortgagee. We have actually 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 as soon as the senior bonds are paid off. Because there is no intercreditor arrangement, the deal is silent regarding settlement procedures upon an occasion of default. Subordinate mortgagees, who normally have a closer relationship with the borrower-sponsor and misaligned interest with the senior mortgagees, frequently take the reins working out with proprietors in a workout without alerting or speaking with the senior mortgagees. Either the ground lease ought to clarify that the proprietor will prioritize the most senior secured mortgagee in negotiation and disagreement resolution, and/or an intercreditor agreement with clear standards should be recorded on the project.

Before buying a ground lease task, shareholders should completely understand the task and its dangers. While evaluating the official declaration and engaging with the underwriter, this customer alert need to serve as a detailed list of problems that must be attended to. In the context of a minimal offering, point of view purchasers of the bonds have take advantage of to request our recommended modifications to the ground lease. In those deals, the majority of proprietors relate celebrations that directly benefit from the conduit funded project. It would typically benefit property owners for the projects to be successful, and a failure to work out in good faith or a termination of the ground lease with a leasehold mortgage would negatively affect their credibility and ranking in the bond market. If any of these defenses are not included when the bonds are issued, it is vital to get them in an exercise as a condition for forbearance or refinancing.