Ground Lease Risks In Municipal Bond Projects - turk

Most of the jobs involve tax-exempt lessor structures. Since government entities and nonprofit companies are exempt from genuine residential or commercial property taxes in a lot of jurisdictions, a ground lease between such entities and a borrower-sponsor supplies a task 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 substantial savings over the life of a project.

In greater education, universities normally use channel financed ground lease structures to develop trainee housing tasks. These jobs consist of a ground lease in 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 repayment of the bonds and the mortgage is on the leasehold, the university can construct a task on campus without sustaining debt and keep the project for complimentary once the ground lease is terminated. During the term of the ground lease, the arrangements of the ground lease supplies a method for the university to control or monitor the task and get an annual ground lease rent.

In other markets, the provider typically owns the land and ground rents the land on which the project is to be constructed to the borrower-sponsor, who constructs the project and subleases it back to the issuer. Such a job qualifies for a genuine residential or commercial property tax exemption due to the fact that it is owned by a federal government entity, and since the federal government entity is likewise renter under the sublease, the job receives sales tax exemptions on products throughout building. The company, as renter under the sublease, is accountable for payment of the bonds, while the borrower-sponsor develops and runs the task pursuant to conditions of agreements with the issuer. The borrower-sponsor typically has an opportunity to purchase the land and project when the bonds are paid.

These structures present distinct risks to bond purchasers. The bonds are normally protected by mortgages on the leasehold and/or subleasehold estates. Bondholders must be conscious of the rights of celebrations to terminate the ground lease or interfere with their ability to exercise remedies. If the ground lease is ended or the trustee can not acquire the job, the matching lien on the physical task is snuffed out and the collateral bundle has no worth.

With that in mind, bondholders need to seek the following securities in any ground lease that becomes part of a local bond financing:

Term - the term of the ground lease ought to be at least 5 years beyond the maturity date of the bonds, and shareholders need to press for more if at all possible. The additional 5 or more years permits for a workout and extension of the regard to the bonds in the event it is needed to allow the job to capital to cover business expenses and debt service. If the bonds on a task have a bullet maturity, the term of the ground lease need to be at least double the regard to the bonds to enable a refunding of the maturing bonds.

Authorization - the ground lease ought to clearly license the borrower-sponsor to incur 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 need to be assignable by the trustee without constraints. Failure to consist of 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 important for the arrangements to enable the trustee to designate another entity to take position in lieu of the trustee given that the funding structure might count on the status of borrower-sponsor to maintain the tax-exempt status of the bonds and/or offer other tax benefits. Additionally, such designee must be entitled to a brand-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 renter under the ground lease need to be supplied to the trustee, and the trustee should have an opportunity to treatment of a minimum of 1 month. An uncured occasion of default of occupant under the ground lease generally gives the lessor the right to end the ground lease, which would eliminate the trustee's collateral. A notice and opportunity to cure allows the trustee to preserve its collateral and later look for repayment for such expenditures of debtor under the leasehold mortgage, trust indenture or other bond documents.

New Lease - if the ground lease is ended for any factor, like termination upon default, or is rejected in bankruptcy, the trustee must have the opportunity to get in into a brand-new lease on the exact same terms.

No Modification - the ground lease need to not be allowed to be modified without the authorization of mortgagee, or else the landlord and customer could customize mortgagee rights and remedies without mortgagee's knowledge or permission.

In our experience representing bondholders, the majority of the ground leases we have reviewed have included the foregoing arrangements. As we have actually experienced more intricate 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 contract 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 documents must offer the trustee the opportunity to exercise solutions, not offer the property manager 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 ought to acknowledge the trustee and any successor trustee as third-party beneficiaries. This can be done by consisting of a provision that designates any leasehold mortgagee as a third-party beneficiary that can enforce the contract against the landlord 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 versus the landlord and renter in court. Additionally, if success of the job depends on the property manager and borrower-sponsor meeting specific standards or providing particular services under the ground lease or sublease, the third-party recipient classification is needed for the leasehold mortgagee to impose those arrangements versus the parties if they stop working to fulfill 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 tenant and sublease proprietor is more of a passthrough entity for the project up until the bonds are paid, while the borrower-sponsor as designer and supervisor is a real party-in-interest to the job. Just as developers and managers normally do not have consent rights to adjustments of the security, the borrower-sponsor should not have those approval rights to the mortgage in the project. It grants the borrower-sponsor severe utilize in a workout versus bondholders. If the borrower-sponsor has approval rights over mortgages in the sublease, for example, it could avoid the execution of a mortgage on the subleasehold estate over unsettled management and designer fees that are secondary to financial obligation service.

Shared Parcels - the ground lease and sublease must be on their own subdivided plot, not part of a larger charge estate parcel. When ground lease projects belong to a bigger cost estate parcel, the task is at threat of unrelated actions and charges on the fee estate. For example, if a proprietor that has ground rented part of the cost residential or commercial property to a project, moneyed by bonds and protected by a leasehold mortgage, decides to develop the rest of the residential or commercial property on the cost estate and secure it by a fee mortgage, a foreclosure of that charge mortgage would snuff out the leasehold and subleasehold estates. Similarly, if the property manager's fee task sustains taxes, energy charges, homeowners association costs or other expenses that have the possible 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 need to belong to a bigger charge parcel, the ground lease and sublease ought to (a) require that any mortgage or lien put on the cost interest is subordinate to the ground lease, (b) require that the property manager without delay pays any charges or fees that risks the leaseholds, and (c) permit the borrower-sponsor and the leasehold mortgagee to cure charges on the fee estate and seek reimbursement from the property manager.

Multiple Mortgagees - The ground lease should recognize the capacity for numerous mortgagees and focus on the most senior mortgagee. We have actually encountered tasks with numerous mortgagees where the mortgagees do not have an intercreditor contract. In those cases, either the secondary mortgagees are secondary to the senior mortgagees based on time of recording and the other bond documents, or the subordinate mortgagees have a springing security interest that connects when the senior bonds are settled. Because there is no intercreditor arrangement, the deal is quiet as to settlement procedures upon an event 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 an exercise without notifying or consulting the senior mortgagees. Either the ground lease should clarify that the landlord will prioritize the most senior protected mortgagee in negotiation and conflict resolution, and/or an intercreditor contract with clear guidelines ought to be taped on the job.

Before buying a ground lease job, bondholders should fully understand the job and its dangers. While reviewing the official declaration and engaging with the underwriter, this customer alert must work as a comprehensive checklist of issues that must be resolved. In the context of a minimal offering, point of view purchasers of the bonds have utilize to request our suggested changes to the ground lease. In those deals, most landlords relate celebrations that straight take advantage of the avenue financed job. It would typically benefit property managers for the jobs to succeed, and a failure to negotiate in good faith or a termination of the ground lease with a leasehold mortgage would negatively impact their credibility and score in the bond market. If any of these defenses are not consisted of when the bonds are provided, it is vital to get them in a workout as a condition for forbearance or refinancing.