July 01, 2000

Leasehold Financing and Mortgagee Protections (2000, 14:04)

Eugene A. DiPrinzio

Leasehold Financing and Mortgagee Protections

Probate and Property, July/August 2000, Volume 14, Number 4

By Eugene A. DiPrinzio
Eugene A. DiPrinzio is a member of Young Conaway Stargatt & Taylor, LLP in Wilmington, Delaware. He is a member of the Real Property Division's Sports, Entertainment, Gaming and Related Real Estate Issues (H-2), Mortgage Loan Structure and Origination (I-1) and Loan Practices and Lender Liability (I-2) Committees.  

Leasehold mortgage financing, by its nature, is a complicated form of lending. It involves the competing interests of landlords, their fee mortgagees, tenants and their leasehold lenders. From a transactional perspective, the challenge is to strike a balance among these competing interests. Leasehold mortgage financing can take several different forms, such as recourse and nonrecourse types. The financing may require subordinated or unsubordinated lien positions on the possessory interests of the ground lease. Although leasehold mortgage financing could be the subject of an entire treatise, this article is concerned solely with the perspective of a leasehold mortgagee interested in financing a ground lease. The mortgagee protections suggested here are not intended to be exhaustive but are meant to demonstrate the basic issues that are usually at the top of each leasehold mortgage lender's priority list.

Pre-Leasing and Post-Leasing Considerations

In a perfect world, every lender's counsel would like the opportunity to negotiate specific mortgagee protections before or coincident with the negotiation of the underlying ground lease. It is clearly easier to negotiate the terms of a tenant's financing arrangements and the lender's requirements before the ground lease is consummated. Too often, however, lender's counsel is presented with a ground lease that has already been negotiated and executed by the parties. Lender's counsel is then faced with an uphill battle to make changes or amendments and force a new negotiation to add mortgagee protection provisions.

The number and type of provisions or amendments that may be necessary to effect leasehold mortgage financing are unique to each ground lease. If experienced real estate counsel drafted a ground lease, many of the protective provisions may already have been anticipated or addressed, making the overall financing process that much easier. Counsel to a leasehold mortgagee should carefully review a ground lease document, as a whole, from the tenant's perspective and make sure that specific tenant protections safeguard the possessory interest. Lender's counsel should carefully review the status of title to the underlying fee to confirm the landlord's ownership and the suitability of any miscellaneous exceptions. It is also critical to examine any fee mortgages to confirm that the ground lease is permitted and to determine what rights, if any, the fee mortgagee has relative to tenants in possession.

The goal is to secure the leasehold lender's benefits in the event of a termination of the underlying ground lease. The relative bargaining strengths of the interested parties play a significant role in how the eventual negotiation is concluded. For example, a "national credit" tenant can strongly influence the level of mortgagee protections that must be inserted in the ground lease. Lender's counsel will usually insist on subordination of the ground lease to the leasehold mortgage or deed of trust. Nevertheless, the issue does not turn on "true subordination" but rather on the number of protections granted to the leasehold mortgagee.

Illustrative Case: Glendale Federal Bank v. Hadden

The failure of a leasehold mortgagee to insist on a minimum level of protection in the underlying ground lease can result in the loss of the mortgagee's lien rights as well as a collateral assignment of the possessory interest. In Glendale Federal Bank v. Hadden, 87 Cal. Rptr. 2d 102 (Cal. Ct. App. 1999), a leasehold mortgagee (a beneficiary of a deed of trust) had no right to cure a tenant's default in the ground lease. When the tenant defaulted, the landlord terminated the tenant's leasehold estate and did not join the leasehold mortgagee in the unlawful detainer action. The leasehold mortgagee then sought declaratory relief that it maintained an interest in the extinguished leasehold. The landlord successfully moved for summary judgment.

On appeal, the California appeals court held that the leasehold mortgagee was not an indispensable party to the unlawful detainer action and had forfeited i ts interest in the leasehold when the lease was terminated because of the tenant's default. The court stated that the leasehold mortgagee acquired its lien with notice of the ground lease provisions, including the provision for forfeiture in case of nonpayment of rent. It also held that the leasehold mortgagee's collateral assignment of possessory interest would become worthless if the ground lease were terminated because of a default. The court noted that the leasehold mortgagee could have protected itself against termination of the leasehold interest by negotiating an agreement with the landlord or by obtaining an amendment to the lease.

Collateral Assignment-Sample Mortgagee Protections

 In the case of a ground lease that has already been negotiated and executed, the tenant's lender typically requires a collateral agreement or collateral assignment of the ground lease providing for, among other things, the lender's right to cure any tenant default under the ground lease, appropriate notice provisions, exculpation of the lender from liability to the landlord and the exercise of lender's possessory rights. Even a fairly simple collateral assignment of ground lease containing these fundamental mortgagee protections might have prevented the result in the Glendale case.

In most cases, lender's counsel will need to determine from the client the most important protective provisions to accomplish the lender's underwriting standards. Sometimes a lender will maintain a checklist of these provisions. Such a checklist may include some, if not all, of the following: 

  • terms for the subordination of the ground lease to the lender's leasehold mortgage lien; 
  • consistency for handling proceeds from condemnation and casualty loss between the ground lease and the leasehold mortgage; 
  • forms of, and time periods for, notice between the parties including fee mortgagees and other third parties for events of default or claims; 
  • logistics for cure or reinstatement of the ground lease; 
  • a designation of future acceptable fee mortgagees (e.g., institutional or non-institutional); 
  • rights of the leasehold mortgagee to require a new lease with the landlord after termination of the original ground lease; 
  • a leasehold mortgagee's right to exercise renewal rights or options; 
  • the handling of voluntary or involuntary prepayments of the leasehold mortgage occasioned by condemnation or casualty loss; 
  • a transfer restriction on the fee estate, so that the tenant does not acquire the fee estate directly or indirectly through an affiliate and thereafter force the leasehold mortgagee into a weakened position; 
  • rights of the leasehold mortgagee to participate in any litigation proceedings, such as the unlawful detainer action in Glendale; 
  • a leasehold mortgagee's right of quiet enjoyment, in case the leasehold mortgagee activates the collateral assignment; 
  • a prohibition against amendment, modification or termination of the ground lease without the leasehold mortgagee's prior written consent; 
  • a leasehold mortgagee's right of access or use of a reciprocal or offsite easement, in case it activates the collateral assignment; 
  • a leasehold mortgagee's right to preserve subleases or assignment rights; 
  • payments under protest and bonding off of liens; 
  • bankruptcy and its effects; 
  • transfers by a lender to third parties of the possessory leasehold and the expansion of use provisions; 
  • an application of escrowed payments; 
  • durable powers of attorney to allow the leasehold mortgagee to act; and 
  • estoppel provisions, security deposits and the leasehold mortgagee's rights and remedies pre-and post-default.

Although the foregoing is not intended to be exhaustive, it should provide a reasonable checklist from which lender's counsel may cross-check provisions in the ground lease that may need to be supplemented or amended. More particular attention should be placed on these provisions if the collateral includes personal property or equipment and not just real estate interests. Specific state laws may require special sheriff sales or other commercially reasonable disposition of personal property collateral.

The Role of Leasehold Title Insurance

Leasehold title insurance can provide additional leasehold mortgagee protection. Similar in nature to, but different from, lender's coverages on fee interests, leasehold title insurance defines loss or damage differently from the typical owner's or loan policy. A leasehold policy redefines the value of the leasehold estate and adds certain items of loss not found in an owner's or loan policy. A leasehold policy contains all of the same protections, exclusions from coverage and conditions and stipulations found in a fee owner's or loan policy, but also contains the following additional items.

  • Valuation of insured estate. The value of a leasehold estate is defined as the difference between the fair market rental value (undiminished by claimed title defects) and the rent reserved to the lease, all brought to present value. 
  • Miscellaneous items of loss. In addition to the lost value of the leasehold estate, the following items are included as part of loss or damage: 
  • the cost of removing, relocating and repairing the insured's personal property within a 25 mile radius;
  • rent or use and occupancy payments that the insured may be obligated to pay a party having paramount title to that of the landlord; 
  • post-eviction rent that the insured may be obligated to continue to pay the landlord for the land from which the insured has been evicted; 
  • fair market value of the insured's interest in any subleases; and 
  • damages that the insured may be obligated to pay a sublessee for breach of a sublease.

It is important to note that the leasehold estate is valued at the time of loss and not at the time of entering into the lease. A leasehold mortgagee will typically suffer a greater loss later in the lease term, especially if the fair market value of the leasehold is increasing more than the rent. Coverage for cost of defense and consequential damages flowing from an unlawful termination of a ground lease gives comfort to the leasehold mortgagee under an appropriate leasehold loan policy.

Conclusion

It may be an impossible task to protect a leasehold mortgagee adequately from losing the possessory leasehold interest that it contemplated as security at the time of loan origination. Nevertheless, certain minimum provisions should be negotiated by lender's counsel to address the issues that are viewed as critically important to the lender. Notice and opportunity to cure a tenant default, as well as the ability to obtain a new lease to protect the improvements financed, should be top priorities in both a pre- and post-ground lease negotiation. Although the sheer breadth of issues presented is enough to make any counsel wary about the scope of these transactions, items such as leasehold title insurance and collateral assignments provide some level of leasehold mortgagee protection. Just how much protection (if indeed "protection" is the correct nomenclature) is the primary question to resolve in each deal.

Eugene A. DiPrinzio